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5. Taxation of Inbound Direct Investment

Introduction

5.1   As noted in Chapter 2, direct investment in Canada by foreign businesses is important to Canada’s prosperity. Inbound foreign direct investment stimulates business activity and creates jobs in Canada. It fosters competition, facilitates the importation of new technology and skills, and contributes to the growth and productivity of Canada’s economy.

5.2   The Panel is guided by the principle described in Chapter 3 that Canada’s tax system should seek to treat foreign investors in a way that is similar to domestic investors while ensuring that foreign companies investing in Canada pay an appropriate amount of Canadian tax on their Canadian-source income.

5.3   In this chapter, we address two important aspects of Canada’s system for taxing foreign inbound investment: the tax treatment of interest expense incurred by foreign-owned Canadian businesses and access to Canada’s tax treaty network by foreign investors. Both aspects present challenges in ensuring foreign and Canadian investors are treated similarly while protecting the integrity of Canada’s tax base. The Panel recognizes that the playing field can never be perfectly level. For example, some non-resident investors could structure the financing of their investments into Canada in a more tax-effective way than could Canadian domestic investors. The Panel’s pragmatic approach was to focus on the tax consequences arising within the Canadian tax system and not on the tax consequences in other jurisdictions. Canada’s withholding tax regime — a third area affecting foreign inbound taxation — is discussed in Chapter 6.

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Interest expense incurred by foreign-owned Canadian businesses

Canada’s approach

5.4   Foreign businesses investing in Canada typically have the flexibility to choose between debt and equity in financing their Canadian subsidiaries. Using related-party debt rather than equity allows a foreign business to reduce its overall tax burden to the extent that the interest paid by the Canadian subsidiary is deductible in Canada at a higher tax rate than the rate at which the interest is taxed in the parent company’s or related company’s home country. Without any restrictions, a foreign business could leverage its Canadian subsidiary entirely or mainly with debt, thereby eliminating or significantly reducing the amount of tax the subsidiary would otherwise pay in Canada.

5.5   To address this concern, Canada has adopted rules — known as “thin capitalization” rules — to limit the erosion of the Canadian corporate income tax base from deductions claimed by foreign-owned Canadian corporations regarding interest paid on loans from related non-residents. Under these rules, interest paid by a Canadian corporation on loans received from certain non-resident persons⁷⁸ is not deductible to the extent that such loans exceed twice the equity (computed under special rules) of that corporation.

5.6   These rules do not apply to loans received from third-party lenders, whether Canadian or foreign, including loans guaranteed by a related foreign company. Interest expense denied under these rules cannot be carried forward for use in future years.

5.7   In the early 1970s, Canada became one of the first countries to adopt thin capitalization rules. The Panel believes that Canada’s current approach has stood the test of time and works well: it is effective, transparent and relatively simple to administer and comply with. Many other developed countries also restrict the amount of interest paid on related-party debt that a foreign-owned corporation can deduct, although some of these countries use different approaches. Many countries also restrict interest paid on other forms of debt, as discussed below.

5.8   The Panel believes Canada’s current approach should be maintained. In the course of our review, the Panel noted some specific issues, discussed below, which should be addressed to ensure the system remains effective in protecting Canada’s tax base.

Other countries’ approaches

5.9   Other countries face similar challenges in protecting their domestic tax bases, and many significantly changed their treatment of interest expense in recent years. While some countries, like Canada, impose limits on related-party indebtedness that are based on fixed debt-to-equity or debt-to-assets ratios (for example, Australia, Japan, the Netherlands and New Zealand), others impose different restrictions on related-party debt financing (sometimes together with a fixed-ratio limit).⁷⁹ These approaches and their possible application to Canada are discussed below.

Earnings stripping rules

5.10   As an alternative to a fixed-ratio approach, some countries have adopted “earnings stripping” rules. Under this approach, the amount of related-party interest that a foreign-owned corporation can deduct is limited to a percentage of that corporation’s earnings before interest, tax, depreciation and amortization. The United States was among the first countries to adopt such an approach, with rules enacted in 1989. Denmark, France, Germany and Italy recently adopted similar rules.

