In the consultation paper, the advisory panel set out the following possible approaches to treaty shopping (paragraph 3.23):

As noted above, certain treaty benefits are afforded to "beneficial owners" who are resident in a treaty country. The CRA has challenged some structures on the basis that the person resident in the treaty country who is receiving the payment is not the beneficial owner, and so the treaty benefits should be denied. One option is to define the term "beneficial owner" in Canada's domestic tax law, specifying the criteria that a person must meet to be considered the beneficial owner of a stream of income. This approach could add some clarity and certainty for taxpayers and the CRA alike. Another option is for Canada to update each of its tax treaties to include a specific, detailed anti-treaty-shopping rule, similar to the rules in most U.S. tax treaties. Alternatively, such an anti-treaty-shopping rule could be adopted in Canada's domestic tax law, although this may raise issues regarding the possible override of existing tax treaties.

In the final report, the advisory panel elaborated on Canada's approach to treaty shopping as follows (paragraphs 5.65-5.67, footnotes omitted):

Canada grants access to treaty benefits only to persons who are residents of a country with which Canada has entered into a treaty. A corporation is a resident of a treaty partner if the corporation is liable to taxation in that country. Certain treaty benefits, such as eligibility for reduced rates of withholding tax on dividends, interest and royalties, are limited to residents who are the "beneficial owners" of such income.

Neither Canada's tax treaties nor its domestic law define "beneficial owner." Courts in Canada and other countries have attempted to interpret or define what "beneficial owner" means, and the Panel heard that it might be best to wait for a globally agreed definition before taking unilateral action in this regard. Moreover, the OECD Model Tax Convention on Income and on Capital and Commentaries set out numerous counter-measures, based on the concepts of residence and beneficial owner, which member states—including Canada—use in their treaties and domestic law to counter treaty shopping or limit access to treaty benefits. The recent inclusion of a broad anti-treaty shopping provision in the fifth protocol to the Canada-U.S. tax treaty shows that Canada is willing to include such a provision in its tax treaties when it sees fit to do so.

In 2004, Canada extended application of its general anti-avoidance rule to tax treaties. However, a recent court case [MIL (Investments)] has cast doubt on the extent to which this rule could be used to counter treaty shopping. A number of tax authorities, including the CRA, seem to be moving toward an implied general anti-abuse rule regarding improper tax treaty use. A body of international jurisprudence is developing on what constitutes an abuse of a tax treaty (although these decisions have produced somewhat mixed results). [Emphasis added.]

Finally, in the final report, the advisory panel made the following recommendations to the government of Canada (paragraph 5.68):

The Panel believes that businesses should be able to organize their affairs to obtain access to treaty benefits. Tax treaties are complex and the relationships among tax treaties even more so. While there may be situations in which inappropriate access to tax treaties can arise, the Panel believes that Canada has adequate resources and tools in its tax treaties and domestic law and in international jurisprudence to police treaty shopping. However, the government should continue to monitor developments in this area. [Emphasis added.]

In other words, the advisory panel seems to say that treaty shopping is generally benign and the Canadian government should not take any precipitious action in an attempt to halt such tax planning. The advisory panel does conceive of treaty-shopping structures that could be abusive, but believes that the government has adequate resources to address such situations. What remains to be seen is to what extent the Canadian government will heed the advisory panel's advice. If it does, it is to be expected that the government will limit itself to bringing to the courts cases that it considers abusive; if it does not, the Department of Finance may choose to amend the Act or renegotiate certain of Canada's treaties to include anti-treaty-shopping provisions. The discussion below explores the avenues of possible development of Canada's treatment of treaty shopping in these terms.

B. Possible Bases for Future Court Challenges to Treaty Shopping

1. Under the GAAR

It is understood that the government's expectations of MIL (Investments) were very high and the resulting defeat was a disappointment. Yet, despite the taxpayer-favourable outcome of MIL (Investments), it is unclear to what extent this decision constitutes a strong, adverse precedent against the CRA. The TCC appears to have decided the case on the basis of subsection 245(3) of the Act, finding as a matter of fact that the relevant transactions were arranged primarily for bona fide purposes and not to obtain a tax benefit. Hence, the TCC's analysis of abuse in subsection 245(4) and its strong statements, in particular that "the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive," were obiter dicta. This makes MIL (Investments) a weak precedent, because the facts of another case may easily be distinguished from its facts.

