Specialty Manufacturing Ltd. v. R., 97 DTC 1511, [1998] 1 CTC 2095 (TCC)

Rip T.C.J.:

In computing its income for a taxation year from a business, a Canadian resident corporation’s ability to deduct an amount of interest payable in the year to a non-resident corporate shareholder pursuant to paragraph 20(1)(c) of the Income Tax Act (“Act”) may be limited by subsection 18(4)! of the

^For the taxation years 1984, 1985, 1986 and 1987 subsection 18(4) reads as follows:

(4) Notwithstanding any other provision of this Act, in computing the income for a taxation year of a corporation resident in Canada from a business or property, no deduction shall be made in respect of that proportion of any amount otherwise deductible in computing its income for the year in respect of interest paid or payable by it on outstanding debts to specified non-residents that

(a) the amount, if any, by which

(i) the greatest amount that the corporation’s outstanding debts to specified non-residents was at any time in the year,

exceeds

(ii) 3 times the aggregate of

(A) the retained earnings of the corporation at the commencement of the year, except to the extent that those earnings include retained earnings of any other corporation,

(B) the corporation’s contributed surplus at the commencement of the year, to the extent that it was contributed by a specified nonresident shareholder of the corporation, and

Act. The issue in these appeals by Specialty Manufacturing Ltd. (“Specialty”) from assessments for 1984, 1985, 1986 and 1987 taxation years is whether the application of subsection 18(4) is restricted by the Canada-U.S. Income Tax Conventions of 1942 and 1980.

During its 1984 to 1987 taxation years Specialty, a resident of Canada, borrowed money from two related corporations resident in the United States of America, Ace Novelty Co. Inc. (“Ace”) and World’s Fair Souvenirs, Inc. (“World’s”). All three corporations were controlled, directly or indirectly, by individuals resident in the United States. On April 10, 1987, the individuals transferred all their shares in Specialty to Ace. Interest rates payable by Specialty to the U.S. corporations were equal to those charged by Seafirst Bank, a Washington State bank, on loans it made to Ace and World’s to fund the debt. During its 1984 to 1987 taxation years Specialty credited all of the interest payable to Ace and World’s in respect of the loans and, in computing its income for each year, deducted the interest so credited.

The Minister of National Revenue (“Minister”), in reassessing the appellant, disallowed the bulk of the amount of interest deducted in each of the years, applying subsection 18(4). The Appellant has appealed [2] the assessments on the basis that the disallowances of the deductions pursuant to subsection 18(4) are themselves disallowed by a combination of Article IV of the Canada-U.S. Income Tax Convention, 1942, as amended (“1942 Treaty”), and Article XXX(5) of the Canada-U.S. Income Tax Convention, 1980, as amended (“1980 Treaty”), for the appellant’s 1984 and 1985 taxation years and by Article IX of the 1980 Treaty for the appellant’s 1986 and 1987 taxation years. The 1980 Treaty was signed on September 26, 1980 and entered into force with the exchange of instruments of ratification on August 16, 1984.

Facts

The trial proceeded by way of a Statement of Agreed Facts [3] . The essential facts are as follows:

6. At all relevant times the Appellant was resident in Canada for purposes of the Act and was incorporated in British Columbia.

7. For purposes of the Act the Appellant’s 1984 taxation year was from January 1-December 31, 1984; its 1985 taxation year was from January 1-December 31, 1985; its 1986 taxation year was from January 1-April 30, 1986 and its 1987 taxation year was from May 1, 1986-April 30, 1987.

8. Up to April 1, 1987 Mr. and Mrs. Ben Mayers (the “Mayers”), who were non-residents of Canada and residents of the United States, owned all the shares of the Appellant.

9. On April 1, 1987 the Mayers transferred their shares of the Appellant to Ace Novelty Co., Inc. (“Ace”), a Washington State, U.S.A. corporation.

10. At all relevant times the Mayers owned all the shares of Ace.

11. At all relevant times Mr. Mayers owned all the shares of World’s Fair Souvenirs, Inc. (“World’s”), a Washington State, U.S.A. corporation.