5.11   The merit of earnings stripping rules is that they target interest deductions — and related tax planning — more directly than the balance sheet approach used in thin capitalization regimes. Earnings may be better than equity as a proxy for a firm’s borrowing capacity; equity is typically valued at historical cost and does not reflect current profit expectations. For that reason, a limitation based on earnings would treat similarly situated taxpayers more consistently and could better accommodate industries with higher degrees of leverage.

5.12   However, earnings stripping rules tend to be more complicated than fixed-ratio approaches. Adopting an earnings stripping rule in Canada would be particularly complex given that Canada does not have a consolidation regime for tax purposes.⁸⁰ Earnings stripping rules also can adversely affect cyclical businesses by limiting their ability to deduct interest expense during economic downturns. While carryover provisions could be adopted to mitigate these adverse effects, more complexity in the rules would result.

Arm’s length approaches

5.13   Under another alternative, some countries apply transfer pricing principles to determine how much related-party debt of a foreign-owned subsidiary is appropriate. For example, the United Kingdom denies deductions for interest paid by corporations on related-party loans to the extent that the loans exceed what those corporations could have borrowed from third-party lenders. Other countries, such as Australia, do not restrict interest deductibility under their thin capitalization or earnings stripping rules if the corporation can demonstrate that it could have borrowed the same amount from arm’s-length lenders. Also, a foreign-owned Japanese corporation can exceed Japan’s maximum allowable 3:1 debt-to-equity ratio if other Japanese corporations in a similar business and of a similar size carry higher debt-to-equity ratios.

5.14   The merit of an arm’s length approach is that it considers the corporation’s specific situation in determining how much interest the corporation can deduct. In contrast, under Canada’s current thin capitalization regime, foreign-owned Canadian corporations are subject to the same maximum debt-to-equity ratio regardless of their size, profitability or line of business.

5.15   On the other hand, the arm’s length approach would be more difficult and costly to comply with and administer, as foreign-owned Canadian corporations would have to demonstrate to the CRA that their level of debt meets the arm’s-length test. This approach could cause uncertainty because it would likely be difficult for the government to provide clear and timely guidance on exactly what constitutes an arm’s-length amount of debt. Canada’s bright-line test of how much related-party debt a foreign-owned corporation can borrow offers greater certainty to businesses, and is simpler and easier to administer.

Third-party and guaranteed debt

5.16   Rules to limit interest deductibility also differ as to the type of debt to which they apply. Canada’s current thin capitalization rules only apply to related-party debt. In recent years, an increasing number of countries have extended thin capitalization or earnings stripping rules to cover third-party debt as well as related-party debt.

5.17   New Zealand introduced rules which took effect in 1996 that limit interest deductions on related and third-party debt to the higher of 75 percent of a corporation’s total assets and 110 percent of the debt-to-asset ratio of the corporation’s worldwide group. Australia adopted a similar regime in 2001.

5.18   Germany adopted an earnings stripping rule in 2008 that limits the interest expense claimed by a German resident company where the company’s total net interest expense exceeds 30 percent of its taxable earnings before interest, taxes, depreciation and amortization. This restriction applies to interest paid on any debt of a taxpayer, as long as the taxpayer is a member of a corporate group. Denmark and Italy have adopted similar earnings stripping rules in the last two years.

5.19   France and the Netherlands do not restrict the amount of interest paid on third-party debt that a corporation can deduct, but they do take into account how much third-party debt has been borrowed to determine whether to restrict deductions for related-party interest expense.

5.20   A few other countries, including the United States, the United Kingdom, Japan and the Netherlands, allow deductions for interest paid to third-party lenders but restrict interest paid on third-party debt that is guaranteed by a foreign parent company (“guaranteed debt”).

5.21   Some of the above countries, notably Australia, New Zealand and many European jurisdictions, extend the scope of their rules beyond foreign-owned businesses to domestic companies with foreign operations or even to all companies. EU countries have been extending their rules to both domestic and foreign-owned companies to ensure they are in line with EU law regarding non-discrimination and the free movement of capital within the EU.⁸¹

5.22   Based on the Panel’s benchmarking research, Canada now appears to be one of the few developed countries to apply thin capitalization rules to related-party debt only. The Canadian government proposed to extend the thin capitalization rule to guaranteed debt in the 2000 federal budget, but this proposal was later withdrawn.⁸² Recently, two Canadian international tax experts called for Canada to adopt a comprehensive domestic thin capitalization rule that would apply to all indebtedness of all Canadian corporate groups, and not just to foreign-owned Canadian corporations.⁸³

5.23   The policy case for limiting interest deductions on these forms of indebtedness is mixed. In some circumstances, third-party and guaranteed debt can substitute for related-party debt and can be sourced out of Canada to produce a higher interest deduction in Canada. To that extent, foreign businesses can use both related-party and third-party debt to leverage their Canadian operations. However, other non-tax considerations can restrict how much third-party and guaranteed debt a foreign-owned Canadian corporation can borrow.⁸⁴ Related-party debt and third-party debt are less-than-perfect substitutes, which may act as a constraint that lessens the need to impose limits on third-party debt.

