International Tax Panorama

On February 12, the Federal Court of Appeal (FCA) gave its decision in The Queen v. Alta Energy Luxembourg S.a.r.l. (Alta Energy), a case that is significant in relation to  guidance on the tax treaty interpretation under the domestic general anti-abuse rule (GAAR) on Capital gains tax exemption in Canada.

1. Facts: 

Alta Energy, a private U.S.-based company established its Canadian subsidiary (Alta Canada) in order to acquire an interest in a shale development in Alberta. Holding the Alta Canada shares had possible adverse U.S. tax consequences for the private equity fund. Thus this holding was restructured by way of a transfer of the Alta Canada shares to a Luxembourg holding company (Alta Lux).

After a brief period of property accumulation, well drilling and planning the construction of the necessary infrastructure for a full-scale development, the Alta Energy board decided to exit from the project after market factor consideration. This led to a sale deal of the Alta Canada shares to the third-party buyer where Alta Lux realized a gain of over $380 million.

Initially Alta Lux argued before the Canada Revenue Agency (CRA) that the gain was exempt from Canadian capital gains tax under the Canada-Luxembourg tax treaty. The claim was denied by the CRA, which was later appealed to the Tax Court of Canada (TCC). The TCC allowed the appeal by finding that the Alta Canada shares were treaty-protected property and that the GAAR will not apply to deny the exemption under the Canada-Luxembourg tax treaty. The Crown appealed to the Federal Court of Appeal (FCA), although the appeal was limited to the GAAR issue.

2. Judgement: 

In the earlier judgment, Alta Luxembourg conceded that there was a tax benefit and an avoidance transaction. In the appeal before FCA the only issue was whether the transactions resulted in an abuse of the provisions of the Act or the Luxembourg Convention for the purposes of the application of the GAAR. 

The court emphasised that that real focus was on whether there was an abuse of the relevant provisions of tax treaty rather than GAAR provisions. As the GAAR provision under paragraph 115(1)(b) provides for the carve-out for treaty-protected property it means that the intentions were to not tax the gain realized on the dispositions of certain properties, under the tax treaty. If there is no abuse of the Luxembourg Convention, there would be no abuse of paragraph 115(1)(b) of the Act.

3. Two Stage Abuse Analysis: 

The Court proceeded to perform the abuse analysis through two stages. 

3.1. First Stage 

The first stage involved the determination of the object, spirit, and purpose of the provisions giving rise to the tax benefit.. The relevant provisions are Art. 1. 4 and Art.13(4) and (5) of the tax treaty, which provides the tax benefit in the form of Capital gain tax exemption in Canada realized on the disposition of the shares of Alta Canada. It also qualifies as treaty-protected property under the GAAR. 

The object, spirit and purpose of Articles 1, 4 and 13(4) is that a person will qualify for the exemption in issue in this appeal, which is applicable to gains arising on the disposition of certain shares, if:

(a) that person is a resident of Luxembourg for the purposes of the Luxembourg Convention, and 

(b) the value of the shares is principally derived from immovable property (other than rental property) situated in Canada in which the business of that corporation is carried on. 

In this case, the Crown conceded that Alta Luxembourg has complied with the wording of Articles 1, 4, 13(4) and (5) of the tax treaty. Therefore, relying on OSFC ratio, the court held that it is the Crown’s responsibility to identify the object, spirit, or purpose of the GAAR provisions, that according to them, has been frustrated. To identify the rationale of the provisions the court went on to analyze Paragraph 91 of the Crown’s memorandum, which formed the basis of the Crown’s arguments. 

In paragraph 91 of its memorandum, the Crown submits that:

91.  Articles 1, 4 and 13(4) of the Convention, together, are intended to grant a particular treaty benefit to Luxembourg investors whose investments in specific taxable Canadian property gives rise to gains for them, in Luxembourg. Those provisions are not intended to benefit entities who do not have the potential to realize income in Luxembourg, nor have any commercial or economic ties therewith. Such situations are wholly dissimilar to the relationships or transactions that are contemplated by those provisions of the Convention.

