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CRA Releases New APA Report

On January 10, 2013, the Canada Revenue Agency released its 2011-2012 Advance Pricing Arrangement Program Report (previous reports are available here).

This is the eleventh year in which the CRA has issued such a report, which is generally intended to enhance taxpayer awareness of the APA program and to describe (i) current operational status, (ii) relevant changes, and (iii) issues that may affect the program in future years.

The general purpose of an APA is to create certainty between the taxing authorities of Canada and a foreign country concerning the transfer pricing of cross-border intercompany transactions.  In the absence of an APA governing such transactions, taxpayers may be exposed to higher audit risk relating to their intercompany transfer pricing methodologies, which may ultimately result in costly and time-consuming negotiations with the multiple tax authorities as well as potential litigation. Accordingly, the CRA encourages taxpayers to avail themselves of the APA program to mitigate the transfer pricing risk in the appropriate circumstances, particularly where the taxpayer engages in intercompany transactions of a recurring nature (i.e., frequent sale of goods between affiliates or the ongoing provision of intercompany services).

The APA program has proven popular with taxpayers over the years and the number of applicants continues to grow – the 2011-2012 fiscal year had the highest number of applicants to the program (34) since the 2007-2008 fiscal year.  The inventory of unresolved cases also continues to grow (the inventory increased from 96 at the end of the 2010-2011 fiscal year to 102 at the end of the 2011-2012 fiscal year).  In the 2011-2012 fiscal year, 17 new cases were admitted to the APA program whereas only 10 cases were completed (and one was withdrawn).  The large discrepancy between the number of applicants and the number of cases formally admitted to the program in the year is partially a reflection of the changes introduced by the CRA beginning in the 2010-2011 fiscal year requiring that taxpayers invest significantly more time and resources during the initial application/due diligence phase of the APA process and to provide a greater amount of financial and business information prior to acceptance into the program.  This results in a longer and more extensive “screening” process but is intended to eliminate inappropriate cases before they are accepted into the program inventory.

Other highlights of the Report include:

  • The average amount of time required to conclude a bilateral APA from acceptance into the program until completion was 44 months, which appears generally consistent with prior years;
  • The majority of APA’s relate to the cross-border transfer of tangible property.  Approximately 47% of APA cases in process relate to tangible personal property whereas cases involving tangible personal property and intra-group services represent approximately 31% and 22% of cases in process;
  • The transactional net margin method (“TNMM”) continues to be the most frequently used transfer pricing methodology in APA cases; and
  • APAs involving the United States represent approximately 71% of all APA cases that are in process (which is slightly lower than the percentage of completed APA cases that involve the United States).

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CRA Releases New APA Report

New Guidance from the OECD on the Meaning of “Beneficial Owner” for Tax Treaty Purposes

Taxpayers and their advisors should be aware of a significant new development concerning the appropriate withholding tax rate on the payment of cross-border interest, royalties and dividends.

On October 19, 2012, the Organisation for Economic Cooperation and Development (the “OECD”) released a revised discussion draft concerning the meaning of “beneficial owner” for the purposes of Articles 10, 11 and 12 of the OECD’s model tax convention (the “OECD Model”). The discussion draft builds on the OECD’s prior discussion draft (released on April 29, 2011), which received widespread international criticism for its ambiguity and lack of meaningful guidance on this fundamental issue of international taxation.

Background

Canada’s Income Tax Act (the “Act”) requires that a Canadian company withhold 25 percent of dividends, interest and royalties paid to non-residents and remit this amount to the Canada Revenue Agency (the “CRA”) on behalf of the non-resident. However, Canada has entered into numerous bilateral tax treaties with various countries that reduce or eliminate the withholding tax. To benefit from these reductions or eliminations of Canadian withholding tax, the treaties generally require (among other things) that the recipient qualify as the “beneficial owner” of the amount paid.