12. At all relevant times the Appellant had a business in Canada of distributing novelties and souvenirs at exhibition, carnivals and fairs.

13. At all relevant times Ace had manufacturing facilities, warehouses and sales offices in Washington State and had manufacturing and importing capabilities for novelties and souvenirs.

14. At all relevant times Ace and World’s had experience in the negotiations for and operations of large scale novelty and souvenir concessions and sales operations.

15. At all relevant times Expo 86 Corporation (“Expo 86”) was a B.C. Crown corporation responsible for all aspects of the Special Exposition held in Vancouver, B.C. from May 2 to October 13, 1996.

16. During 1983 and 1984 Ace and World’s negotiated with Expo 86 on behalf of the Appellant for the Appellant’s operation of the Expo 86 novelty and souvenir concession in Vancouver, both on and off the Expo site.

17. As a result of the negotiations, Expo 86 granted the following to the Appellant:

(i) a concession for the exclusive rights to the sale of any primarily non-food items on the Expo site (the “Concession Contract”);

and

(ii) an exclusive license in connection with Expo 86 intellectual property or trade-marks for any primarily non-food items (the “Licence Agreement”).

18. On June 6, 1984 the Appellant, Ace and World’s agreed (the “Service Contract” — Tab 5) that the Appellant would engage Ace and World’s to provide management, administrative and financial services to the Appellant in respect of the Concession Contract and License Agreement, as more fully set out in the Service Contract.

19. The Appellant’s gross Expo sales during its 1986 and 1987 taxation years equalled approximately $77,000,000.

20. Pursuant to the Service Contract, during its 1984-1987 taxation years the Appellant borrowed money from Ace and World’s Fair in the course of and for the purpose of earning income from its business of carrying out the Concession Contract and the Licence Agreement.

21. For its 1984-1987 taxation years the debts (the “Debts”) referred to in the preceding paragraph were as follows:

CREDITOR	1984	1985	1986	1987
Ace	$1,037,877	$2,593,569	$ 3,909,883	$ 3,909,883
World’s	nil	$2,661,144	$ 6,184,558	$ 6,184,558
TOTAL	$1,037,877	$5,254,713	$10,094,441	$10,094,441

22. The Debts were true debts.

23. The money used by Ace and World’s to fund the Debts was borrowed by Ace and World’s from Seafirst Bank, a Washington State, U.S.A. bank (“Seafirst”) acting at arm’s length with the Mayers, the Appellant, Ace and World’s.

24. In its 1984-1987 taxation years the Appellant credited interest to Ace and World’s in respect of the Debts as follows:

CREDITOR	1984	1985	1986	1987
Ace	$76,984	$215,673	$110,737	$64,923
World’s	nil	$334,659	$160,715	nil
TOTAL	$76,984	$550,332	$271,452	$64,923

25. The interest rate paid by the Appellant to Ace and World’s in respect of the Debts was an arm’s length interest rate, equal to the rate Ace and World’s paid to Seafirst on the money borrowed by them to fund the Debts.

26. In computing its Part I income under the Act for its 1984-1987 taxation years the Appellant deducted the interest credited to Ace and World’s in each relevant year.

27. Subject to subsection 18(4) of the Act, the interest deducted by the Appellant for its 1984-1987 taxation years as shown in paragraph 24 was properly deducted by it pursuant to paragraph 20(1 )(c) of the Act.

28. For the 1984-1987 taxation years, the Minister disallowed a portion of the interest deducted pursuant to subsection 18(4) of the Act. Subject to the applicability of either or both the 1942 Canada-US Tax Treaty and the 1980 Canada-US Tax Treaty, the quantum of interest disallowed by the Minister was correctly calculated under subsection 18(4) of the Act, as more particularly set out in Tab 6.

29. The Appellant duly objected to the reassessments denying the interest deductions for each year on the basis that such denials was not permitted under the 1942 Canada-US Income Tax Treaty (for the 1984 and 1985 taxation years) and the 1980 Canada-US Income Tax Treaty (for the 1986 and 1987 taxation years) but the reassessments were duly confirmed by the Minister.

