David G. Duff, "Tax Treaty Abuse and the Principal Purpose Test – Part 2", Canadian Tax Journal, (2018) 66:4, 947-1011

Summaries

Meaning of transaction (p. 972)

[W]hile the official French version of the ITA translates “transaction” as “operation,” which is defined to include "une convention, un mecanisme ou un evenement," the official French version of the MLI refers to "une transaction" and "un montage"— the latter of which is also broad and clearly contemplates a series of transactions. As well, since contracting jurisdictions presumably intended the PPT to have a consistent application in all CTAs, it seems reasonable that the words "arrangement or transaction" should he given a meaning independent of domestic law.

Examples in OECD commentary re little or real economic substance (pp. 993-997)

Beginning with tax treaty shopping, it is notable that examples in the OECD commentary consistently suggest that the PPT would not apply to arrangements or transactions that involve genuine cross-border economic activities.

…[W]here arrangements or transactions have little or no real economic substance, the commentary concludes that the PPT or anti-conduit provisions should apply to deny treaty benefits. In one example, based on the Royal Dutch Oil Company case, [fn 233: … (June 6, 1994) RNR 1994/217 (Netherlands Supreme Court)] a company (TCO) resident in state T, which owns shares of a company (SCO) resident in state S, with which state T does not have a tax treaty, assigns the right to dividends that have been declared but not yet paid by SCO to RCO, an independent financial institution resident in state R, which has a tax treaty with state S that exempts dividends from withholding tax.

…In another example, based on the Bank of Scotland case [fn 233: … Ministre de l’Econimie v. Bank of Scotland (2006), 9 ITLR 683 (Counseil d’Etat)] company (TCO), resident in state T, has a wholly owned subsidiary (SCO) that is resident in state S, with which state T does not have a tax treaty, and enters into an agreement with a financial institution (RCO) in state R, with which state S has a tax treaty that provides a reduced withholding tax rate on dividends of 5 percent (instead of the domestic rate of 25 percent). Under this agreement, RCO acquires the usufruct of newly issued preferred shares of SCO for a period of three years in exchange for the present value of the dividends to be paid on the preferred shares over three years, discounted at the rate at which TCO could borrow from RCO.

…Yet another example, based on Aiken Industries, [fn 237: Aiken Industries, Inc. v. Commissioner, 56 TC 925 (1971)….] involves a company (TCO) resident in state T, which loans funds at a rate of 7 percent to a wholly owned subsidiary (SCO) in state S, which does not have a tax treaty with state T, and then assigns the debt to another wholly owned subsidiary (RCO) in state R, with which state S has a tax treaty, in exchange for a note paving interest at a rate of 6 percent.

…[T]he analysis in the commentary appears to suggest that the PPT could also apply to transactions or arrangements like those in Del Commercial Properties [fn 239: C Memo 1999-411 • aff'd 251 F.3d 210 (DC Cir. 2001), denying treaty benefits on the basis of a domestic substance-over-form doctrine….] A Holdings ApS [fn 240 A Holdings ApS v. Federal Tax Administration (2005), 8 ITLR 536 (Swiss FC), denying treaty benefits on the basis of an implicit anti-abuse principle.] the VSA case, [fn 241: (February*28^*2001), 4 ILTS~2b02, 191 (Swiss Commission of Appeals in Tax Matters), denying treaty benefits on the grounds that the recipient of dividends was not their beneficial owner.] and the HHU and Cook case [fn 242: SKM 2011.57 LSR, and SKM 2011.485 LSR (Danish Tax Tribunal), denying treaty benefits on the ground that the recipients of interest payments were not their beneficial owners…] in which companies with little or no economic substance were established in order to obtain treaty benefits that would otherwise have been unavailable. The analysis in the commentary also seems to suggest that the PPT could apply to transactions or arrangements like those in Northern Indiana Public Service Corp. [fn 243: Northern Indiana Public Service Corp. v. Commissioner, 115 F.3d 506 (7th CIR. 1997), alIowing treaty benefits on the basis that a wholly owned finance subsidiary incorporated by the taxpayer had conducted "recognizable" though "concededly minimal" business activity, earning a profit from the spread between interest paid on euronotes and interest charged to the taxpayer, as well as reinvested profits.] Prévost Car, Velcro, and the Spanish cases involving payments by the Real Madrid football team to Hungarian companies for the image rights of various team members [fn 246: (July 18, 2006), JUR\2006\204307, JUR\2007\8915, and JUR\2007\6549; (November 10, 2006), JUR\2006\284679; (July 20,2006), JUR\2007\6526; (November 13, 2006), JUR\2006\284618; and (March 26, 2007), JUR\2007\101877, denying treaty benefits on the basis that the recipients of the royalty payments were not their beneficial owners.] in which companies to which interest, dividends, or royalties were paid appear to have earned some profits on the spread between amounts received and amounts paid as well as reinvested profits, but otherwise conducted little or no business activity. In contrast, it seems less likely that the PPT should apply to payments such as those in the Swiss swap case, [fn 247: May 5, 2015), BGE 141 II 447, no. 2C_364/2012 (Swiss Federal Supreme Court) … concluding that the recipient of payments from investments designed to hedge against swap payments was not the beneficial owner of the payments.] which are designed to hedge against swap payments—at least where these arrangements represent genuine business activities carried out by a financial institution.