5.24   There is little evidence that Canada’s income tax base is at risk from the use of third-party and guaranteed debt by non-financial foreign-owned Canadian corporations. At the industry level, enterprises under foreign control do not appear to be significantly more indebted than enterprises under Canadian control. Table 5.1 shows the total assets in non-financial industries of enterprises under foreign control, categorized by the magnitude of the difference at the industry level between the debt-to-equity ratio of foreign-controlled enterprises and the debt-to-equity ratio of Canadian-controlled enterprises. On average, industries where the aggregate debt-to-equity ratio of foreign-controlled enterprises is no greater or at most 10 percent greater than the aggregate debt-to-equity ratio of Canadian-controlled enterprises account for three-quarters of all assets of foreign-controlled enterprises.⁸⁵

5.25   Restricting the use of third-party or guaranteed debt would increase the complexity of the current system and the compliance burden of businesses. Unlike most developed countries, Canada does not permit consolidated reporting for tax purposes. Rather, all members of a corporate group compute their tax liabilities and file returns separately. The lack of tax consolidation in Canada would make it difficult to restrict interest deductibility related to third-party or guaranteed debt. For example, a foreign business could set up one Canadian financing company for channelling debt to its Canadian operating subsidiaries. By borrowing from third parties with a parent guarantee, the financing company could exceed a 2:1 debt-to-equity ratio, even though the debt-to-equity ratio of the Canadian consolidated group might be under 2:1. If the rules covered guaranteed debt, additional measures would be needed to ensure that no restriction applies in such situations.

5.26   Another complication would be the need to exclude financial institutions (e.g., banks, non-banks and lessors) from the scope of any such restrictions. Use of third-party and guaranteed debt is within the normal business practices of the financial intermediation sector, and restrictions on such indebtedness could impair the competitiveness of these businesses and limit the ability of foreign-owned financial institutions to service key sectors of the Canadian financing market.

5.27   Having considered whether Canada’s thin capitalization rules should apply to third-party and guaranteed debt, the Panel concluded that such restrictions are not required at this time. More specifically, Canada’s thin capitalization rules should not be extended to limit the deductibility of interest payable by foreign-owned Canadian corporations on third-party debt and guaranteed debt, nor should they be modified to take into account third-party and guaranteed debt in determining the amount of related-party interest that a foreign-owned Canadian corporation can deduct.

5.28   Although restricting deductions related to interest paid on third-party and guaranteed debt is not advisable at this time, the government should continue to follow developments in other countries and monitor the use of these forms of debt in Canada to ensure that the existing rules support the proper measurement of Canadian-source business income.

Tightening Canada’s thin capitalization regime

5.29   For the reasons discussed above, the Panel believes that Canada’s current approach to interest expense incurred by foreign-owned Canadian businesses is sound in principle and appropriate in scope. The approach is transparent and relatively easy to enforce, and the Panel believes it should be maintained.

5.30   Many developed countries have tightened their approaches to thin capitalization in recent years. This trend may reflect the increasing use of cross-border financial transactions and the rising need for governments to take steps to protect their tax bases. In light of ongoing change in the tax environment, business practices and capital markets, Canada’s rules should be assessed to ensure they appropriately address the use of related-party debt.

5.31   The central feature of Canada’s current thin capitalization regime is the maximum debt-to-equity ratio. Interest on related-party debt of foreign-owned Canadian corporations over this ratio is not deductible. The maximum debt-to-equity ratio was initially set at 3:1 and reduced to 2:1 following the 2000 federal budget.

5.32   In our consultation paper, the Panel asked whether the current 2:1 ratio is a good proxy for the amount of related-party debt that a foreign-owned Canadian corporation should be allowed to incur in Canada. Based on our analysis, the Panel has concluded that a more restrictive ratio is appropriate.