Treaty Provisions

Article IV(1) of the 1942 Treaty read as follows:

(a) When a United States enterprise, by reason of its participation in the management or capital of a Canadian enterprise, makes or imposes on the latter, in their commercial or financial relations, conditions different from those which would be made with an independent enterprise, any profits which should normally have appeared in the balance sheet of the Canadian enterprise but which have been, in this matter, diverted to the United States enterprise, may be incorporated in the taxable profits of the Canadian enterprise, subject to applicable measures of appeal.

(b) In order to effect the inclusion of such profits in the taxable profits of the Canadian enterprise, the competent authority of Canada may, when necessary, rectify the accounts of the Canadian enterprise, notably to correct errors and omissions and to re-establish the prices or remuneration entered in the books at values which would prevail between independent persons dealing at arm’s length. To facilitate such rectification the competent authorities of the contracting States may consult together with a view to such determination of profits of the Canadian enterprise as may appear fair and reasonable.

Provisions of the 1980 Treaty relating to this appeal follow:

Article IX

1. Where a person in a Contracting State and a person in the other Contracting State are related and where the arrangements between them differ from those which would be made between unrelated persons, each State may adjust the amount of the income, loss or tax payable to reflect the income, deductions, credits or allowances which would, but for those arrangements, have been taken into account in computing such income, loss or tax.

2. For the purposes of this Article, a person shall be deemed to be related to another person if either person participates directly or indirectly in the management or control of the other, or if any third person or persons participate directly or indirectly in the management or control of both.

Article XXV

7. Except where the provisions of paragraph 1 of Article IX (Related Persons), paragraph 7 of Article XI (Interest) or paragraph 7 of Article XII (Royalties) apply, interest, royalties and other disbursements paid by a resident of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable profits of the first-mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first- mentioned State. Similarly, any debts of a resident of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable capital of the first-mentioned resident, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State.

8. The provisions of paragraph 7 shall not affect the operation of any provision of the taxation laws of a Contracting State:

(a) relating to the deductibility of interest and which is in force on the date of signature of this Convention (including any subsequent modification of such provisions that does not change the general nature thereof); or

(b) adopted after such date by a Contracting State and which is designed to ensure that a person who is not a resident of that State does not enjoy, under the laws of that State, a tax treatment that is more favourable than that enjoyed by residents of that State.

Article XXX

5. Where any greater relief from tax would have been afforded by any provision of the 1942 Convention than under this convention, any such provision shall continue to have effect for the first taxable year with respect to which the provisions of this Convention have effect under paragraph 2(b).

Appellant’s Arguments

Appellant says that Articles IV and IX(1) of the 1942 Treaty and 1980 Treaty, respectively, apply to thin capitalization situations. Counsel argued that if a Canadian subsidiary pays an arm’s length rate of interest to a U.S. related company, then Canada is prevented by these treaty provisions from disallowing any interest deduction by virtue of subsection 18(4) of the Act. In other words, as I understand counsel, these treaty provisions only apply to non-arm’s length interest rates; Canada cannot question the deductibility of an amount of interest that is at arm’s length and is otherwise allowed by subsection 20(1)(c) of the Act.

a) 1942 Treaty (1984 taxation year)

This treaty contemplated the concept of thin capitalization, counsel submitted. Article IV refers to “financial relations” between the U.S. and Canadian enterprises. A rate of interest paid on a loan between parties is part of those parties’ financial relations, counsel asserted.

Counsel stated that Article IV is intended to apply to cases of excessive interest deductions paid by a Canadian subsidiary to its U.S. parent or related company [4] Revenue Canada had the right under Article IV(a) to increase the profits of the Canadian enterprise to the extent of the excessive rate of interest (over an arm’s length rate of interest) payable to the U.S. or related company.