Changing residence (p. 998)

In contrast, where a corporation changes its residence by continuing from one jurisdiction to another or by changing its place of effective management, it is less certain that this transaction or arrangement would have sufficient economic substance for one to conclude that obtaining treaty benefits would be in accordance with the object and purpose of the relevant provisions of a treaty—particularly if the change of residence results in non-taxation or reduced taxation, and treaty benefits are indirectly obtained by shareholders who are residents of third jurisdictions. For this reason, the PPT could be expected to apply to transactions such as those in MIL Investments, in which the taxpayer continued from the Cayman Islands to Luxembourg shortly before selling shares the gain from which would otherwise have been subject to tax in Canada, and Yanko-Weiss Holdings, in which the taxpayer moved its place of effective management from Israel to Belgium before receiving dividends from an Israeli subsidiary. [fn 253: … Yanko-Weiss v. Holon Assessing Office (2007), 10 TLR 524 (Tel Aviv-Yafo DC) denying treaty benefits on the basis of an implicit anti-abuse principle.]

Burden on taxpayer to establish that a benefit should be allowed (p. 1001)

Canadian courts have generally held that the GAAR should apply only where the object and purpose of the relevant provisions is "clear and unambiguous”. [fn 267: See, for example, OSFC, at paragraph 69; Canada Trustco, at paragraph 50; and Copthorne Holdings, at paragraph 68. …]

In the PPT, on the other hand, the object and purpose test is an exception that Allows a benefit that would otherwise be denied under the provision on the ground that one of the principal purposes of an arrangement or transaction was to obtain the benefit. As a result, the PPT shifts the onus to the taxpayer to establish that a benefit that would otherwise be denied should be allowed because it is in accordance with the object and purpose of the relevant provisions of the CTA….

Complete denial of benefit can be punitive (p. 1003)

[B]ecause the PPT states that a benefit under the CTA "shall not be granted” when the provision applies, the application of this provision could make taxpayers worse off than they would have been under an alternative arrangement or transaction that might reasonably have been carried out but for the existence of the treaty benefit that is denied. For example, where an individual assigns the right to receive dividends that have been declared but not paid to a company owning more than the specified shareholding threshold to qualify for the lower rate of withholding tax on dividend payments from a subsidiary to a parent, the PPT could deny the benefit of any withholding tax reduction under the CTM rather than the benefit of the lower withholding rate….

Threshold for PPT is lower than in most domestic general anti-avoidance rules (pp. 1008-9)

Unlike the Canadian GAAR, for which the concept of a tax benefit may be interpreted by reference to a benchmark transaction that might reasonably have been carried out but for the existence of the tax benefit, the most reasonable interpretation of a benefit under a CTA relates to the tax consequences that would have resulted under the domestic law of the relevant contracting jurisdiction absent the CTA.

The purpose test requires an objective assessment of the principal purposes of the arrangement or transaction in order to determine whether one of those purposes was to obtain a benefit under the CTA. Interpreting similar language in the context of domestic tax provisions, UK courts have held that a principal purpose "has a connotation of importance” [fn 298 Travel Document Services] and that a principal purpose of a transaction may be to obtain a tax advantage even if the transaction had a commercial objective at least as important as the tax advantage. [fn 299: Lloyds TSB Equipment Leasing] As a result, the threshold for this purpose test is lower than the threshold in most domestic general anti-avoidance rules.

…Since the purpose test in the PPT applies where it is "reasonable to conclude" that one of the principal purposes of an arrangement or transaction was to obtain a benefit under the CTA, it also imposes a relatively low burden on the tax authority, effectively requiring taxpayers to argue that it would be unreasonable to conclude that obtaining the benefit was a principal purpose of the arrangement or transaction….

Preamble effectively overrides Union of India approach (p. 891)

[I]t is necessary to consider not only the primary arm of the CTA to encourage cross-border economic activity by allocating taxing rights in a fair and reasonable manner in order to reduce or eliminate double taxation, but also the intention of the contracting jurisdictions that the CTA not create opportunities for non-taxation or reduced taxation through tax treaty shopping and other forms of tax avoidance. For this reason, when interpreting the object and purpose of a CTA that is modified by this preamble language, it is no longer possible to conclude, as the Supreme Court of India did in the context of the India-Mauritius tax treaty, that treaty shopping is necessarily consistent with the object and purpose of tax treaties because it encourages capital and technology inflows. [fn 224: Union of India v. Azadi Bacbao Andolan (2003), 6 ITLR 233 (India SC)…]

Burden on Crown to establish abused policy (p. 1001)

Canadian courts have generally held that the GAAR should apply only where the object and purpose of the relevant provisions is "clear and unambiguous”. [fn 267: See, for example, OSFC, at paragraph 69; Canada Trustco, at paragraph 50; and Copthorne Holdings, at paragraph 68. This conclusion is consistent with the language of subsection 245(4) of the ITA as it read at the time of the decision in OSFC, which provided that section 245 would not apply to an avoidance transaction where it was reasonable to conclude that the transaction did not result in a misuse or abuse, but is not consistent with the amended language of this provision, which provides that section 245 applies to an avoidance transaction if such transaction may reasonably be considered to result in a misuse or abuse. See David G. Duff, "The Supreme Court of Canada and the General Anti-Avoidance Rule: Canada Trustco and Mathew" (2006) 60:2 Bulletin for International Taxation 54-71, at 67….]

Limited adoption and poor drafting of remedial benefits rule

[T]he MLI contains a remedial benefits rule … [fn 277 Article 7(4) … .]

Of the 84 jurisdictions that had signed the MLI as of September 18, 2018, however, only 28 (not including Canada) indicated that they would adopt this provision. …

Although this provision allows for the possibility of remedial benefits, it is poorly drafted since it limits these benefits to those that would have been granted to the same person ("that person") in the absence of the transaction or arrangement. As the above example indicates, however, the alternative treaty benefits might have been granted to a different person than the person whose treaty benefits are denied under the PPT.

…Finally, it is unfortunate that neither the MLI nor the OECD model convention or commentary addresses the consequences in the other contracting jurisdiction where one contracting jurisdiction applies the PPT to deny benefits that would otherwise have been available under the CTA.