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Prince v ACE: Extra-territorial effect of U.S. tax laws?

Should a Canadian court exercise its jurisdiction to hear a class action lawsuit against Air Canada for improperly collecting U.S. travel taxes on ticket purchases in Canada and on air travel in Canada?

That was the question in Prince v. ACE Aviation Holdings Inc. (2014 ONCA 285), in which the Ontario Court of Appeal declined to exercise its jurisdiction and stayed the class action on the basis that the U.S. was clearly a more appropriate forum until the plaintiffs exhaust their rights in the U.S. by first applying to the IRS for a refund and, if refused, appealing to the U.S. courts.

In Prince, a class action was commenced in Ontario against Air Canada for improperly collecting U.S. travel taxes on ticket purchases in Canada and on air travel in Canada. Effectively, the plaintiffs alleged that Air Canada was giving extra-territorial effect to U.S. tax laws. The plaintiffs claim raised issues about the taxes imposed by the U.S. government, the methods used to collect those taxes, the immunity conferred on intermediaries who collect the taxes, the procedures established for the recovery of those taxes and the interpretation of the taxing statute.

Analysis

Before a Canadian Court will engage in the interpretation of a foreign revenue law, the party alleging the infringement must raise the issue in the appropriate forum in the foreign jurisdiction.  Doing so achieves the goals of order, fairness, efficiency and comity, all of which underlie the forum non conveniens analysis.

Jurisdiction

Ontario had presence-based jurisdiction over Air Canada.  However, Air Canada argued that the “revenue rule”, which provides that a Canadian court will not entertain a suit by a foreign state to recover a tax, bars the Ontario court from having subject-matter jurisdiction over the plaintiffs’ action.  The Court of Appeal reasoned that an Ontario court has jurisdiction to determine whether a foreign law is being enforced extra-territorially and to grant appropriate relief.  Such an approach is consistent with the “revenue rule” as the court would only determine those rights and obligations of the plaintiffs and Air Canada which are not derivative of the sovereign authority of the U.S.

Forum Non Conveniens

The forum non conveniens analysis engaged in by the Court of Appeal included a consideration of juridical advantages and disadvantages.

In the U.S., Air Canada, as an intermediary tax collector for the U.S. government, is entitled to statutory immunity (comparable immunity provisions exist in Canadian tax law).  Air Canada would not have the benefit of that immunity in Canada.

The administrative procedure to recover an overpayment of tax from the IRS is a complete system for the effective administration of taxes in the U.S and was not considered to be a procedural disadvantage to the plaintiffs.  Comity requires respect for the right of a foreign state to make and apply laws within its territorial limits.

Conclusion

As a matter of comity, the interpretation of the U.S. statute, including its scope, should be undertaken by agencies and courts in the U.S.  This would require the IRS to determine whether Air Canada acted beyond the scope of the taxation statute. If the plaintiffs are unsuccessful, the IRS decision can be challenged in the U.S. courts.   If the U.S. court affirms the decision of the IRS, then the Ontario Court will have the benefit of those reasons if the Court is called upon to decide whether the collection of taxes by Air Canada is a violation of the principles governing the conduct of sovereign states and an extraterritorial application of U.S. law in Canada.

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Prince v ACE: Extra-territorial effect of U.S. tax laws?

Emerging Markets: Non-EU Investment Funds Eligible for Withholding Tax Refund

In Emerging Markets Series of DFA Investment Trust Company (C -190/12), the European Court of Justice (ECJ) confirmed that investment funds based outside the European Union (EU) should benefit from the EU free movement of capital rule regarding investments in Europe. Thus, if an EU domestic investment fund can benefit from local income tax exemptions, then non-EU investment funds (e.g., U.S. or Canadian) investing in the EU should also be entitled to apply for such exemptions.

In Emerging Markets, a U.S. investment fund applied for a refund of withholding tax paid on dividends derived from Polish companies. The ECJ stated that U.S. investment funds are entitled to put themselves in a position similar to that of local funds. This means that under certain conditions non-EU investors may benefit from local tax preferences/exemptions.

In light of the relevant Polish regulations (which provide for income tax exemptions for domestic investment funds and funds based in the EU/EEA) and the tax information exchange agreement between Poland and U.S., the dividends paid to a U.S. investment fund should also be exempt from withholding tax in Poland.