Canada’s tax treaties are generally based on the OECD Model, which, together with its commentaries, generally provide that a resident of a contracting state will be the beneficial owner of an amount received from a resident of the other contracting state so long as the recipient was not acting in its capacity as an agent, nominee, fiduciary or administrator on behalf of a person not resident in that state.

However, there is surprisingly little additional insight into the intended meaning or possible interpretations of this term. There is a growing body of Canadian and international jurisprudence on the issue, with the Canadian case of Prevost Car, Inc. v. The Queen (2009 D.T.C. 5053 (F.C.A.), aff’g 2008 D.T.C. 3080 (T.C.C.)) currently serving as the high-water mark.  Nevertheless, inconsistencies remain in the manner in which different states interpret and apply “beneficial owner” (see also the earlier article by FMC’s Matt Peters on Velcro v. The Queen (2012 TCC 57)) .

OECD Guidance

Instead of clarifying the issue, the OECD’s prior discussion draft was roundly criticised for adding further uncertainty to the meaning of “beneficial owner”. In the prior draft, the OECD emphasized the desire to introduce a meaning that could be universally accepted and applied by all countries.  In this respect, the prior draft focused on assessing the recipient’s ability to have the “full right to use and enjoy” dividend, interest or royalty income and stated that a recipient will not be the beneficial owner if its powers are constrained by a contractual or legal obligation to pass the payment received to another person.  Many commentators suggested that this approach was too broad and ambiguous and left taxpayers with little certainty when structuring their affairs.  Moreover, the exact role of a country’s domestic law meaning of “beneficial owner” was left somewhat open.

The new draft attempts to clarify the issue by (i) more strongly abandoning the relevancy of any particular state’s domestic law meaning of “beneficial owner”; and (ii) providing further guidance as to what is meant by the right to use and enjoy an amount unconstrained by contractual or legal obligations.  The revised draft reviews in some detail the comments received by the OECD on it’s prior draft and explains in more detail (and through examples) the rationale behind its approach.

Next Steps

This is a controversial issue and the approach adopted by the OECD in its revised discussion draft will undoubtedly stir debate in the international tax arena.  The OECD has indicated that it will be accepting comments on the revised draft before 15 December, 2012, suggesting that another revised draft will likely be released in 2013.  Tax practitioners and their clients will need to carefully consider the approach that contained in the OECD’s revised draft and assess whether it presents any risks in their particular circumstances.

* Special thanks to Christian Orton, Articling Student, for his valuable contributions to this article. 

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New Guidance from the OECD on the Meaning of “Beneficial Owner” for Tax Treaty Purposes

“Beneficial Owner” – CRA’s Assessment of Velcro Doesn’t Stick

The Tax Court has once again considered the meaning of the phrase “beneficial owner” for purposes of the tax treaty between Canada and the Netherlands (the “Treaty”).  It has also once again ruled in favour of the taxpayer in determining that a Dutch holding company was the “beneficial owner” of amounts received from a related Canadian company.

On February 24, 2012, the Tax Court of Canada released its eagerly-anticipated decision in Velcro Canada Inc. v. Her Majesty the Queen, which addresses the applicable Canadian withholding tax rate in respect of cross-border royalty payments within a multinational corporate group.  The decision comes almost four years after the Tax Court of Canada released its landmark decision in Prévost Car Inc. v. The Queen, which dealt with the identical treaty interpretational issue in the context of cross-border dividend payments.  The decision of the Tax Court was affirmed by the Federal Court of Appeal.

Both the Prévost Car Inc. and Velcro decisions are relevant to any multinational enterprise using a foreign holding company as an investment/financing vehicle and provide considerable comfort concerning the tax effectiveness of such structures.

