14 December 2023 External T.I. 2019-0820291E5 - Meaning of "Capital"

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: What is the meaning of the word “capital” for the purposes of subparagraph 2(a) of Article 10 of the Canada-Israel Tax Convention?

Position: “Capital” for the purposes of subparagraph 2(a) of Article 10 of the Canada-Israel Income Tax Convention generally refers to the amount of capital based on the relevant corporate law, which is generally the stated capital of the shares.

Reasons: OECD Commentary on the meaning of the word “capital”.

XXXXXXXXXX							2019-082029

								Catherine Zhang

December 14, 2023

Dear XXXXXXXXXX:

Re: Meaning of “capital” in Article 10 of the Canada-Israel Income Tax Convention (footnote 1) (Treaty)

This is in response to your letter in which you requested our interpretation of the word “capital” in subparagraph 2(a) of Article 10 of the Treaty (hereinafter “Article 10(2)(a) of the Treaty”). More specifically, in the context of the facts described below, you asked us whether the Israeli company in question will be subject to 5% rate of withholding tax on dividends received, pursuant to Article 10(2)(a) of the Treaty.

This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.

Facts

The hypothetical facts outlined in your letter can be summarized as follows:

• A Canadian resident corporation (Canco) issued common shares and Class A preferred shares.
• Mr. A, B, C, D and E each acquired 200 common shares of Canco out of a total of 1,000 common shares outstanding. The stated capital of the common shares is $0.10 per share (the total stated capital of the common shares is therefore $100). The fair market value of the common shares is $1 per share (the total fair market value of the common shares is therefore $1,000). The common shares give right to 1 vote per share.
• Mr. A also acquired 100,000 Class A preferred shares of Canco. The total stated capital and paid-up capital of the Class A preferred shares is $0.0001 per share (the total stated capital and paid-up capital of the preferred shares is therefore $10) and the redemption value of these shares is $1,000,000.The fair market value of the Class A preferred shares is $10 per share (the total fair market value is $1,000,000). The Class A preferred shares do not give the right to vote.
• Mr. A sold his 100,000 Class A preferred shares of Canco to a company that is resident in Israel (IsraeliCo) for their fair market value, which was $1,000,000.
• The Class A preferred shares of Canco held by IsraeliCo were redeemed by Canco for their redemption value of $1,000,000.

Question: What is the meaning of the word “capital” for the purposes of Article 10(2)(a) of the Treaty?

Our Comments

In general, where a Canadian resident corporation redeems shares of any class of its capital stock from a shareholder, subsection 84(3) deems a dividend to have been paid at that time to the extent that the amount paid by the corporation for the shares exceeds their paid-up capital. Where a dividend is deemed under Part I of the Act to have been paid to a non-resident, the non-resident will be subject to Canadian withholding tax of 25% on the dividend pursuant to subsection 212(2). Therefore, upon the redemption of the Class A preferred shares of Canco, to the extent the redemption value of the Class A preferred shares exceeds their paid-up capital, the excess is deemed to be a dividend paid by Canco to IsraeliCo and the latter will be subject to Canadian withholding tax on the deemed dividend. Since the redemption value of the Class A preferred shares of Canco that were held by IsraeliCo was $1,000,000 and the paid-up capital of the Class A preferred shares was $10, subsection 84(3) deems a dividend of $999,990 to have been paid by Canco to IsraeliCo upon the redemption of the Class A preferred shares, which is subject to a 25% Canadian withholding tax pursuant to subsection 212(2).

In the case of a dividend recipient who is resident in a jurisdiction with which Canada has a tax treaty, the withholding tax rate of 25% may be reduced to a lower rate. More specifically, under Article 10(2)(a) of the Treaty, a reduced withholding rate of 5% can apply if the beneficial owner of the dividends is a company (other than a partnership) resident in Israel and holds directly at least 25% of the capital of the company paying the dividends. If the beneficial owner is a resident of Israel but those conditions are not met, a reduced 15% withholding rate may apply under Article 10(2)(b).