The ECJ’s judgment in Emerging Markets provides a basis for non-EU investors to benefit from certain EU rules and to rely on tax preferences granted to EU/EEA entities. Therefore, if these investors have paid withholding tax on dividends derived from EU/EEA companies, they should consider whether certain tax preferences are available for investment funds in the country of residence of the companies paying the dividends (subject to any applicable time limits).

Canadian companies should also consider whether a refund of withholding tax would impact the foreign tax credit available in respect of any withholding tax previously paid and not refunded.

Additional information is available here.

Cezary Przygodzki and Rafal Mikulski practice in Dentons’ Warsaw office. 

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Emerging Markets: Non-EU Investment Funds Eligible for Withholding Tax Refund

International and Transfer Pricing Audits: Toronto Centre Canada Revenue Agency & Professionals Breakfast Seminar

International and Transfer Pricing Audits

At the Toronto Centre Canada Revenue Agency & Professionals Breakfast Seminar on February 18, 2014, the CRA provided an update on international and transfer pricing audits. The slides can be found here. The discussion was led by Paul Stesco, Manager of the International Advisory Services Section, International and Large Business Directorate, Compliance Programs Branch of the CRA and Cliff Rand, National Managing Partner of Deloitte Tax Law LLP.  Here is a brief overview of some of the highlights from the presentation on how such audits are performed:

  • Research and Analysis Stage: the CRA uses the internet extensively for research (e.g. industry analysis, competitor analysis, etc.) as well as prior audit reports, tax returns and annual reports of taxapyers to identify transactions and the appropriate transfer pricing methods applicable to those transactions.
  • Mandatory Referrals to Headquarters: mandatory referrals by the field auditor to the International Tax Division (“ITD”) are required in several situations including: cost contribution arrangements, reassessments that could be issued after the tax treaty deadlines, transfer pricing penalties under subsection 247(3), recharacterization under paragraphs 247(2)(b) and (d), the application of subsection 95(6) and downward pricing adjustments under subsection 247(2) and (10). Situations which involve the use of “secret comparables” to reassess the taxpayer (i.e. comparables used by the CRA that cannot be found in a public database) will automatically be forwarded to the ITD; the CRA will not forward audit issues to the ITD if the “secret comparables” were used only for risk analysis.
  • Access to Taxpayers: during an audit, the CRA may request access to certain individuals involved in the taxpayer’s business. The CRA does not necessarily require physical access to non-resident taxpayers; a telephone interview may suffice. An interview with operational personnel is likely to streamline the audit and, as such, is in the best interests of the taxpayer. Taxpayers are permitted to record such interviews (even including the use of a court reporter to produce a transcript).
  • Currency of Auditsinstead of proceeding on a year by year basis, audits will now generally begin with the most current risk-assessed taxation year (and one back year) and may then move back to other open years in respect of the same issue.  Having said that, there are still “legacy files” within the CRA’s system.
  • Concerns/Complaints: a taxpayer who wishes to express concerns about a transfer pricing audit should follow the appropriate local chain of command: first contact the auditor, then the Team Leader and the relevant Section Manager at the local TSO. Taxpayers should refrain from directly contacting Head Office. The CRA stressed the importance of communicating with the audit team on a regular basis.
  • Contemporaneous Documentation Requirement in subsection 247(4): the CRA acknowledged that transfer pricing studies have been accepted even if they were prepared after the period to which they relate.
  • Transfer Pricing Review Committee (TPRC): two types of referrals proceed to the TPRC: (1) penalty referrals under subsection 247(3) which involve transfer pricing adjustments in excess of 10% of gross revenue or greater than $5,000,000; and (2) referrals of recharacterization as an assessing position under paragraph 247(2)(b).
    • As of October 31, 2013, penalty referrals made up 86.5% of all referrals while recharacterization referrals accounted for 13.5% of all referrals.
    • The taxpayer does not have direct access to the TPRC to make submissions. However, minutes of committee meetings may be obtained by making an Access to Information request.

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International and Transfer Pricing Audits: Toronto Centre Canada Revenue Agency & Professionals Breakfast Seminar

Canada Revenue Agency Toronto Centre Tax Services Office Describes Current Audit Issues

At today’s Canada Revenue Agency Toronto Centre Tax Professionals Group Breakfast Seminar (November 14, 2012), the CRA provided an update on a number of current audit issues.

