15 May 2024 IFA Roundtable Q. 7, 2024-1007641C6 - Principal Purpose Test in the Multilateral Instrument

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: Can the CRA provide their views regarding the application of the PPT in the following situations:

Situation (a): Same Rate

Canco is owned by a Foreign Entity (FE) and FE is owned by Foreign MNC. FE’s only activity is holding shares of Canco and it has no employees. FE is resident in a country that has a treaty with Canada (Treaty 1). Treaty 1 provides for a 5% withholding tax on dividends paid by Canco to FE where FE has sufficient ownership of Canco shares. Foreign MNC is also resident in a country that has a treaty with Canada (Treaty 2). Treaty 2 would also provide for a 5% withholding tax on dividends paid by Canco to Foreign MNC if it held shares of Canco directly. Treaty 1 is a Covered Tax Agreement.

In this situation, will CRA confirm whether it is reasonable to conclude that the principal purpose test (PPT) should not apply in respect of a dividend paid by Canco to FE?

Situation (b): Non-Treaty Country in ownership chain

Same facts as above, however, there is a holding company (HC) in the ownership structure between Foreign MNC and FE. HC is resident in a jurisdiction that does not have a treaty with Canada. Foreign MNC chose to add HC into the structure for non-Canadian tax reasons (before or after the Canco shares were acquired). The funding for the acquisition of the shares of Canco came from Foreign MNC and any dividends paid flow back to Foreign MNC.

In this situation, will CRA confirm whether it is reasonable to conclude that the PPT should not apply in respect of a dividend paid by Canco to FE?

Position: For both situation (a) and (b): The CRA’s approach to the PPT, as informed by the OECD’s BEPS Action Report 6 and the MLI, involves a case-by-case analysis to determine whether, upon examination of all the facts and circumstances, obtaining a treaty benefit is one of the principal purposes of the arrangement or transaction. The CRA can make that examination on proposed transactions in the context of an Advance Income Tax Ruling Request.

2024 International Fiscal Association Conference
CRA Roundtable

Question 7: Principal Purpose Test in the Multilateral Instrument

At the 2020 Canadian Tax Foundation Annual Conference, the CRA acknowledged that there was general concern in the tax community regarding uncertainty surrounding the application of the principal purpose test (“PPT”) that was implemented into Canada’s “Covered Tax Agreements” through the Multilateral Instrument (“MLI”). In response to this concern, the CRA released a list of questions it felt could be relevant in determining whether an arrangement or transaction had as one of its principal purposes the obtaining of a treaty benefit. While the list of questions supported that the application of the PPT is highly fact-dependent, the question did little to address the uncertainty regarding the application of the PPT in several relatively common situations. It is also noted that the questions were addressed at the first prong of the PPT (i.e., was obtaining the tax benefit one of the principal purposes of the transaction(s)) and did not address the second prong of the PPT (i.e., the object and purpose test).

Can the CRA provide their views regarding the application of the PPT in the following situations?

Situation (a): Same Rate

Canco is owned by a Foreign Entity (“FE”) and FE is owned by Foreign MNC. FE’s only activity is holding shares of Canco and it has no employees. FE is resident in a country that has a treaty with Canada (“Treaty 1”). Treaty 1 provides for a 5% withholding tax on dividends paid by Canco to FE where FE has sufficient ownership of Canco shares. Foreign MNC is also resident in a country that has a treaty with Canada (“Treaty 2”). Treaty 2 would also provide for a 5% withholding tax on dividends paid by Canco to Foreign MNC if it held shares of Canco directly. Treaty 1 is a Covered Tax Agreement.

In this situation, will CRA confirm whether it is reasonable to conclude that the PPT should not apply in respect of a dividend paid by Canco to FE?

Situation (b): Non-Treaty Country in Ownership Chain

Same facts as above, however, there is a holding company (“HC”) in the ownership structure between Foreign MNC and FE. HC is resident in a jurisdiction that does not have a treaty with Canada. Foreign MNC chose to add HC into the structure for non-Canadian tax reasons (before or after the Canco shares were acquired). The funding for the acquisition of the shares of Canco came from Foreign MNC and any dividends paid flow back to Foreign MNC.

In this situation, will CRA confirm whether it is reasonable to conclude that the PPT should not apply in respect of a dividend paid by Canco to FE?