The Supreme Court of Canada indicated in The Queen v. Crown Forest Industries Ltd et al. [1995] 2 S.C.R. 802 (SCC) that the process of finding the meaning of the words in interpreting a treaty namely “involves looking into the language used and the intention of the parties”. It also added that extrinsic materials, such as other international tax conventions and technical explanations that accompany treaties, can help “illustrate and illuminate the intentions of the parties”. The Court stated that the OECD Model Tax Convention on Income and Capital (the “OECD Model Treaty”) is “of high persuasive value” in interpreting income tax treaties and it relied on the OECD commentary in its decision. More recently, the Supreme Court of Canada made a similar comment in The Queen v. Alta Energy Luxembourg S.A.R.L. 2021 SCC 49, by indicating that “the OECD Model Treaty and its Commentaries are relevant to the interpretation of treaties based on that model”.

Paragraph 15 of the OECD 2014 commentary to Article 10 provides that, in general, “capital” refers to the amount based on corporate law, which “in the majority of cases will be shown as capital in the company’s balance sheet”. More specifically, the Commentary states the following:

“In subparagraph a) of paragraph 2, the term “capital” is used in relation to the taxation treatment of dividends, i.e. distributions of profits to shareholders. The use of this term in this context implies that, for the purposes of subparagraph a), it should be used in the sense in which it is used for the purposes of distribution to the shareholder (in the particular case, the parent company).

a) As a general rule, therefore, the term “capital” in subparagraph a) should be understood as it is understood in company law. Other elements, in particular the reserves, are not to be taken into account.

b) Capital, as understood in company law, should be indicated in terms of par value of all shares which in the majority of cases will be shown as capital in the company’s balance sheet.

c) No account need be taken of differences due to the different classes of shares issued (ordinary shares, preference shares, plural voting shares, non-voting shares, bearer shares, registered shares, etc.), as such differences relate more to the nature of the shareholder’s right than to the extent of his ownership of the capital.

d) When a loan or other contribution to the company does not, strictly speaking, come as capital under company law but when on the basis of internal law or practice (“thin capitalisation”, or assimilation of a loan to share capital), the income derived in respect thereof is treated as dividend under Article 10, the value of such loan or contribution is also to be taken as “capital” within the meaning of subparagraph a).

e) In the case of bodies which do not have a capital within the meaning of company law, capital for the purpose of subparagraph a) is to be taken as meaning the total of all contributions to the body which are taken into account for the purpose of distributing profits.

In bilateral negotiations, Contracting States may depart from the criterion of “capital” used in subparagraph a) of paragraph 2 and use instead the criterion of “voting power”.”

Accordingly, the stated capital of the Class A preferred shares of Canco held by IsraeliCo is the amount that should be used for the purpose of determining if the conditions in Article 10(2)(a) of the Treaty are met. Since IsraeliCo holds less than 25% of Canco’s capital computed on that basis, IsraeliCo does not qualify for the 5% withholding tax rate on the $999,990 deemed dividend pursuant to Article 10(2)(a) of the Treaty. However, to the extent that all of the conditions in Article 10(2)(b) of the Treaty are met, IsraeliCo may benefit from a reduced 15% rate.

For dividends paid after January 1, 2020, Article 7(1) of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), which sets out the principal purpose test (PPT), identifies the circumstances in which a benefit under Article 10 of the Treaty may be denied. Although not specifically mentioned in the question, it is assumed that the principal purposes of any person involved in the transaction did not include obtaining the benefits of Article 10 of the Treaty. Should this not be the case, the answer could be different depending on the facts and circumstances of that particular situation.

We trust that these comments will be of assistance to you.

Yours truly,

Yves Grondin
Section Chief
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Convention between the Government of Canada and the Government of the State of Israel for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income Signed on September 21, 2016.