In counsel’s view Article IV only applies where transactions between the parties are on a basis other than arm’s length. If conditions of a transaction between the non-arm’s length parties are not different from those which would be made between independent or arm’s length enterprises, then Article IV has no application. Counsel explained that Article IV(b) refers to the Canadian competent authority, Revenue Canada, rectifying the accounts of the Canadian enterprise to include “such profits”. The “profits” referred to are those in Article IV(a), the profits that would have accrued to the Canadian enterprise if it had paid a market rate of interest. In the case at bar, however, there are no “such profits” because the rate of interest was an arm’s length rate. Therefore, Revenue Canada has no jurisdiction under Article IV(b) to add anything to the appellant’s profits. Any change to the taxable profits of the Canadian enterprise, counsel insisted, may be made only if the actual rate of interest is different from the arm’s length rate of interest. [5]

Counsel referred to section 7.25 of the Internal Revenue Regulations [6] . According to section 7.25, the “purpose of Article IV was to place the controlled domestic enterprise on a tax parity with an uncontrolled domestic enterprise by determining, according to the standards of an uncontrolled enterprise, the true net income ...”. Thus, counsel declared, the true net income is to be determined on an arm’s length basis, not the 3:1 ratio of equity to debt stated in the Act.

Counsel also argued that a press release issued by Revenue Canada on June 3, 1992 confirms that the drafters of the 1942 Treaty had established that the concept of thin capitalization was included in that Treaty. The press release, in part, stated that:

Revenue Canada, Taxation announced today that thin capitalization adjustments made under subsection 18(4) of the Income Tax Act ... will no longer be accepted for discussion by the Competent Authorities under Article XVI of the Canada-United States Income Tax Convention [the 1942 Treaty].

b) 1942 Treaty and 1980 Treaty (1985 taxation year)

I agree with appellant’s counsel that under the transitional provision in Article XXX (5) of the 1980 Treaty, the appellant has the choice of applying either the 1942 Treaty or the 1980 Treaty to its 1985 taxation year, whichever is the more beneficial to it.

c) 1980 Treaty (1986 and 1987 taxation years)

The word “arrangements” in Article IX(1), appellant’s counsel submitted, affects the word “deductions” in the provision and the word “arrangement” is broad enough to refer to any type of arrangement, including financial arrangements leading to interest deductions.

The Organisation for Economic Co-Operation and Development (“OECD”), of which Canada is a member, has published several model tax treaties. As noted by the Supreme Court of Canada and the Federal Court of Appeal in Crown Forest Industries Ltd. v. R.’, [7] the OECD Model Double Taxation Convention on Income and on Capital (1963, re-enacted in 1977) (“OECD Convention”) served as the basis for the 1980 Treaty and, stated lacobucci, J. at p. 5398, is “of high persuasive value in terms of defining the parameters” of the 1980 Treaty. Appellant’s counsel claims support in Article 9 of the OECD Convention, for his view that Article IX(1) of the 1980 Treaty applies to thin capitalization.

Article 9 of the Model Convention states that:

Where

a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

The OECD also publishes Commentaries on provisions of the OECD Convention. In 1992, updated as of 1 September 1995, the OECD published a Commentary on the views of the Committee on Fiscal Affairs Report on Thin Capitalization. [8] The Committee considered, at paragraph 2, that with respect to Article 9:

a) the Article does not prevent the application of national rules on thin capitalisation insofar as their effect is to assimilate the profits of the borrower to an amount corresponding to the profits which would have accrued in an arm’s length situation;

b) the Article is relevant not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be re- garded as some other kind of payment, in particular a contribution to equity capital; [9]

c) the application of rules designed to deal with thin capitalisation should normally not have the effect of increasing the taxable profits of the relevant domestic enterprise to more than the arm’s length profit, and that this principle should be followed in applying existing tax treaties.

Even though the OECD Commentary was written after the 1980 Treaty was in force, counsel submitted it should be relied on in interpreting Article IX(1) of the 1980 Treaty. The introduction to the Commentary stated that the Committee “considered that existing conventions should, as far as possible, be interpreted in the spirit of the revised Commentaries, even though the provisions of these conventions did not include the more precise wording of the 1977 Model Convention”. Changes to the Articles of the Model Convention and the Commentaries that have been made since 1977 should also be similarly interpreted, counsel insisted. [10]

However, as respondent’s counsel pointed out, the Commentary [11] cautioned that:

Needless to say, amendments to the Articles of the Model Convention and changes to the Commentaries that are a direct result of these amendments are not relevant to the interpretation or application of previously concluded conventions where the provisions of those conventions are different in substance from the amended Articles. However, other changes or additions to the Commentaries are normally applicable to the interpretation and application of conventions concluded before their adoption, because they reflect the consensus of the OECD Member countries as to the proper interpretation of existing provisions and their application to specific situations.

