Treaty Shopping and GAAR: To be or not to be

In late 2004, Canada extended the application of Canada’s general antiavoidance rule (GAAR) to Canada’s tax treaties. Basically, section 245, which contains the GAAR rule, was retroactively amended to make explicit reference to tax treaties Taking into account the uncertainty surrounding the application and compatibility of GAAR in the field of tax treaties, any case-law in this area is helpful, not only to discuss this issues, but also to determine whether GAAR is an effective tool to counter abusive tax Treaty transactions.

In a very recent case decided by the Tax Court of Canada (MIL (Investments) S A v. The Queen), a Luxemburg company was able to claim for an exemption under the previous Canada-Luxembourg income tax treaty on capital gains derived from the sale of shares, notwithstanding the Canadian tax authorities claim that the Canada's GAAR or even an "inherent anti-abuse rule" in the Treaty denied the benefits of the said exemption.

The facts of the case involve a series of (rather complex) transactions, namely (i) the acquisition by a Cayman Islands incorporated company (MIL) of shares of a Canadian company (DFR), (ii) exchange of DFR shares for shares of another Canadian public company (INCO) by MIL reducing the shareholding of MIL in DFR to just less than 10%; (iii) the transfer of the place of effective management of MIL from Cayman to Luxemburg; and (iv) the sale to INCO by MIL of DFR shares, amounting to a sale of shares representing less than 10 percent.

According to Paragraph 4 of Article 13 of the Canada-Luxembourg income tax treaty, capital gains derived by a resident of Luxemburg (MIL) from the alienation of shares (other than shares listed on an approved stock exchange in the other Contracting State) forming part of a substantial interest (i.e. 10% or more) in a Canadian company may be taxed in Canada. Nevertheless, in this case the sale of shares was just below the 10% threshold. As such, paragraph 5 of the same article was applicable, determining that capital gains from the alienation of shares were taxable only in Luxemburg, namely the country where the alienator is a tax resident.

In first place the Canadian tax authorities attempted to apply the Canada's GAAR (i.e. Section 245) in order to deny the treaty exemption. In that regard, the Tax Court made a number of interesting findings in the course of deciding that the GAAR did not apply to deny the treaty exemption.

According to the Court, the application of the Canadian GAAR involves three steps. The first step is to determine whether it is a 'tax benefit' arising from a 'transaction'. The second step is to determine whether the transaction is an avoidance transaction, in the sense of not being 'arranged primarily for bona fide purposes other than to obtain the tax benefit. The third step is to determine whether the avoidance transaction is abusive. All three requirements must be fulfilled before GAAR can be applied to deny a tax benefit.

In this case there was no discussion as to whether the treaty exemption afforded the Luxemburg company a “tax benefit”, but instead whether the transactions taken by the taxpayer qualified as an “avoidance transaction”.

In that regard, the court noted that if there are both tax and non-tax purposes to a transaction, it must be determined whether it was reasonable to conclude that the non-tax purpose was primary. If so, the GAAR cannot be applied to deny the tax benefit. In this case and after careful and long examination, MIL was said to have a bona fide commercial reason for selling the shares.

As to the transfer of place of effective management to Luxemburg, The Court considered that MIL continuance into Luxembourg was commercially justified because it was a better jurisdiction than the Cayman Islands from which to carry on a mining business in Africa and that there was sufficient business presence in Luxemburg to demonstrate that fact.

Having considered that both the sale and underlying transactions were not avoidance transactions, the issue whether any of those transactions was abusive was no longer necessary. Nevertheless, the Tax Court considered whether the tax treaty exemptions relied upon by MIL were abusive in the context of the GAAR.

As regards the choice of Luxemburg as the (new) place of residence of the holding, the court noted that here is nothing inherently proper or improper with selecting one foreign regime over another. The Court stated that, although the selection of a low tax jurisdiction may speak persuasively as evidence of a tax purpose for an alleged avoidance transaction, the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive.

The Court further noted that one must examine the treaty in question and in this case the general rule, contained in Art. 13(5) of the Treaty, is that capital gains on the sale of shares are taxable only in the country in which the taxpayer is resident (i.e. Luxembourg). An exception is only made (allowing Canada also to tax) for capital gain on the sale of shares amounting to a substantial interest (10% or more).

The Court noted that the reliance by MIL (Luxemburg resident company) on the treaty provision agreed upon by both Canada and Luxembourg couldn’t be viewed as being a misuse or abuse. In fact, if Canada concern was directed to the use of preferable tax rates by any of its treaty partners, the Court recommended the (more difficult) option of renegotiate the treaty, instead of attempting to apply the GAAR provision!

