As several countries move to clamp down on “treaty shopping” by global companies, Canada is doing the same. Indeed, new rules to prevent foreign companies from using our tax treaties to avoid paying taxes could be in effect soon.

As always with new tax measures, however, tax practitioners are watching to see whether legitimate activities will be caught by the new restrictions. Michael Kandev, a tax specialist with Davies Ward Philips and Vineberg LLP, a law firm in Montreal, notes that not all treaty shopping is problematic and that Canada needs to find the middle ground between abusive treaty shopping and international arrangements that do not undermine our tax system.

In August, the Department of Finance Canada released a consultation paper that outlines the growing problem of treaty shopping and calls for public comments on Finance Canada’s suggested new measures. This paper defines treaty shopping as “a situation under which a person who is not entitled to the benefits of a tax treaty uses an intermediary entity that is entitled to such benefits in order to obtain those benefits.” The deadline for submissions is Dec. 13.

In simple terms, the mechanics of treaty shopping typically involve creating an intermediary company in a country that has a tax treaty with Canada. Using the treaty, the taxpayer elects to direct its Canadian income to the intermediary, where it is taxed at the treaty rate, which usually is lower than the non-treaty rate. The income then flows to the taxpayer in a third country that has no treaty with Canada – often, a tax haven.

Canada has tax treaties with 90 countries, one of the largest networks of bilateral tax treaties. Such treaties appeal to foreign investors, who use them to take advantage of Canadian tax breaks. Tax treaties also address double taxation, so a non-resident taxpayer from a treaty country may elect not to pay taxes in Canada and instead pay taxes in the home country.

The goal of the anti-shopping initiative, Finance Canada’s paper says, is to protect the integrity of Canada’s tax system by eliminating “indirect and unintended” tax benefits to residents of non-treaty countries.

Clearly, restricting such activities will require complex rules, which may have unanticipated effects. Part of the problem, Kandev says, is that Finance Canada seems to imply that all treaty shopping is inherently bad and that “the notion of treaty shopping is pejorative.” But, he notes, there are different methods of tax planning in an international context, of which only some result in treaty abuse.

Other comments note that new, anti-shopping rules could end up discouraging many types of foreign investment that Canada normally welcomes, especially in the resources sector. According to a note from law firm Osler Hoskin and Harcourt LLP: “[New anti-shopping rules could] have an especially significant impact on foreign direct investment in Canadian companies (particularly mining and oil and gas companies), because private equity and other investors in these companies often invest through holding companies in jurisdictions that have a tax treaty with Canada.”

Ken Buttenham, international tax services partner with PricewaterhouseCoopers LLP in Toronto, notes that Canada’s initiative is following the lead of the Organization for Economic Co-operation and Development (OECD), which, in its February 2013 Action plan on base erosion and profit shifting, stated that the erosion of tax bases through treaty shopping represents “a serious risk to tax revenues, tax sovereignty and tax fairness for OECD members and non-members alike.”

Finance Canada does recognize that distinguishing between acceptable uses of a tax treaty and treaty shopping can be difficult, given the increasing sophistication of international tax planning. Partly as a result, the government frequently has failed in its attempts to police this practice. Despite apparent evidence of treaty shopping, Canada has been unsuccessful in all but one instance in challenging treaty shopping in the courts.

Finance Canada is seeking comments on several points – most important, on whether to use domestic law, a treaty-based approach or a combination of both. The paper also asks for input on the design of the specific approaches and suggestions regarding which approach strikes the best overall balance between effectiveness, certainty, simplicity and ease of administration.

However, both Kandev and Buttenham suggest the government appears to have a distinct preference for using domestic law. Finance Canada apparently believes that renegotiation of multiple treaties would be time-consuming and inefficient and would require consent from the treaty partners. Conversely, revisions to domestic law can be implemented much more efficiently and have an immediate effect.

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