Appellant’s counsel submitted that when Articles IX(3) and (4) of the 1980 Treaty were amended in 1995, Canada did not amend Article IX(1) to eliminate the possibility that Article IX(1) would be interpreted in accordance with the meaning of paragraph 2 of the 1992 OECD Commentary. Counsel said that Canada took this precaution when it negotiated the 1995 Tax Treaty with Argentina [12] .

Appellant’s counsel declared that tax authorities such as Professor V. Krishna agree that Article 9 of the OECD Convention conflicts with subsection 18(4) of the Act and thus restricts Canada’s power to make any interest deduction adjustment to thinly capitalized corporations beyond amounts that would be earned in equivalent arm’s length commercial transactions. [13]

That Article IX(1) prevents Canada from applying subsection 18(4) where the appellant was already paying an arm’s length rate of interest, counsel argued, is independent of any OECD Convention. In Article IX(1), he declared, the introductory words specify that the provision applies “where” the actual arrangements differ from arm’s length transactions. Unless the word “where” is merely superfluous, he submitted, “this means ‘only where’”. Otherwise, Article IX(1) could be read to allow an adjustment to deductions or other amounts even when the two related parties are already acting on an arm’s length basis. Counsel said his submission is supported by the United States Treasury Department’s Technical Explanation of the 1980 Treaty (“Technical Explanation”) [14]

Paragraph 1 [of Article IX] authorises Canada and the United States, as the case may be, to adjust the amount of income, loss, or tax payable by a person with respect to arrangements between that person and a related person in the other Contracting State. Such adjustment may be made when arrangements between related persons differ from those that would obtain between unrelated persons...

Therefore, counsel argued, if the arrangements do not “differ” from those that would obtain between unrelated parties, Article IX(1) cannot be applied by Canada to disallow interest under subsection 18(4). This, he said, accords with the views expressed in the OECD Commentaries on Article 9. Counsel concluded that no re-writing of taxable profits is allowed by the Commentaries if the arrangements between related parties are at arm’s length terms. He noted that Canada, as was her right as a member of OECD, never entered a reservation to any of the Commentaries.

Counsel also said he finds support in the view of Professor Krishna that Article IX( 1 ) “prevents Canada from applying subsection 18(4) if the effect of doing so is to create an arm’s length deduction, but not beyond that.” [15]

Appellant’s counsel declared that there is nothing in the 1980 Treaty which overrides his conclusion that by virtue of Article IX(1), subsection 18(4) of the Act does not apply where a taxpayer pays an arm’s length rate of interest. Article XXV(7) of the 1980 Treaty does not apply simply because of Article XXV(8)(a). Article XXV(7) is not the exclusive defences to a subsection 18(4) assessment. In his view Articles IX(1) and XXV(7) are two independent defences to a subsection 18(4) assessment and the fact that the Article XXV(7) is taken away by Article XXV(8)(a) has no bearing on the validity of the Article IX(1) defence.

Appellant’s counsel also argued that Article XXV(7) provides that if an adjustment is in accordance with Article IX(1), that adjustment is not discriminatory for purposes of Article XXV(7). In his view this implies that some adjustments may not be in accordance with Article IX(1) because the parties may already be dealing as if they were at arm’s length. In that case, he stated, the appellant does not need to, and this case does not, rely on Article XXV(7) to prevent the application of subsection 18(4); the adjustment has already been prevented by Article X(1). Counsel asserted that the text of Article XXV(8)(a) only says that it overrules Article XXV(7) but does not say “notwithstanding Article IX( 1)”. Counsel suggested that if respondent is relying on Article XXV(7), she is reading the words “notwithstanding Article IX(1)” into Article XXV(8)(a).