The decision of the FCA, however, includes a confusing and slightly mysterious statement that the taxpayer had admitted that its continuance as a Luxembourg corporation was, in fact, an avoidance transaction. This element is absent from Bell J's trial decision, which was based on findings of fact contrary to that admission. Nonetheless, it is unlikely that the admission would elevate the TCC's abuse analysis to the level of binding reasoning, because, in any event, the TCC had found that the sale, which crystallized the tax benefit, was not part of the same series of transactions that included the continuance from the Cayman Islands to Luxembourg; hence, the abuse analysis remains obiter dictum.

Considering this, its single defeat in MIL (Investments) is not likely to discourage the CRA from using the GAAR to challenge situations that it perceives as offensive treaty shopping. Arguably, the GAAR should be the CRA's principal (if not the only) weapon against tax treaty abuse. In this respect, the author is not aware of any pending court cases that involve a GAAR challenge to inbound treaty shopping, but a 2008 technical interpretation shows that the CRA is prepared to use the GAAR to curb perceived abusive treaty shopping.41 The CRA document describes a situation where a Dutch resident owns a vessel and leases it, pursuant to a bareboat charter, to a sister corporation resident in Norway, which in turn leases it to a Canadian resident that uses it in Canada's territorial waters. The crewing and operation are provided by another related company resident in Norway. The CRA opined on whether the Canadian withholding tax applies to the rentals from the Canadian lessee of the vessel to the Norwegian corporation and to the rentals from the Norwegian resident to the Dutch owner of the vessel. The CRA was asked to assume that the Norwegian corporation was not an agent or nominee of the Dutch corporation. The CRA stated that both sets of rental payments would be exempt from the Canadian withholding tax pursuant to Canada's treaties with Norway and the Netherlands. At the end of its technical interpretation, however, the CRA stated:

The application of … the general anti-avoidance rule ("GAAR") may be considered in the type of situation you describe. … In reference to the GAAR, if the 2 separate Bareboat Arrangements and /or the separation of the time charter and bareboat activities were created in order to avoid Canadian Part I or Part XIII tax, then GAAR may apply to re-characterize the transactions to eliminate any tax benefit arising from the arrangements.

The reason why the CRA raised the possible use of the GAAR is probably that the situation in the technical interpretation involves a form of treaty shopping. The Canada-Norway tax treaty42 is Canada's only treaty with a developed country that does not include rents for "industrial, commercial or scientific equipment" in the definition of "royalties";43 hence, it provides an exemption for rentals that are not attributable to a permanent establishment in Canada.

2. Under Tax Treaty Law

a. Treaty Residence

The advisory panel did not identify "treaty residence" as an area of development of the law as it relates to treaty shopping. As mentioned above, the reason may be that the holding in Crown Forest has been well-settled law in Canada for over ten years. This was confirmed by the CRA in its Income Tax Technical News No. 35 (February 26, 2007). However, from the same document it appears that the CRA may be preparing the ground for a more aggressive stance on treaty residence where the CRA perceives that a particular situation involves abusive treaty shopping:

It remains CRA's position that, to be considered "liable to tax" for the purposes of the residence article of Canada's tax treaties, a person must generally be subject to the most comprehensive form of taxation as exists in the relevant country. This, however, does not necessarily mean that a person must pay tax to a particular jurisdiction. There may be situations where a person's worldwide income is subject to a contracting state's full taxing jurisdiction but that state's domestic law does not levy tax on a person's taxable income or taxes it at low rates. In these cases, the CRA will generally accept that the person is a resident of the other Contracting State unless the arrangement is abusive (e.g. treaty shopping where the person is in fact only a "resident of convenience"). Such could be the case, for example, where a person is placed within the taxing jurisdiction of a Contracting State in order to gain treaty benefits in a manner that does not create any material economic nexus to that State. [Emphasis added.]

This position of the CRA regarding abusive arrangements is unsubstantiated by Canadian legal authority.44 In fact, the phrase "resident of convenience" seems to first have been coined by the CRA in the above-mentioned technical news document. However, the CRA may now argue that the recent Federal Court decision in RCI Trust 45 lends support to such position.