5.33   While the planned reductions in Canada’s statutory corporate income tax rate will bring many economic benefits, these reductions alone will not be enough to reduce the incentive for foreign businesses to use related-party debt to finance their Canadian subsidiaries for the following reasons:

• The elimination of withholding tax on non-arm’s-length interest paid to U.S. residents under the fifth protocol to the Canada-U.S. tax treaty will make it more attractive for U.S.-based corporate groups to finance their Canadian subsidiaries with debt.
• While Canada’s rate is expected to be six percentage points lower than the average rate of other G7 countries by 2012, it will still be higher than the rates in many other OECD and non-OECD countries.

• Reducing the corporate tax rate does not discourage certain transactions that allow foreign businesses to gain a significant cost advantage over Canadian-owned companies (i.e., inbound double dips).⁸⁶

5.34   The debt-to-equity ratio permitted under Canada’s current thin capitalization rules is relatively high compared to actual Canadian industry ratios, suggesting that the ratio permits inappropriate levels of related-party debt. Accordingly, reducing the current ratio probably should not significantly affect access to capital. As Table 5.2 shows, average industry-level, debt-to-equity ratios over the 2000-2005 period were well under 2:1 in most industries, especially in the non-financial sector. The same is true for enterprises under foreign control.

Source: Calculations based on a special tabulation obtained from Statistics Canada using data from the Financial and Taxation Statistics for Enterprises program. Debt-to-equity ratios are calculated as the ratios of short-term loans and long-term loans and debt to total shareholders’ equity.

5.35   Table 5.3 shows the percentage of the total market capitalization of the 1,000 largest publicly traded Canadian companies by industry, as reported annually by the Report on Business magazine. In the 2007 and 2008 surveys, companies with an overall debt-to-equity ratio greater than 2:1 (mostly in the financial sector) accounted for 6.1 and 3.3 percent respectively of the total market capitalization of these 1,000 largest companies.⁸⁷ The average debt-to-equity ratio, weighted by market capitalization, was 0.63 in 2007 and 0.59 in 2008.

5.36   Our benchmarking research shows that the currently permitted debt-to-equity ratio in Canada’s thin capitalization rules may be high relative to world standards, because the ratios in many other countries apply to third-party and related-party debt. Many countries with ratios equal to or greater than 2:1 apply them to related-party, guaranteed and third-party debt.

5.37   Although tightening the restrictions on the use of related-party debt might encourage companies to source more of their debt from third parties, such a change would put foreign and Canadian-owned businesses on a more similar footing because foreign businesses would not enjoy any advantage regarding the use of third-party debt.

5.38   Foreign-owned corporations have an incentive to use related-party debt to reduce their Canadian tax liabilities. The above data suggests that the current thin capitalization ratio is not in line with current industry practices or with the rules in place in other countries. For these reasons, the Panel believes that the current maximum debt-to-equity ratio of 2:1 should be reduced.

Recommendation 5.1: Retain the current thin capitalization system, and reduce the maximum debt-to-equity ratio under the current thin capitalization rules from 2:1 to 1.5:1.

Technical issues related to the thin capitalization rules

5.39   In the course of our work, the Panel identified certain technical issues related to the thin capitalization rules that should be addressed. The Panel believes that the measures discussed below would strengthen the integrity of the current regime. Addressing these issues could add complexity to the existing rules, and further study and consultations are needed to gauge the significance of these issues in practice.

Partnerships, trusts and branches

5.40   The current thin capitalization rules apply only to foreign-owned Canadian corporations. Foreign companies that carry on business in Canada through partnerships, trusts or branches are not subject to the same limitation, which raises issues about the integrity and fairness of the current rules.⁸⁸ In 1998, the Technical Committee on Business Taxation recommended extending the current rules to partnerships, trusts and Canadian branches of foreign corporations.⁸⁹ In the 2000 federal budget, the government said it intended to hold consultations on how best to extend these rules to entities other than corporations. The Panel recommends that these consultations proceed and that the rules be extended to these other business entities.

Recommendation 5.2: Extend the scope of the thin capitalization rules to partnerships, trusts and Canadian branches of non-resident corporations.