The Technical Explanation of Articles XXV(7) and XXV(8)(a) is silent with respect to those Articles taking away the defence provided by Article IX(1). If the drafters of the 1980 Treaty intended to take away the Article IX defence, counsel submitted, such intended words would have been expressed.

The appellant’s counsel also stated that Articles IX(1) and XXV(7) together indicate that domestic adjustments to the profits of one State’s enterprise (e.g. as contemplated by subsection 18(4)) are subject to a dual restriction, the first being the arm’s length criterion in Article IX(1) and the second the non-discrimination rules of Article XXV. The fact that the second restriction is eliminated by Article XXV(8)(a) says nothing about the continued restriction of Article IX(1). [16]

Analysis

Ordinarily interest that is paid by a taxpayer for the purpose of earning income from a business is deductible by that taxpayer in computing its income for the year: paragraph 20(1)(c) of the Act. Subsection 18(4) of the Act is designed to prevent a non-resident of Canada who owns 25% or more in number or value of the voting shares of a Canadian resident corporation from withdrawing profits of the corporation in the form of interest rather than in the form of dividends. Subsection 18(4) creates the thin capitalization rule to prevent the undercapitalization of a Canadian corporation by non-residents by requiring that a debt to equity ratio (of 3:1) be maintained. The Canadian corporation may not deduct the amount of interest that is paid to the non-resident that is in excess of the ratio. Subsection 18(4) does not rewrite the profits of the Canadian corporation. However, the effect of subsection 18(4) is that the excess amount, for all practical purposes, results in a dividend. The thin capitalization rule in subsection 18(4) is clearly a statutory provision that discriminates against a corporate taxpayer solely because of the ownership of that taxpayer’s share capital.

The question before me is whether the 1942 Treaty and 1980 Treaty, or either of them, prevent the application of subsection 18(4) of the Act. One must therefore interpret the treaties.

In Crown Forest Industries, supra, lacobucci J. explained, at page 5393, that:

In interpreting a Treaty, the paramount goal is to find the meaning of the words in question. This process involves looking to the language used and the intention of the parties.

The principle that bilateral tax conventions should be given a liberal interpretation in the light of their object and purpose, rather than a more strict and literal interpretation that may be applicable with respect to domestic tax litigation, has been generally accepted in Canadian and U.K. jurisprudence [17] . The reasons are that a tax convention is an international agreement between two states rather than purely domestic legislation and that tax conventions are not drafted in the precise and detailed form in which domestic legislation is drafted, but in more general language. [18]

Mr. Justice lacobucci set out two headings in his analysis in Crown Forest Industries: A) the plain language, and B) what was the intention of the drafters of the 1980 Treaty? At page 5396; he explains how the intention of the drafters of a tax treaty is to be determined and the importance in treaty interpretation of such a determination:

Clearly, the purpose of the Convention has significant relevance to how its provisions are to interpreted. I agree ... that, in ascertaining these goals and intentions, a Court may refer to extrinsic materials which form part of the legal context (these include accepted model convention and official commentaries thereon) without the need first to find an ambiguity before turning to such materials.

1942 Treaty

Article IV is of no assistance to the appellant. Essentially that Article states that where a U.S. corporation imposes on the non-arm’s length Canadian corporation, in their financial relations, conditions different from those which would have been made with an independent enterprise, Canada may rewrite the books of account of the Canadian corporation to include any profits that normally ought to have been included in the Canadian corporation’s income, but had been diverted to the U.S. corporation.

Article IV(l)(a) is concerned with the diversion of profits from a Canadian corporation to a U.S. corporation. It is true that interest paid by a Canadian corporation to a non-arm’s length U.S. corporation may, in certain cases, divert the Canadian corporation’s profit from Canada to the United States but Article IV(a) does not target excessive interest deductions.