The tax authorities presented an alternative line of argumentation that even if the GAAR would not apply to deny the treaty benefit, it is still possible to deny the treaty benefits based on the anti-abuse rule inherent within the Tax Treaty itself. For that purpose, the Canadian Tax Authorities relied on an expert from Luxembourg, namely Prof. Dr. Alain Steichen.

Accordingly, inherent anti-abuse test considers that that a specific Treaty benefit may be denied in situations where both domestic anti-avoidance rules (i.e. Canada and Luxembourg) would deny that benefit. As such, it would be important also to consider the "reversed scenario" in which MIL continued into Canada from the Cayman Islands in order to use the Treaty. In order to establish the inherent anti-abuse rule, reference was made to international legal principles, namely the Vienna Convention on the Law Treaties and the OECD Commentaries.

The expert mentioned that neither Art. 13 nor any other article appears to be providing for a specific anti-treaty shopping provision eventually explicitly authorizing Luxembourg under the reversed scenario to deny the Treaty Benefits under Article 13(5). Only the preamble, which refers to the prevention of fiscal evasion, could be relied upon. Nevertheless, the expert considered that such reference does not constitute an anti-treaty shopping provision on which Luxembourg could rely upon in order to deny Treaty benefits.

When considering the proper Treaty interpretation, the expert mentioned that only in case of ambiguity under the Treaty, one should refer to other principles in international public law to confer the proper meaning of the Treaty. Accordingly, the expert considered that silence in a Treaty equals ambiguity and such ambiguity could be avoided by writing in the Treaty that local GAAR cannot affect the validity of the application of the Treaty. The expert noted that such inclusion would be a clear statement, in which case one would not have to argue about whether that implicit anti-abuse provision exists or not. Furthermore, the tax authorities presented the 2003 revisions to the OECD commentary as support for the existence of an inherent anti-abuse rule in tax treaties.

As regards the inherent anti-abuse rule, the tax court considered the expert’s opinion unconvincing, in light of the OECD commentary and the decision not to include an explicit reference to anti-avoidance rules in the said Treaty. The Tax Court relied on "ordinary meaning" of the Treaty and found no ambiguity in the Treaty permitting it to be construed as containing an inherent anti-abuse rule. In conclusion, the claim of MIL for capital gains exemption under Art. 13(5) of the Canada-Luxembourg Tax Treaty was allowed.

Note
Following the 2003 revisions to the OECD commentary, this case is perhaps one of the first in a series of expected cases (in countries which apply a GAAR or substance-over-form rules) dealing with issue of tax treaties and domestic anti-abuse rules.

It is widely discussed by scholars (without sometimes reaching any meaningful conclusion) whether tax treaties preclude the application of domestic anti-abuse or substance-over-form rules. This problem was further emphasized by 2003 revisions to the OECD Commentaries that support the tax authorities view on the subject. Accordingly, Para. 9.2 of the Commentary on Art. 1 of the OECD Model Tax Convention. states that “(...) the answer to that second question [i.e. whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law], is that to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them.”

Albeit the victory of the taxpayer, this case demonstrates the willingness of tax authorities to push the boundaries of domestic anti-abuse provisions into the sphere of the tax treaties. Now the question is whether Treaty Shopping and GAAR is to stay or not to stay!

Further (recent) reading
(1) Weeghel, S. van, Boer, R. de, Anti-abuse measures and the application of tax treaties in the Netherlands, Bulletin for international taxation, Vol. 60 (2006), no. 8/9 ; p. 358-364

(2) Arnold, B.J., Weeghel, S. van The relationship between tax treaties and domestic anti-abuse measures, In: Tax treaties and domestic law, IBFD, 2006 ; p. 81-120

(3) Matteotti, R., Interpretation of tax treaties and domestic general anti-avoidance rules - a sceptical look at the 2003 update to the OECD commentary, Intertax, Vol. 33 (2005), no. 8/9 ; p. 336-350

(4) Obermair, C. Weninger, P.J. Treaty shopping and domestic GAARs in the light of a recent Austrian decision on Irish IFS companies, Intertax, Vol. 33 (2005), no. 10 ; p. 466-473

(5)Bernstein, J., GAAR and treaty shopping: an international perspective, Tax notes international, 2005, no. 12 ; p. 1107-1110

(6) Arnold, Brian J., “Tax Treaties and Tax Avoidance: The 2003 Revisions to the Commentary to the OECD Model”, 58 Bulletin for International Fiscal Documentation (2004) no. 6, p. 249-252.

(7) Zimmer, F., “Domestic Anti-Avoidance Rules and Tax Treaties – Comment on Brian Arnold’s Article”, 59 Bulletin for International Fiscal Documentation 1 (2005), no. 1, p. 25.

(8) Martín Jiménez, A.J., Domestic anti-abuse rules and double taxation treaties : a Spanish perspective - part I and 2, Bulletin for international fiscal documentation (2002), no. 11 /12; p. 542-553