The CRA was represented by Sal Tringali, Regional Technical Advisor of Aggressive Tax Planning, and James McNamara, Manager of International Taxation and Aggressive Tax Planning Audit Division from the Toronto Centre Tax Services Office. The discussion was moderated by Jacques Bernier (Baker McKenzie LLP) and Rachel Gervais (BDO Canada LLP).

The audit issues highlighted by the panel included the following:

GST/HST

  1. Recapture input tax credit
  2. ITC allocation % – mixed supplies
  3. Financial services
  4. Imported supplies
  5. Reinsurance/loading
  6. Loyalty reward points
  7. VDP – Related parties

Income Tax

  1. Artificial capital losses
  2. Loss trading
  3. Surplus strips
  4. Offshore bank accounts held by individuals
  5. Donation arrangements
  6. International transactions
  7. S. 85 rollovers
  8. RRSP appropriations
  9. Tax-free savings accounts (TFSA)

Additionally, the CRA made the following comments:

    • The CRA’s access to/requests for accountants’ working papers remains a “hot topic”. Generally speaking, the CRA will first ask the taxpayer for information/documents, after which the CRA may request information/documents from the taxpayer’s accountants. The CRA’s objective is to perform high-quality audits, and access to complete information is required to do so.
    • The CRA reminded taxpayers of its recent announcement that the CRA will not assess a taxpayer’s return where the taxpayer has claimed a charitable donation and the alleged gift is made as part of a donation arrangement. The delay in assessing the return could be two years or more (see Jamie Golombek’s recent article on the subject).
    • The CRA has appealed the Tax Court’s decision in Guindon v. The Queen to the Federal Court of Appeal. In light of the Tax Court’s decision, the CRA is currently considering its options in respect of the assessment of third party penalties.
    • The CRA has considered the application of third party penalties in 185 cases. In 71 of those cases the penalty was applied, resulting in the imposition of $79 million of penalties. In 50 cases the penalty was not applied, and 64 cases are ongoing.
    • The CRA will continue to revoke e-file privileges where a tax preparer is subject to a penalty, even where a penalty against a single tax preparer may result in the revocation for his or her entire firm.
    • The CRA referred to the recent Supreme Court decision in GlaxoSmithKline v. The Queen and stated that it intends to follow the new OECD guidelines on transfer pricing and the hierarchy of pricing methods. The CRA said that it did not expect to release any formal communication to the public on this issue, but Information Circular IC 87-2R “International Transfer Pricing” may be updated to reflect this position.

UPDATE: After the seminar, the CRA informed us that it intends to follow the guidance in the recently updated OECD Guidelines and will be issuing a Transfer Pricing Memoranda (TPM) on the matter to the public. This TPM will reflect a recently released internal Communique on the same subject and will be made available in the near future.

    • The CRA clarified that Tax Earned By Audit (“TEBA”) remains a metric for measuring ”tax at risk”, but it is not used to measure the performance of an auditor. Rather, the CRA measures the performance of auditors based on six major elements: (i) planning the audit, (ii) conducting the audit, (iii) applying the appropriate legislation/policy, (iv) the end product of the audit, (v) professionalism in the audit, and (vi) timeliness of completion of the audit.
    • The CRA plans to convene face-to-face meetings with approximately 160 large businesses (i.e., annual sales over $250 million) as part of the CRA’s large business audit project. The CRA will continue to risk-assess all large businesses/entities annually.
    • The CRA intends to clear a backlog of approximately 1,300 audit files so that it may assess the most recent taxation year and the immediately preceding taxation year for most businesses by 2015-16.
    • The CRA reiterated that issues that arise during the audit process should be raised with the auditor, after which it may be appropriate to involve the auditor’s team leader. If the issue cannot be resolved at that level, it would be appropriate to raise the issue with the auditor’s manager or the assistant director of audit at the particular TSO.

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Canada Revenue Agency Toronto Centre Tax Services Office Describes Current Audit Issues

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

Canada’s Sommerer Decision and Double Taxation

A recent decision of Canada’s Federal Court of Appeal provides insight on the application of the country’s tax treaties to income that is attributed to a Canadian resident taxpayer under the Income Tax Act (Canada). Also, the court made useful comments on the classification of an Austrian private foundation (privatstiftung) for domestic Canadian tax purposes.