Disallowed interest expense

5.41   Currently, interest expense that is not deductible under the thin capitalization rules maintains its character as interest for both domestic and tax treaty purposes. This treatment could allow U.S. investors to inappropriately reduce their Canadian withholding tax liabilities once the withholding tax reduction in the fifth protocol to the Canada-U.S. tax treaty is fully in force. For example, a U.S. investor will have a preference for substituting non-deductible interest, which would not attract withholding tax, for a non-deductible dividend from its Canadian subsidiary (subject to withholding tax at five percent).

5.42   Some countries deem interest expense that is disallowed under their thin capitalization regimes to be treated as dividends subject to withholding tax. This treatment would be consistent with the policy underlying Canada’s thin capitalization rules and would address the issue arising under the fifth protocol to the Canada-U.S. tax treaty. However, applying the same approach to disallowed interest paid to countries other than the United States, would have the effect of reducing the withholding tax collected in Canada on such payments.

5.43   The Panel encourages the government to review the treatment of interest expense not deductible under Canada’s thin capitalization rules to ensure non-resident investors are prevented from inappropriately reducing their Canadian withholding tax obligations.

Back-to-back loans

5.44   The current thin capitalization rules prevent foreign businesses from circumventing the rules by financing their Canadian subsidiaries through an intermediate lender (i.e., by using “back-to-back” loans). The rule that addresses back-to-back loans is quite narrow. The Technical Committee on Business Taxation recommended strengthening this provision “to include all indebtedness (such as amounts on deposit) between a specified non-resident and a third party, where all or a portion of the amount may reasonably be considered to have been loaned or transferred, directly or indirectly, by the third party to a Canadian business.”⁹⁰

5.45   The Panel agrees with this recommendation and encourages the government to review the scope of the thin capitalization rule governing back-to-back loans, while ensuring that any changes in this area do not affect bona fide business transactions.

Specified non-resident shareholder

5.46   Canada’s thin capitalization rules apply when a Canadian corporation borrows from a specified non-resident shareholder (or a non-resident person who is not dealing at arm’s length with a specified shareholder). A specified non-resident shareholder of a Canadian corporation is a non-resident person who, alone or together with non-arm’s-length persons, owns shares of the corporation accounting for 25 percent or more of total votes or value of the corporation’s capital stock. No issues were raised before the Panel in consultations regarding this definition. The Panel believes this threshold is appropriate and recommends that no change be made to the existing definition.

Debt dumping

5.47   As part of our mandate, the Panel was asked to review issues related to debt dumping with respect to foreign-controlled Canadian corporations.

5.48   The term “debt dumping” has no precise definition. The term is typically considered to refer to situations where a foreign-controlled Canadian corporation is leveraged with related or third-party borrowings (the latter usually guaranteed by the corporation’s non-resident parent company) so that the resulting interest expense significantly reduces the corporation’s Canadian taxable income. The borrowings are often used by the foreign-controlled Canadian corporation to acquire shares in a related, non-resident company.

5.49   The Panel also heard that debt dumping could be used to describe situations where a Canadian corporation is acquired by a foreign or domestic company (usually a private equity fund or a domestic or foreign non-taxable entity) in a heavily leveraged buyout. In such transactions, the acquisition debt is typically absorbed by the acquired Canadian company and the related interest expense is used to significantly reduce or eliminate the taxable income of the acquired company. Therefore, some commentators described transactions that are exclusively domestic as debt dumping.

5.50   In summary, the term debt dumping can describe a variety of transactions, including many that are acceptable from a tax policy perspective. The Panel does not believe that all transactions involving foreign-controlled Canadian corporations that use related party borrowings or guaranteed debt to finance non-Canadian investments should raise tax policy issues. For example, as part of the normal expansion of its business, a foreign-controlled Canadian corporation might borrow to finance an investment outside Canada or to acquire a foreign company. Such outbound investment would be motivated by ordinary business considerations, would probably complement the company’s Canadian operations, and would generate benefits for the Canadian economy. This result is similar for a Canadian corporation with foreign affiliates that is acquired by a foreign corporation and continues to borrow to finance its foreign operations.

5.51   Consistent with Recommendation 4.7, the Panel does not believe that interest expense should be restricted in situations where a Canadian company borrows to make a foreign investment with ordinary business motives. In the Panel’s consultations, however, it was widely agreed that one particular type of debt-dumping transaction raises significant tax policy concerns.