Briefly, the RCI Trust case involved a Barbados trust, which, on May 5, 2006, disposed of shares in the capital of a Canadian corporation, RCI Environment Inc., to a related corporation for $145 million. The trust was settled in 2002 for the benefit of a Cayman Island trust, which itself had been formed in 1995 for the benefit of the Canadian-resident children of Lucien Remillard, the Canadian-resident principal of the Canadian corporation.

Regarding the sale of the RCI Environment Inc. shares, the Barbados trust argued before the court that the gain from such sale is exempt from Canadian tax because the trust is a resident of Barbados for the purposes of the Canada-Barbados tax treaty and, therefore, qualifies for a treaty exemption. The government questioned the residency claim on the basis that Canada's non-resident trust anti-deferral rule in section 94 may deem the trust to be resident of Canada and that this may give rise to dual residency under the treaty, which would trigger the competent authority tie-breaker procedure under article IV(3).

In deciding the matter, Simpson J considered where the trust was resident for the purposes of the Canada-Barbados tax treaty. She held as follows:

[37] The Respondent acknowledges that the Barbados Trust is a prima facie resident of Barbados.46 Based on the facts described above, it meets the physical criteria associated with actual residence of the kind described in Article IV, paragraph 1, of the Treaty, which speaks of "domicile," "place of management" and "criterion of a similar nature." In my view, similar criteria would include other aspects of actual physical presence and not more esoteric concepts such as deemed residence.

[38] The question is whether Article 3 [sic] of the Treaty allows me to conclude that the Barbados Trust is also a resident of Canada. In my view, such conclusion is not open to me on the facts of the case because Article IV, paragraph 3, limits the assessment to the provisions of paragraph 1 of the Treaty. This means that a finding of dual residence must be based on actual physical factors and there are no such factors linking the Barbados Trust to Canada. Accordingly, the Barbados Trust is only resident in Barbados. [Emphasis added.]

On the basis of this case, the CRA may argue that Simpson J's description of the treaty residence criteria in the Canada-Barbados tax treaty as "physical criteria" lends support to its suggestion, in Income Tax Technical News No. 35, that the benefits of a treaty are available only to persons that have "material economic nexus" to one or both of the treaty countries. Arguably, such line of reasoning would not be correct. Simpson J's statements should be read to the effect that the treaty residence criteria in the Canada-Barbados tax treaty (like in Canada's other treaties) require full tax liability based on territorial jurisdiction as opposed to any other type of jurisdiction (such as nationality). In this respect, corporate taxation based on a corporation's place of management or based on incorporation, which gives rise to domicile, 47 should meet the territorial criteria for treaty residence without the further need of any particular degree of economic nexus to one or both of the contracting states.

In any event, as of yet, it is unclear what exactly the CRA means by the statements in Income Tax Technical News No. 35 and how it intends to use them in practice.48 It is hoped that the reference to "abusive" indicates that the CRA will use the GAAR to challenge situations it perceives as a residence of convenience (whatever this means). Besides, in light of the holding of the Supreme Court of Canada in Shell Canada Ltd. v. Canada,49 it seems unlikely that the CRA should apply an economic-substance approach to determine treaty residence. However, in light of MIL (Investments), it is questionable whether a challenge to treaty residence based on the GAAR could be successful in the courts.

b. Specific Anti-Avoidance Rules: Beneficial Ownership

The decision in Prevost is an important victory against the CRA's attempt to use the concept of "beneficial ownership" to address its treaty-shopping concerns. Yet, as a consequence of the FCA's observations on the interpretational value of later OECD commentaries, it may be expected that the CRA will not be discouraged from using the OECD's interpretation of "beneficial owner" to challenge perceived abusive treaty shopping.50 Hence the meaning of the undefined treaty term "beneficial owner" will likely remain a source of contention between taxpayers and the CRA at least until another higher court decision solidifies the authority of Prevost. In this respect, to the author's knowledge, another inbound treaty-shopping case, Velcro Canada Inc. v. Canada,51 concerning the interpretation of the treaty notion of "beneficial owner," is pending before the Tax Court. In Velcro, during its 1995 to 2004 taxation years, the taxpayer, Velcro Canada Inc. (VCI), an operating Canadian corporation, paid royalties for intellectual property licensed from Velcro Industries BV (VIBV). On December 29, 1995, VIBV changed its residence to the Netherlands Antilles. Before that, on October 27, 1995, VIBV had assigned the VCI licence to Velcro Holdings BV (VHBV), a substantial Dutch corporation that acted as the exclusive sublicensor of VIBV's intellectual property in some jurisdictions. The CRA reassessed VCI on the basis that VHBV was not the beneficial owner of the royalties from VCI and was a conduit for VIBV, a resident of a non-treaty jurisdiction.