Relying on Par. 91, the Crown asserted the following three arguments to disqualify the capital gains tax exemption, which were subsequently dismissed by the court. 

a.Residents must be investors to claim exemption : 

Firstly, the Crown asserted that resident requirement to claim the exemption is not sufficient as they need to be investors too. Here the court dismissed the argument by stating that Art. 13(4) provides for exemption solely to Luxembourg residents, not to investors, as evidenced from the clear treaty wordings.

The combined reading of Art. 13(4) and (5) provides that the person claiming the exemption (who holds a substantial interest) is a resident of Luxembourg, and that the company (whose shares were sold) satisfies the asset test as set out in Article 13(4). There are no further requirements. Nowhere it has been suggested that the person must invest any particular amount in the corporation in order to claim exemption. 

On the other hand, if the GAAR provides for the additional requirement, it must be interpreted through a “unified textual, contextual and purposive approach”. (Copthorne). The very application of GAAR suggests for an additional investment requirement by the resident in the corporation in order to qualify for the exemption which might lead to an abuse of the tax treaty. This would result in a significant change in the requirements that the resident of Luxembourg would have to satisfy as against the tax treaty provision. 

b. No Material Luxembourg tax due to no potential to earn income by Alta Lux:

Secondly, the Crown argued that there was no material Luxembourg tax on the gain as the entity didn’t have the potential to earn income in Luxembourg as per par. 91. The very argument in relation to the potential to realize income in Luxembourg appears to be related to the Profit Participating Facility Agreement that Alta Luxembourg entered into with Alta Energy Canada Partnership, which held all of the shares of Alta Luxembourg. 

The Court held that the additional condition that a resident will only be a resident of Luxembourg for the purposes of the Tax treaty if a certain amount of tax is paid, would alter the definition from the words as chosen. Whether Luxembourg will impose any income tax on Alta Luxembourg is a matter for the Luxembourg tax authorities (subject, in the event of a dispute, to any review or appeal process that may be available in Luxembourg).Thus, the court dismissed the Crown’s argument as the additional condition significantly alters the original residence requirement under the tax treaty which was unfounded in the tax treaty wordings. 

c. Little Commercial and economic ties to Luxembourg :

Thirdly, the Crown argued that the trusts could not claim treaty exemption as they had little commercial and economic ties to Luxembourg. The court observed that there is no distinction in the Luxembourg Convention between residents with strong economic or commercial ties and those with weak or no commercial or economic ties. If a person satisfies the definition of resident in Article 4, then that person is a resident for the purposes of Articles 13(4) and (5). 

3.2. Second stage:

The Court observed that the second stage of abuse analysis focuses on whether the provisions, so construed, were frustrated by the tax benefit achieved.

Here the court held that the selection of a low tax jurisdiction may speak persuasively as evidence of a tax purpose for an alleged avoidance transaction, but the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive. It is the use of the selected treaty that must be examined.

Thus, the court held that the tax treaty exemption can be claimed with respect to capital gains under Canada-Luxembourg tax treaty, in the absence of any evidence of abuse. The GAAR interpretation of the tax treaty provisions do not supersede the tax treaty benefits as the treaty itself has provided clear and express requirements reflecting the object, spirit and purpose of its relevant provisions.

4. Implications of the Judgment: 

The judgment sets a good precedent in relation to interpretation of tax treaty provision when it interacts with GAAR. It provides that the express wordings of the treaty itself reflects the object, spirit and purpose for claiming tax treaty benefits in absence of any guidance from GAAR.

However, the same precedent might be short-lived when countries are implementing the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI).The MLI will impact the majority of Canada’s bilateral tax treaties to incorporate treaty abuse countermeasures. The prominant measure that the impact the present case is the Principle Purpose Test (‘PPT’). The PPT will be imported via MLI into most of Canada’s tax treaties with respect to treaty exemptions for capital gains tax realized. The PPT requires that the granting of a tax benefit must be in accordance with the object and purpose of the provisions of the Treaty. Thus the present case might come under the PPT if the purpose of setting a holding structure in Luxembourg is to obtain tax benefit. There is little guidance on PPT application as it is yet to be tested before the courts.Thus, it remains to be seen what impact, if any, the PPT will have on the court’s assessment of the spirit, object and purpose of the tax treaty and its provisions. The decision is subject to a possible appeal to the Supreme Court of Canada.