5.52   The type of transaction in question involves a foreign-controlled Canadian corporation that borrows to acquire preferred shares of another related foreign corporation (see Figure 5.2 above).⁹¹ In this circumstance, a foreign company (“Parent”), which owns all the common shares of a non-Canadian subsidiary (“ForSub”), loans funds to its Canadian subsidiary (“CanSub”). CanSub uses the borrowed funds to purchase preferred shares of ForSub, for example, from Parent. The arrangement is structured so that dividends received by CanSub on the preferred shares are exempt from tax in Canada. The dividend will be greater than the interest expense on CanSub’s borrowing, which is deductible in Canada and reduces CanSub’s Canadian tax liability on its profits derived from its Canadian operations.⁹²

5.53   Where there is no other connection between the businesses conducted by CanSub and ForSub and especially where CanSub does not take part in the management of ForSub or share or benefit from an increase in the value of ForSub’s operations subsequent to CanSub’s investment, such a transaction has the effect of inappropriately reducing CanSub’s Canadian tax liability. It permits Parent to leverage its existing Canadian operations by simply reorganizing the group’s ownership structure. The reorganization may not have had any purpose other than to shift deductible expenses into Canada. As a result, the reorganization reduces the Canadian tax base, generates no new economic activity in Canada, and provides little or no economic benefit to Canadians. Any part of the return earned by CanSub that might be captured as Canadian taxes would typically be negligible (even more so if Parent is a U.S. company once the withholding tax on non-arm’s-length interest paid to the United States is fully eliminated).

5.54   Preventing tax-motivated debt-dumping transactions would protect Canada’s tax base and ensure that foreign-controlled Canadian corporations pay tax in Canada on their properly measured Canadian-source income. Reducing the maximum debt-to-equity ratio under the thin capitalization rules, as the Panel recommends, will not be enough to discourage such transactions. Canada needs to supplement its thin capitalization rules with a specific anti-avoidance rule addressing such transactions. The rule should be robust, easy to administer, and narrowly targeted to ensure it does not impede acceptable business transactions that benefit the Canadian economy.

Recommendation 5.3: Curtail tax-motivated debt-dumping transactions within related corporate groups involving the acquisition, directly or indirectly, by a foreign-controlled Canadian company of an equity interest in a related foreign corporation while ensuring bona fide business transactions are not affected.

5.55   Although the Panel believes that the type of debt dumping described above should be curtailed, distinguishing preferred shares from common shares is often difficult in practice. In the Panel’s view, any proposed rule targeting these transactions should cover the acquisition of any equity interest in a non-Canadian affiliate by a foreign-controlled Canadian company.

5.56   In the Panel’s consultations, Canadian businesses were nearly united in preferring a specific anti-avoidance rule to prevent abusive debt-dumping transactions over any broader reform of the thin capitalization rules. This approach is used in France and the Netherlands, which have similar anti-avoidance rules in place. Sweden is currently reviewing possible rules in this area.

5.57   The Panel identified two alternatives for specifically targeting these transactions:

• One approach would restrict the deductibility of interest paid by a foreign-controlled Canadian corporation in respect of borrowings used to purchase, directly or indirectly, an equity interest in a related foreign corporation.
• Another approach would apply an appropriate level of Canadian tax to the purchase price paid by the foreign-controlled Canadian corporation in respect of the direct or indirect acquisition of the equity interest in the related foreign corporation. For example, the purchase price paid by the Canadian corporation could be deemed to be a dividend subject to withholding tax in Canada.

5.58   Each option has its pros and cons. For example, the first option would be complex to implement, as it would require tracing of loans used to acquire foreign related companies. Such a rule may be easy for taxpayers to circumvent. Moreover, this option may also be inconsistent with non-discrimination clauses in some of Canada’s tax treaties to the extent that any new restrictions on interest deductibility would apply to foreign-controlled corporations only and would be considered to deviate substantially from the restrictions currently in place.⁹³

5.59   The second option is similar to an existing rule in Canada’s tax law which has effectively curtailed certain related-party transactions which non-residents have used to leverage a foreign-controlled Canadian corporation.⁹⁴ The Panel believes that the rate of tax imposed on the value of the shares being acquired as part of debt-dumping transactions must be set high enough to discourage them. For example, if the purchase price is deemed to be a dividend subject to withholding tax, then the question would arise as to whether such deemed dividends should qualify for withholding tax relief under Canada’s tax treaties. Such a deeming rule would lose its effect if the withholding tax rate were too low or if Canada were to eliminate its withholding tax on dividends under its treaties (see Chapter 6). An additional benefit of the second option is that no transitional or grandfathering rules would be needed to ensure existing structures are not affected.