In Peter Sommerer v. The Queen, 2012 FCA 207, the court affirmed the decision of the Tax Court of Canada (2011 TCC 212) finding that gains realized on dispositions of shares by an Austrian private foundation were not taxable in the hands of an individual beneficiary of the foundation on the basis that either (a) the gains could not be attributed to the Canadian individual under the ITA’s attribution rules or (b) the capital gains article of the Austria-Canada Income Tax Convention of 1976, as amended, prohibited Canada from taxing the gains.

To read the full article by Jesse Brodlieb, Matthew Peters, and Tony Schweitzer, as published in Tax Notes International, Vol. 67, Number 6, August 6, 2012, please click here. For our earlier blog post on the decision, please click here.

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Canada’s Sommerer Decision and Double Taxation

Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

It is trite law that one of the main purposes of tax treaties is to prevent double taxation of the same income. In Canada this principle has often been treated with a grain of salt since Canadian domestic rules do not bar double taxation and, in fact, the Canada Revenue Agency often resorts to double taxation where, for example, a shareholder appropriation is disallowed as a corporate expense while fully taxed in the shareholder’s hands.

The recent decision of the Federal Court of Appeal in The Queen v. Sommerer illustrates a refreshing approach to the concept of double taxation, at least in the context of Canada’s network of bilateral tax treaties based on the OECD Model Convention (and, to a lesser extent, the UN Model Convention).

Mr. Sommerer was at all material times a resident of Canada. He was a contingent beneficiary of an Austrian Privatstiftung (the “Sommerer Private Foundation”) created by his father in 1996. The Sommerer Private Foundation was at all material times a resident of Austria for the purposes of the Canada-Austria Tax Treaty. The facts that gave rise to the assessments under appeal are summarized by Sharlow JA as follows:

[30] On October 4, 1996, Peter Sommerer sold to the Sommerer Private Foundation 1,770,000 shares of Vienna Systems Corporation (the “Vienna shares”) for their fair market value of $1,177,050 (66.5¢ per share). The Sommerer Private Foundation paid $117,705 of the purchase price on the date of the agreement and was legally obliged to pay the remainder at a later date, with interest. The sale was unconditional. The cash portion of the purchase price was paid using part of the initial endowment from Herbert Sommerer (paragraphs 67 and 88 of Justice Miller’s reasons).

[31] In December of 1997, the Sommerer Private Foundation sold 216,666 of the Vienna shares for $4.50 per share to three individuals unrelated to the Sommerer family, realizing a capital gain. In December of 1998, the Sommerer Private Foundation sold the remaining Vienna shares to Nokia Corporation for $9.00 per share, realizing a further capital gain.

[32] In April of 1998, Peter Sommerer sold to the Sommerer Private Foundation, unconditionally, 57,143 shares of Cambrian Systems Corporation (the “Cambrian shares”) for $100,000 (approximately $1.75 per share). In December of 1998, the Sommerer Private Foundation sold the Cambrian shares to Northern Telecom Limited for $14.97 (US) per share, plus a further $4.12 (US) per share conditional on certain milestones being met in 1999. That sale resulted in another capital gain for the Sommerer Private Foundation.

CRA assessed Mr. Sommerer on the basis of subsection 75(2) of the Income Tax Act alleging that the proceeds from the sale of the shares by the Foundation could possibly revert to Mr. Sommerer. Both Justice Campbell Miller in the Tax Court of Canada and Justice Sharlow in the Court of Appeal rejected that interpretation holding that subsection 75(2) could not apply on a sale of property at fair market value.

Justice Sharlow did not stop there however. She went on to agree with Miller J. that the position advocated by CRA violated the Treaty’s fundamental principle of avoiding double taxation:

[66] The OECD model conventions, including the Canada-Austria Income Tax Convention, generally have two purposes – the avoidance of double taxation and the prevention of fiscal evasion. Article XIII (5) of the Canada-Austria Income Tax Convention speaks only to the avoidance of double taxation. “Double taxation” may mean either juridical double taxation (for example, imposing on a person Canadian and foreign tax on the same income) or economic double taxation (for example, imposing Canadian tax on a Canadian taxpayer for the attributed income of a foreign taxpayer, where the economic burden of foreign tax on that income is also borne indirectly by the Canadian taxpayer). By definition, an attribution rule may be expected to result only in economic double taxation.

