Inconsistency of back-to-back s. 212(3.2) rules with Canada’s Treaty obligations (p. 851)
[E]ven LOB rules, which operate in a mechanical fashion, give tax authorities discretion to provide access to treaty benefits in certain circumstances—for example, where obtaining treaty benefits is not a principal purpose of an arrangement, or where the denial of treaty benefits would be inconsistent with the purpose of the relevant treaty provisions. [fn 53: Canada-US treaty…XXIX A(6)….] The back-to-back rules do not permit such discretionary relief. The joint committee on taxation has observed that the back-to-back rules may impose tax that is inconsistent with Canada's obligations under its bilateral tax treaties. [fn 54: [S]ubmitted to the Department of Finance, July 25, 2016…In a subsequent submission, the joint committee [stated]…that these rules "should not creep by stealth toward becoming a broad unilateral anti-treaty shopping regime."…] Accordingly, it may be appropriate to provide discretionary relief from the rules where their application would be inconsistent with the purpose and spirit of the relevant treaty provisions.
Derivative benefits concept under B2B rules can provide relief where ultimate funder has a Treaty-reduced rate that is higher than that of immediate funder (pp. 852-853)
The back-to-back regime incorporates the concept of derivative benefits, since the rules effectively preserve the treaty benefits of the immediate funder (or licensor) to the extent that the ultimate funder (or licensor) would be entitled to treaty benefits if it received the relevant payments directly….NR 1 is resident in a treaty country for which the withholding tax rate on interest is limited to 15 percent. NR 3 is resident in a treaty country for which this rate is limited to 10 percent. NR 2 is not resident in a treaty country. NR 1 loans $1,000 to NR 2, which in turn loans $1,000 to NR 3, which in turn loans $1,000 to Canco….
Canco will be deemed to have paid interest to NR 1 under proposed subsection 212(3.2). The deemed interest will be $20, because it is adjusted to reflect the difference in withholding tax rates between payments to NR 1 and NR 3, as a proportion of the rate on payments to NR 1 (that is, [15% — 10%]/15%). The deemed interest will be subject to $3 tax, for overall tax of $9 (or 15 percent of the actual interest payment). The total withholding tax reflects the treaty entitlement of the ultimate funder….Interestingly, the derivative benefit tests in the LOB rules might not provide relief in this case, since they generally require that the ultimate owner be entitled to treaty benefits that are at least as favourable (instead of providing relief to the extent of the ultimate owner's entitlement to benefits.)
No relief under B2B rules if immediate funder has higher rate than ultimate funder (pp. 853-854)
Although the back-to-back rules consider the treaty entitlements of the ultimate lenders (or licensors), the withholding tax payable under these rules cannot be less than the tax on the actual payments to the immediate funder (or licensor)….NR 1 is resident in a country for which the withholding tax rate on interest is limited to 10 percent, and NR 2 is not resident in a treaty country. NR 1 makes a loan to NR 2, on condition that NR 2 makes a loan to Canco. Although the connection test in proposed paragraph 212(3. l)(c) is satisfied, the back-to-back rules would not apply in this scenario because the tax on interest paid to the ultimate funder would not exceed the tax on interest paid to the immediate funder. Canadian withholding tax would apply at the full 25 percent rate.…
Difficulties of a Canadian licensee in determining whether the B2B rule is applicable (p. 855)
[T]he joint committee on taxation has noted that a back-to-back royalty rule could increase the cost of doing business for some Canadians. [fn 60: …July 2016 joint committee submission, at 5-7.] Consider a Canadian resident that licenses software from an unrelated US resident. In order to rely on the exemption from withholding tax under the Canada-US treaty [fn 61: … at article XII(3)(b)] the Canadian requests a representation from the licensor that there is no licensing arrangement that may be caught by the connection test in the back-to-back rules. Although the non-resident is a licensor of software to many customers around the world, this is likely a very unusual request, and may be viewed as requiring the disclosure of confidential information. The licensor may be unwilling to divulge this information or may seek additional fees for doing so….
Non-application of B2B rules to dividends paid by Canadian (p. 856)
The back-to-back rules do not apply to dividends paid by Canadian taxpayers This is interesting, given that back-to-back dividend arrangements were challenged by the minister in Prevost Car and were cited by Finance as an arrangement that would be caught by the 2014 proposal. There may be policy reasons for not extending the back-to-back rules to address dividends. Unlike interest, rents, and royalties, dividends are not deductible by the payer, so back-to-back dividend arrangements may pose less of a threat to the Canadian tax base. Furthermore, while interest, rents, and royalties typically involve clearly defined payment obligations, dividends are often discretionary. This could make it more difficult to establish the requisite connection between equity investments (although the back-to-back rules do address some connections involving equity investments—for example, in the character substitution rules)….
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