Arguably, the Crown should lose Velcro and it is hoped that the CRA heeds Brian Arnold's recommendation (cited above) and abandons further treaty-shopping challenges based on the notion of "beneficial owner."

c. Inherent Anti-Abuse Rule in Tax Treaties

In the consultation paper, the advisory panel did not consider the existence of an inherent anti-abuse rule in tax treaties, but in its final report it noted that "[a] number of tax authorities, including the CRA, seem to be moving toward an implied general anti-abuse rule regarding improper tax treaty use."

Certainly, if the only source of such a rule is the 2003 OECD commentaries, MIL (Investments), the only Canadian case on point, made it clear that the rule would not apply to pre-2003 treaties.52 However, the subsequent FCA decision in Prevost has put into question this position. The court in that case opened the door to the use of later OECD commentaries in interpreting pre-existing tax treaties and, hence, to the potential application of the OECD-advocated implied general anti-abuse rule in tax treaties.

As pointed out in the final report and in light of the FCA's decision in Prevost, the CRA may move toward an implied general anti-abuse rule regarding improper tax treaty use. The OECD views on treaty abuse, as reflected in the 2003 OECD commentaries, would be attractive to the CRA, because they, as opposed to the GAAR,53 establish a vaguer and potentially broader approach to tax avoidance, rooted in purposive interpretation54 and economic substance characterization,55 which does not always clearly distinguish between abusive and inoffensive cases.

Certainly, the CRA may be expected to argue the existence of an inherent anti-abuse rule in future cases and will likely seek support in foreign case law on point. In this respect, in A Holding Aps v. Federal Tax Administration,57 the Swiss Federal Court considered whether in a treaty-shopping situation the taxpayer, a Danish-resident company, was eligible for the reduced tax rate on dividends paid by a Swiss company under the 1973 Switzerland-Denmark tax treaty. The Danish company was a wholly owned subsidiary of a Guernsey company, which in turn was wholly owned by a company incorporated in Bermuda. The Swiss Federal Court found the Danish company to be the beneficial owner of the dividend from the Swiss company despite the fact that the Danish company had no staff, offices, or other assets and that, on receipt, it immediately paid the entire dividend to its Guernsey parent. Nonetheless, the claim for the reduced withholding tax rate was denied because the court held that the tax treaty was abused. The court held that the 2003 OECD commentaries, which post-date the Switzerland-Denmark treaty, were relevant in construing the treaty.

Arguably, reliance by the CRA on an inherent anti-abuse rule in tax treaties based on the 2003 OECD commentaries should not be successful, at least with respect to pre-2003 treaties. The 1986 conduit report and the 2003 commentaries, which reflect a particular view of the purposes of tax treaties and the way transactions must be characterized for treaty purposes, if not directly contradicting the OECD's earlier positions, at the very least must be regarded as having added to them something that was not already there before 2003. Therefore, there should be little justification to accord them any weight in the interpretation of Canada's pre-2003 treaties.

C. Changes to the Act or Canada's Tax Treaties

1. Changes to the Act

In the final report, the advisory panel seems to suggest that the Canadian government should not take any legislative action to try to block treaty-shopping situations. Nonetheless, in the consultation paper, the advisory panel discussed the possibility that a specific anti-treaty-shopping rule could be adopted in Canada's domestic tax law. The consultation paper rightly warned that such an approach raises issues regarding the possible override of existing tax treaties.

Nonetheless, other countries have adopted or are considering the adoption of such a rule. For example, Germany has a domestic anti-treaty-shopping rule that was strengthened in 2007. The rule denies treaty benefits if the shareholder of an interposed foreign subsidiary would not otherwise receive treaty benefits if it received the payment directly and if (1) the structure has no business purpose; (2) the interposed foreign subsidiary does not derive more than 10 percent of its income from its own business activities; or (3) the foreign subsidiary does not have adequate business substance to conduct business activities.