The text of the Article IV mandates an examination of whether the “financial relations” between the parties were conducted on a basis that differs from what would be made on an arm’s length basis, effectively resulting in a diversion of profits to the United States parent. The fact that the words “financial relations” are broad enough to include the terms of a loan, including the interest rate for the loan, however, does not necessarily mean that the Article applies to the deductibility of interest by one of the parties to any such arrangement, much less to thin capitalization cases. In my view the words “financial relations” in Article IV bear only upon the relationship between parties, and not upon the deduction of interest by the related Canadian company, which falls outside of the direct relationship between the parties. In other words Article IV clearly covers cases where, for example, the Canadian company makes interest-free loans to a related United States company, or where the Canadian company pays a rate of interest to the United States company which exceeds the market rate and thus enables the Canadian company to divert a greater amount of its profits to the United States company. Messrs. Ehrenzweig and Koch explain: [19]

A foreign enterprise attempting to minimize taxes by minimizing its income purportedly derived from the taxing country, may, in order to avoid taxation of a “permanent establishment”, carry on business in the taxing country through a seemingly independent enterprise actually under its control. Articles 111(3) and IV treating the controlled enterprise as “if it were an independent enterprise” tend to prevent abuse.

The unusual conditions imposed by the controlling enterprise may consist, e.g. in the supply of goods at excessive prices, ... in loans at excessive interest rates, ... [emphasis added]

Article IV is concerned with the diversion of profits to related United States companies; it makes no mention of the domestic company’s tax treatment of the consequences of its non-arm’s length financial relations. More particularly, Article IV(l)(a) does not address the manner in which the Canadian company chooses to treat the payment of interest for tax purposes, namely, through the application of paragraph 20(1)(c) of the Act. Appellant’s counsel seemed to suggest that Article IV is intended to apply only to cases of excessive interest deductions on a loan from a foreign parent to a domestic subsidiary.

The Revenue Canada press release, of June 3, 1982, is not authority for appellant’s submission that the 1942 Treaty regulated thin capitalization transactions. [20] I do not find the press release to be evidence the drafters of the 1942 Treaty had intended for the treaty to include the concept of thin capitalization. Article XVI of the 1942 Treaty, referred to in the press release, authorizes the competent authorities of Canada and the U.S. to review claims of double taxation; there is no reference in that Article to thin capitalization. Indeed, the press release explains that:

...because of conflicting tax laws on the issue of thin capitalization, competent authority action on this issue will no longer be given bilateral consideration.

The wording of the press release is more consistent with the situation in which thin capitalization had not been contemplated until some time after the enactment of the 1942 Treaty.

The intention of the parties to a treaty at the time of its conclusion is of primary importance in its subsequent construction. A tax treaty must be interpreted in the manner in which the State parties to the treaty had intended. [21] There is no indication that any concerns had been raised regarding thin capitalization at any time prior to the drafting of the 1942 Treaty. In fact, it seems that any such concerns would not have been raised much earlier than 1966, when the report of the Royal Commission on Taxation was released. [22] As explained in the publication “Summary of Tax Reform Legislation” of the Department of Finance, 1971: [23]

Under present law it is attractive for non-residents who control corporations in Canada to place a disproportionate amount of their investment in the form of debt rather than shares. The interest payments on this debt have the effect of reducing business income otherwise taxed at 50% and attracting only the lower rate of withholding tax on interest paid abroad.

Under the new bill, if the ratio of total shareholders’ equity to debt due to nonresident shareholders, having a 25% or more ownership interest, is less than 1:3, an appropriate part of the interest paid to non-residents will not be deductible. In effect, the part of the debt in excess of the 1:3 ratio will be treated as equity and the interest on that excess as dividends.

Respondent’s counsel noted that Article XXV(8) the 1980 Treaty grandfathers the thin capitalization rules of subsection 18(4) of the Act from the non-discrimination provision of Article XXV(7). [24] I agree with counsel that the inclusion of a reference to thin capitalization in the 1980 Treaty is consistent with the notion that in legislation successive substantive changes re- veal an evolution of policy. As Sullivan notes in Driedger on the Construction of Statutes, [25] at page 452:

Examining successive amendments to legislation often reveals the direction in which a legislative policy is evolving. An interpretation favouring that evolution is appropriately preferred over possible alternatives.