5.60   The Panel believes that further study and consultation should be undertaken to assess the effectiveness of potential options for addressing the objectionable debt-dumping situations described above. The government should continue to monitor the financing of foreign-controlled Canadian corporations and take action if similar avoidance transactions arise in the future.

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Treaty shopping

Background

5.61   With 86 tax treaties in force,⁹⁵ Canada has one of the largest tax treaty networks among developed countries. Tax treaties offer benefits to investors, including lower withholding taxes on cross-border payments, reduced taxation of capital gains in the countries where the gains arise, and double tax relief in investors’ home countries for taxes imposed abroad. Tax treaties also enable governments to exchange information, provide mutual assistance in tax collection, and encourage foreign investment.

5.62   If Canada’s tax rules are to create a level playing field for domestic business activity carried on in Canada by foreign and Canadian businesses while ensuring Canadian-source income is properly measured and taxed in Canada, then Canada’s treaty network has a critical role to play.

What is treaty shopping?

5.63   “Treaty shopping” refers to the practice of setting up structures through which a resident of one country (the “home country”) derives income or capital gains from another country (the “source country”) and obtains more generous tax treatment than would otherwise apply by accessing a tax treaty in place between the source country and a third country. Reducing treaty shopping may help to ensure the proper measurement and taxation of Canadian-source income. During our consultations, the Panel asked whether treaty shopping was a problem, and, if so, whether Canada needs additional tools to address it.

5.64   The Panel heard that businesses use treaties to mitigate the effect of delays in the negotiation or ratification of treaties when lower withholding rates are expected, to reduce the cost of capital on foreign investments, and to ease compliance burdens when treaty benefits are ultimately available. The Panel also heard that businesses select treaties to reduce tax on capital gains and real estate, to minimize income tax on active business income, and to move such income within a group with no or lower withholding taxes.

Canada’s approach

5.65   Canada grants access to treaty benefits only to persons who are residents of a country with which Canada has entered into a treaty.⁹⁶ A corporation is a resident of a treaty partner if the corporation is liable to taxation in that country.⁹⁷ 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.

5.66   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,⁹⁸ 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.⁹⁹ 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.

5.67   In 2004, Canada extended application of its general anti-avoidance rule to tax treaties. However, a recent court case has cast doubt on the extent to which this rule could be used to counter treaty shopping.¹⁰⁰ A number of tax authorities, including the CRA, seem to be moving toward an implied general anti-abuse rule regarding improper tax treaty use.¹⁰¹ A body of international jurisprudence is developing on what constitutes an abuse of a tax treaty (although these decisions have produced somewhat mixed results).¹⁰²

Conclusion

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.

 

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⁷⁸ Canada’s thin capitalization rules apply to Canadian corporations that have debts owing to “specified non-resident shareholders” or to non-resident persons that do not deal at arm’s length with specified shareholders. A specified shareholder is a shareholder who, either alone or together with persons with whom the shareholder is not dealing at arm’s length, owns shares of the Canadian corporation representing 25 percent or more of its votes or value. In this report, Canadian corporations that are subject to the thin capitalization rules are referred to as “foreign-owned”.

⁷⁹ A few countries, notably Finland and Sweden, have no thin capitalization rules at all. Sweden is currently considering whether to adopt some form of limitation on interest deductibility. See footnote 63 on page 48.

⁸⁰ For example, there may be situations where the financing operations within the same corporate group are separated from the income-earning activities. Absent tax consolidation, the overall amount of interest deductible by the group could be smaller if the income earned by some members of the group is not accounted for in determining how much interest can be deducted by the other group members. Rules would be needed to prevent such an outcome. Such rules could involve a mechanism to allow for the transfer of excess “earnings stripping” capacity within a corporate group.

⁸¹ See, for example, ECJ, Lankhorst-Hohorst GmbH, C-324/00. See paragraph 4.145 and related footnotes.