In the United States, certain proposed amendments to the Internal Revenue Code that are popular with the Obama administration would apply to deductible related-party payments from a US entity to a foreign entity when both are controlled by a common parent to override US treaties by subjecting the payments to the withholding tax rate that would apply if the payment were made directly to the common parent.

Despite these developments, at present, there has been no suggestion by government officials that Canada has the appetite for such a radical and aggressive approach.

2. Changes to Canada's Tax Treaties

As suggested by the advisory panel in the consultation paper, another approach to treaty shopping is for Canada to update its tax treaties to include a US-style LOB provision. Although the amended bilateral LOB provision in the fifth protocol to the Canada-US tax treaty is Canada's first treaty anti-abuse rule of this type, comments by the Department of Finance during the Seminar seem to indicate that, as a general policy, Canada does not intend to include LOB provisions in its other tax treaties.

Although there is no indication to this effect, the Department of Finance may still opt for a more focused approach in order to deal with certain types of treaty shopping.61 As a recent example of such an approach, the protocol to the UK-Switzerland tax treaty, which entered into force on December 22, 2008, amended that treaty to deny the benefits of the dividend, interest, and royalties articles in the context of a "conduit arrangement." This expression is defined in new article 3(1)(l) of that treaty as follows:

the term "conduit arrangement" means a transaction or series of transactions which is structured in such a way that a resident of a Contracting State entitled to the benefits of this Convention receives an item of income arising in the other Contracting State but that resident pays, directly or indirectly, all or substantially all of that income (at any time or in any form) to another person who is not a resident of either Contracting State and who, if it received that item of income directly from the other Contracting State, would not be entitled under a convention for the avoidance of double taxation between the State in which that other person is resident and the Contracting State in which the income arises, or otherwise, to benefits with respect to that item of income which are equivalent to, or more favourable than, those available under this Convention to a resident of a Contracting State and the main purpose of such structuring is obtaining benefits under this Convention.

V. CONCLUSION

It is clear from the above discussion that, to date, Canadian authorities support inbound treaty shopping. The TCC in Canada's first decision on point, MIL (Investments), clearly suggested that treaty shopping to minimize tax, on its own, cannot be viewed as abusive. In its final report, the advisory panel seemed to endorse the idea that treaty shopping is not inherently objectionable, by stating that "businesses should be able to organize their affairs to obtain access to treaty benefits." Most recently, the FCA in Prevost clearly rejected the CRA's attempt to challenge what it apparently perceived as improper treaty shopping by denying the status of "beneficial owner" for treaty purposes.

Nonetheless, this area of the law is changing rapidly and new developments, particularly at the OECD, must be monitored closely. In this respect, Prevost's main significance is that the FCA has opened the door to the use of later OECD commentaries in interpreting pre-existing tax treaties and, eventually, to the potential application of the various treaty anti-abuse notions advocated by the OECD in the 2003 commentaries to the OECD model convention. As a consequence of this, the CRA may consider it desirable to rely more often on an inherent general anti-abuse rule regarding improper tax treaty use. Similarly, it may be expected that the CRA will not be discouraged, at least until Velcro is decided, from using the OECD's interpretation of "beneficial owner" to challenge perceived abusive treaty shopping. As explained above, however, such possible CRA initiatives should not be successful.

Another avenue of possible development of Canada's tax law in respect of treaty shopping is treaty residence. In this respect, the CRA seems to be preparing the ground for a more aggressive assessing practice in situations of perceived abusive treaty shopping, but so far it is unclear what exactly the CRA intends to do in practice.

Finally, despite the CRA's setback in MIL (Investments), it is expected that the CRA will continue to use the GAAR in cases it regards as abusive treaty shopping. Arguably, this is the only reasonable approach for the Canadian government. In other words, the CRA should "stick to its guns."

concluded

(see PART I)

END NOTES:

¹ This paper is dedicated in tribute to the late David A. Ward, who had provided the author with helpful comments with respect to this paper before passing away on January 13, 2010. All errors or omissions remain the responsibility of the author.