[67] The Crown’s argument requires the interpretation of a specific income tax convention to be approached on the basis of a premise that excludes, from the outset, the notion that the convention is not intended to avoid economic double taxation. That approach was rejected by Justice Miller, correctly in my view. There is considerable merit in the opinion of Klaus Vogel, who says that the meaning of “double taxation” in a particular income tax convention is a matter that must be determined on the basis of an interpretation of that convention (Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD –, UN –, and US Model Conventions for the Avoidance of Double Taxation on Income and Capital, 3rd ed. (The Hague: Kluweer Law International, 1997)).

[68] I see no error of law or principle in the conclusion of Justice Miller that Article XIII (5) applies to preclude Canada from taxing Peter Sommerer on the capital gains realized by the Sommerer Private Foundation.

Unless this case is reversed by the Supreme Court of Canada (at the date of this comment, no leave application has been filed), it is likely to be a very important precedent for tax practitioners plying their craft in the highly complex area of international tax treaties.

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Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

In Garron Family Trust v. The Queen (2009 TCC 450), Justice Judith Woods of the Tax Court of Canada came down with a very broad new rule for determining the residence of trusts.

[162]  I conclude, then, that the judge-made test of residence that has been established for corporations should also apply to trusts, with such modifications as are appropriate. That test is “where the central management and control actually abides.”

This was viewed widely as a repudiation of the historic test based on the residence of the trustee. Many tax professionals thought that the test for residence of a trust required a determination of the residence of the majority of the trustees and where their functions were performed, and that it was not necessary to go beyond this test.

The Federal Court of Appeal in St. Michael Trust Corp. v. Canada (2010 FCA 309) appeared to endorse Justice Woods’ new legal test but in a somewhat guarded fashion:

[63]    St. Michael Trust Corp. argues that a test of central management and control cannot be applied to a trust because a trust is a “legal relationship” without a separate legal personality. I do not accept this argument. It is true that as a matter of law a trust is not a person, but it is also true that for income tax purposes, a trust is treated as though it were a person. In my view, it is consistent with that implicit statutory fiction to recognize that the residence of a trust may not always be determined by the residence of its trustee.

[64]    St. Michael Trust Corp. also argues that the residence of the trust must be determined as the residence of the trustee because section 104 of the Income Tax Act embodies the trust, as taxpayer, in the person of the trustee. In my view, that gives section 104 a meaning beyond its words and purpose. Section 104 was enacted to solve the practical problems of tax administration that would necessarily arise when it was determined that trusts were to be taxed despite the absence of legal personality. I do not read section 104 as a signal that Parliament intended that in all cases, the residence of the trust must be the residence of the trustee.

When the Supreme Court of Canada granted leave to appeal, some tax professionals were puzzled.  These tax professionals believed that it was unlikely the decision would be reversed since the Crown had a very strong factual case that the trusts in question were managed in Canada by the trust beneficiaries.  The decision released on April 12 by the Supreme Court (Fundy Settlement v. Canada, 2012 SCC 14) in fact dismissed the appeal in somewhat cursory fashion.

[15]    As with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where “its real business is carried on” (De Beers, at p. 458), which is where the central management and control of the trust actually takes place.  As indicated, the Tax Court judge found as a fact that the main beneficiaries exercised the central management and control of the trusts in Canada.  She found that St. Michael had only a limited role ― to provide administrative services ― and little or no responsibility beyond that (paras. 189-90).  Therefore, on this test, the trusts must be found to be resident in Canada.  This is not to say that the residence of a trust can never be the residence of the trustee.  The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.  These, however, were not the facts in this case.

[16]    We agree with Woods J. that adopting a similar test for trusts and corporations promotes “the important principles of consistency, predictability and fairness in the application of tax law” (para. 160).  As she noted, if there were to be a totally different test for trusts than for corporations, there should be good reasons for it.  No such reasons were offered here.  [Emphasis added]

On a close reading it is arguable that the Supreme Court has gently tempered the new rule set out by Justice Woods and, to some extent, by the Federal Court of Appeal.  Where the trustee does what it is supposed to do, including managing the trust and its properties, the operative test remains the residence of the trustee.  It would seem that only where the trustee carries on those “management and control” activities in a place other than where the trustee is resident, or where the trustee abdicates many of its powers to a third party, that Justice Woods’ new test becomes relevant.

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Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

“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