The introduction of a specific provision in the 1980 Treaty to deal with thin capitalization may be seen as an indication that the 1942 Treaty did not cover that concept.

Thin capitalization had not been contemplated during the drafting of the 1942 Treaty. The concept was subsequently addressed by subsection 18(4) of the Act and Article XXV(8)(a) of the 1980 Treaty which took into account the existence of subsection 18(4).

1980 Treaty

Appellant says Article IX(1) applies to thin capitalization and it is not necessary to refer to Article XXV [26] The respondent’s position is that the more specific wording of Article XXV, in particular paragraphs (7) and (8), which deals specifically with interest, should govern rather than the general provisions of Article IX which deal with many types of transfers between resident and non-resident corporations and thus could generally be referred to as a transfer-pricing provision.

Article XXV of the 1980 Treaty provides Canada and the United States shall not discriminate against a non-resident of the other State with respect to the deductibility of interest, royalties and other disbursements paid by a resident of one State to a resident of the other State. One of the exceptions to this non discrimination provision is where Article IX(1) applies. Thus while Article XXV(l) restrains discriminatory legislation, Article IX(1) permits a State to discriminate where related persons of both States do not deal with each other at arm’s length. I cannot agree with appellant’s counsel that whenever related parties do deal with each other at arm’s length, Article XXV cannot apply.

Article IX(1) provides that where related persons transact with each other not at arm’s length, then a State may make adjustments to the amount of income, loss or tax payable to reflect an arm’s length transaction. Absent Article XXV(7), Article IX does not, in my view, preclude a State from limiting the amount of interest a resident of that State may deduct in computing its income because of the ownership of its share capital. Article XXV(7) and Article IX(1) are to be read together when one is confronted with the facts at bar; this will avoid confusion. Even though Article XXV(7) does not permit discrimination, discrimination is permitted in circumstances where Article IX(1) applies. Article IX(1) permits the States to make adjustments to reflect arm’s length transactions. Article IX(1) does not prevent the States from regulating transactions between related persons in the two States who deal with each other on an arm’s length basis. Where there is discriminating legislation, Article XXV(7) would apply. [27] Indeed, Professor Krishna writes that Article 9 of the Model Convention does not have any effect when associated enterprises transact with each other on normal open market terms. [28]

According to the Technical Explanation:

Paragraph 8 [of Article XXV] provides that, notwithstanding the provisions of paragraph 7, a Contracting State may enforce the provisions of its taxation laws relating to the deductibility of interest, in force on September 26, 1980, or as modified subsequent to that date in a manner that does not change the general nature of the provisions in force on September 26, 1980; or which are adopted after September 26, 1980, and are designed to ensure that non-residents do not enjoy a more favourable tax treatment under the taxation laws of that State than that enjoyed by residents. Thus Canada may continue to limit the deductions for interest paid to certain non-residents as provided in [subsection] 18(4) of Part I of the Income Tax Act. (emphasis added) [29] ^.

The United States Congress passed legislation in 1990 to limit certain interest deductions. In an article discussing the implications of this tax leg- islation to Canadian investors, Messrs. Nathan Boidman and Gary Gartner stated that Article XXV(8)(a):

...confirms Canada’s right to apply thin capitalization rules to a U.S. owned Canadian subsidiary notwithstanding the non-discrimination rule of Article XXV(7).. [30]

Decision

It is clear, therefore, that the drafters of the 1980 Treaty did not attempt to limit the application of subsection 18(4) in force on September 26, 1980. There would be no reason for the 1980 Treaty to include Articles XXV(7) and (8) and for the Technical Interpretation of Article XXV(8) to conclude as it does if it was contemplated that Article XXV(7) would have no application if Article IX applied. Neither Canada nor the United States intended that in any case Article IX would apply to thin capitalization transactions where Article XXV(7) did. Neither the 1942 Treaty nor the 1980 Treaty prevent Canada from enforcing the provisions of subsection 18(4) of the Act.

The appeals for the 1986 and 1987 taxation years will be allowed, without costs, to accord with the terms of the “Partial Consent to Judgment”. In all other respects the appeals will be dismissed with costs.

Appeal allowed in part.