The issue in Velcro was whether a Dutch holding company was the “beneficial owner” of royalties paid by a related Canadian company, and therefore entitled to a reduced rate of Canadian withholding tax under the Treaty in respect of the royalties.  Pursuant to the “beneficial owner test” described in Prévost Car Inc., this required that the Tax Court consider the following issues:

  • Did the Dutch holding company enjoy possession, use, risk and control of the amounts it received from the Canadian corporation?
  • Did the Dutch holding company act as a “conduit”, an agent or a nominee in respect of the amounts it received from the Canadian corporation?

The CRA’s position was that Dutchco was not the beneficial owner of the royalties generally because Dutchco was contractually required to remit a specific percentage of all amounts received from the Canadian corporation to its parent company located in the Netherlands-Antilles (which does not have a comprehensive tax treaty with Canada).  If the Canadian company had paid royalties directly to the Netherlands-Antilles company the royalty payments would have been subject to a 25% Canadian withholding tax.  In the CRA’s view, Dutchco was merely a collection agent for the Netherlands-Antilles company.

The Court rejected the CRA’s arguments and concluded that Dutcho was indeed the beneficial owner of the royalties.  The basis for the Court’s conclusion was that, even though Dutchco may have been contractually required to pay money onward to the Netherlands-Antilles company, it retained some discretion as to the use of the royalties while in its possession. Dutchco therefore possessed sufficient indicia of beneficial ownership while it held the royalties and could not be considered a conduit based on the “beneficial ownership test” outlined in Prévost Car Inc., which requires a lack of all discretion.

It is unclear at this time whether the CRA will appeal the Tax Court’s decision in Velcro to the Federal Court of Appeal. The tax community will continue to watch the progress of this case (if any) with great interest.

Please open the attached PDF for further information about the Velcro case.

Please visit the FMC website for prior coverage of Prévost Car Inc.

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“Beneficial Owner” – CRA’s Assessment of Velcro Doesn’t Stick

Tax Court Denies Deduction in Tower Financing Structure

Taxpayers that have implemented cross-border tower financing structures and that have claimed a Canadian tax deduction for any U.S. taxes paid should revisit their structures carefully in light of the Tax Court of Canada’s recent decision in FLSMIDTH Ltd. v. The Queen (2012 TCC 3), which is the Court’s first decision concerning tower structures.

For a more detailed review of this case, please click here.

The primary tax benefit of the typical tower structure is an interest deduction in both Canada and U.S. in respect of the same borrowing.  However, in certain tower structures, a spread is earned by a U.S. entity based on the amount of interest that is received by that entity from lower-tier entities in the structure and the amount of interest that is paid by the entity on external bank financing.  This spread is typically subject to U.S. federal income tax.

In FLSMIDTH Ltd. v. The Queen, the viability of the double interest deductions was not at issue; rather, the issue was whether an additional deduction under subsection 20(12) of the Income Tax Act (Canada) (the “Act”) was available under the Act with respect to the U.S. income tax that was paid on the spread.

Generally, the taxpayer would be entitled to the deduction under subsection 20(12) of the Act for the U.S. tax paid if two conditions were met:

1. the tax must have been paid in respect of a source of income under the Act; and

2. the U.S. tax must not reasonably be regarded as having been paid in respect of income from the share of a capital stock of a foreign affiliate of the taxpayer.

The Tax Court agreed that the U.S. tax was paid in respect of a source of income for purposes of the Act, even though that specific source of income (i.e., income that was characterized as interest for U.S. tax purposes) was not itself subject to tax under the Act; however, the Tax Court denied the deduction on the basis that the tax was in respect of income from the share of a foreign affiliate of the taxpayer.  Central to the Court’s decision was the broad interpretation that is to be given to the term “in respect of” for purposes of the Act.

Taxpayers that have implemented tower structures and that have claimed a subsection 20(12) deduction on any U.S. tax paid should reconsider their structures and contact a tax advisor to discuss the potential implications of this case in their particular circumstances.

At this time it is unclear whether the taxpayer will appeal this decision to the Federal Court of Appeal.

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Tax Court Denies Deduction in Tower Financing Structure