⁸² Department of Finance Canada news release 2000-039, “Finance Minister Clarifies Certain Income Tax Measures in the 2000 Budget” (May 9, 2000).

⁸³ Allan R. Lanthier and Jack M. Mintz, “Seeking a More Coherent Approach to Interest Deductibility”, Canadian Tax Journal, vol. 55(3) (2007), at pp. 629-654.

⁸⁴ Tim Edgar, Interest Deductibility Restrictions and Inbound Direct Investment (October 2008), research report prepared for the Advisory Panel on Canada’s System of International Taxation.

⁸⁵ For example, a debt-to-equity ratio of 1.24 would be 10 percent greater than the all-industry average debt-to-equity ratio of 1.13 for Canadian-controlled enterprises.

⁸⁶ See Bev Dahlby, Taxation of Inbound Direct Investment: Economic Principles and Tax Policy Considerations (October 2008), research report prepared for the Advisory Panel on Canada’s System of International Taxation, at section 4.

⁸⁷ This information is extracted from financial statements and essentially reflects the total consolidated debt (mostly third-party) incurred by these companies, both in Canada and abroad.

⁸⁸ The Act contains rules for computing the interest deduction that can be claimed in Canada by a foreign bank that operates a Canadian banking business through a Canadian branch (see section 20.2 of the Act).

⁸⁹ Report of the Technical Committee on Business Taxation, at p. 6.30.

⁹⁰ Ibid.

⁹¹ See in particular the submissions to the Panel of Deloitte & Touche LLP (at p. 11) and KPMG LLP (at pp. 5, 16, 18). See also the submissions of the Canadian Bankers Association (at p. 16) and the Canadian Chamber of Commerce (at p. 4) for additional discussion of debt dumping issues.

⁹² There are many variations of this basic structure. For example, CanSub could borrow funds from a Canadian or foreign third-party lender rather than directly from Parent. Under another alternative, CanSub could acquire newly issued shares of ForSub directly from ForSub rather than from Parent.

⁹³ Under certain of Canada’s tax treaties, Canada is prohibited from imposing restrictions on the deductibility of interest expense paid by foreign-controlled companies that are more stringent than restrictions otherwise applicable to Canadian corporations. The existing thin capitalization rules are specifically excluded from the scope of this non-discrimination clause provided the rules are not substantially modified.

⁹⁴ Subsection 212.1(1) of the Act deems a dividend to be paid to a non-resident person by a non-arm’s-length Canadian corporation where the Canadian corporation acquires from the non-resident person a non-portfolio interest in another Canadian corporation and the non-share consideration (e.g., cash or debt) for the acquired shares exceeds their paid-up capital.

⁹⁵ As of December 1, 2008.

⁹⁶ Canada Revenue Agency, Income Tax Technical News No. 35 (February 26, 2007).

⁹⁷ Crown Forest v. Canada, [1995] 2 S.C.R. 802, 95 D.T.C. 5389.

⁹⁸ Prévost Car Inc. v. Canada, 2008 D.T.C. 3080 (TCC); Diebold Courtage, Conseil d’état, October 13, 1999 (France); Royal Dutch, Hoge Raad, April 6, 1994, BNB 1994/217c (The Netherlands — the “market makers” case); and Indofood International Finance Ltd. and JPMorgan Chase Bank NA, London Branch (2006) EWCA Civ. 158 (Court of Appeal, Civil Division) which unlike Prévost Car and Diebold Courtage was not a tax case but a contract law case.

⁹⁹ David A. Ward, Access to Tax Treaty Benefits (September 2008), research report prepared for the Advisory Panel on Canada’s System of International Taxation, at section 2.

¹⁰⁰ MIL (Investments) S.A. v. Canada, 2006 D.T.C. 3307 (TCC), affirmed 2007 D.T.C. 5437.

¹⁰¹ As discussed in “Treaty shopping and countermeasures, in particular the beneficial ownership concept”, a presentation by Aurobindo Ponnaih, Head Asia-Pacific, International Bureau of Fiscal Documentation (July 3, 2007).

¹⁰² Bank of Scotland, Conseil d’état, December 29, 2006; A Holdings ApS v. Federal Tax Administration, (2005) 8 ITLR 536; Yanko-Weiss Holding (1996) Ltd. v. Holon Assessing Office, (2007) 10 ITLR 524. See also David A. Ward, op. cit.

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