CRA Response

Situation (a): Same Rate

Paragraph 1 of Article 7 (“Article 7(1)”) of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (also known as the Multilateral Instrument or “MLI”) is generally referred to as the “principal purpose test” (“PPT”) and reads as follows:

“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement”

The PPT is part of the international efforts under Action 6 of the Base Erosion and Profit Shifting (“BEPS”) project, which aims to prevent the granting of treaty benefits in inappropriate circumstances. The PPT was first introduced as paragraph 9 of Article 29 (“Article 29(9)”) of the the OECD (2019), Model Tax Convention on Income and on Capital 2017 (Full Version), OECD Publishing, Paris (“OECD Model Treaty”) and was replicated as Article 7(1) of the MLI.

While the explanatory statement (footnote 1) that accompanies the MLI does not provide examples, both the OECD (2015), Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, (“BEPS Action Report 6”) (footnote 2) and the Commentary to Article 29(9) of the OECD Model Treaty (“Commentary”) provide guidance to interpret Article 7(1) of the MLI.

When describing how the purpose is to be established, paragraphs 178 and 179 of the Commentary indicate that the PPT is an objective-subjective standard considering all the relevant facts and circumstances to determine if obtaining a treaty benefit was one of the principal purposes of the arrangement or transaction:

“178. […] What are the purposes of an arrangement or transaction is a question of fact which can only be answered by considering all circumstances surrounding the arrangement or event on a case-by-case basis. It is not necessary to find conclusive proof of the intent of a person concerned with an arrangement or transaction, but it must be reasonable to conclude, after an objective analysis of the relevant facts and circumstances, that one of the principal purposes of the arrangement or transaction was to obtain the benefits of the tax convention. […]”

179. A person cannot avoid the application of this paragraph by merely asserting that the arrangement or transaction was not undertaken or arranged to obtain the benefits of the Convention. All of the evidence must be weighed to determine whether it is reasonable to conclude that an arrangement or transaction was undertaken or arranged for such purpose. The determination requires reasonableness, suggesting that the possibility of different interpretations of the events must be objectively considered.”

The facts do not provide any indication or contextual information that might suggest what was the intent of either creating the described corporate structure in place or holding the shares in the entities of that structure. From that perspective, it is not possible to express a view on what the principal purposes of a real life arrangement or transaction leading to the creation of a similar structure would be and whether one of them is obtaining the benefits of Treaty 1. The facts also do not indicate whether there is a treaty reducing the withholding tax rate on an eventual dividend distribution made by FE to Foreign MNC.

In this scenario, FE’s sole activity is holding shares of Canco and it has no employees. This lack of substantial activities beyond holding shares could be indicative of an arrangement one of the principal purposes of which was to obtain treaty benefits, such as the reduced 5% withholding tax rate on dividends.

The fact that Treaty 2 provides for a 5% withholding tax if dividends were paid by Canco directly to Foreign MNC would also form part of the relevant facts and circumstances in determining whether one of the principal purposes for the creation of FE and its residence in that jurisdiction was to obtain the benefit of Treaty 1, such that the dividends paid by Canco to FE would benefit from a withholding tax of only 5%.

As indicated in paragraph 181 of the Commentary, determining whether obtaining the benefit of the treaty was one of the principal purposes of an arrangement or transaction includes determining if the benefit was a principal consideration and justified entering into any such arrangement or transaction:

“181. A purpose will not be a principal purpose when it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining the benefit was not a principal consideration and would not have justified entering into any arrangement or transaction that has, alone or together with other transactions, resulted in the benefit.”

A comparison of rates will not be considered in isolation. Understanding the full context of the structure is important.

Should accessing the withholding tax reduction in Treaty 1 be one of the principal purposes of establishing FE to hold the shares of Canco, obtaining that benefit would still have to offend the object and purpose of Treaty 1’s dividend article for the benefit to be denied under the PPT.

Paragraph 174 of the Commentary provides some additional guidance as to whether the granting of the benefit would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement. It states that the object and purpose of the relevant provisions of the Covered Tax Agreement is “to provide benefits in respect of bona fide exchanges of goods and services, and movements of capital and persons as opposed to arrangements whose principal objective is to secure a more favourable tax treatment.”

The absence of indication that FE is not a genuine resident of the country which agreed to Treaty 1 and the fact that the 5% Canadian withholding tax rate applies under Treaty 1 (on dividends paid by Canco to FE) and would apply under Treaty 2 (if Canco had paid dividends to Foreign MNC), might be relevant in establishing whether granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of Treaty 1 or not.

The CRA’s approach to the PPT, as informed by the OECD’s BEPS Action Report 6 and the MLI, involves a case-by-case analysis to determine whether, upon examination of all the facts and circumstances, obtaining a treaty benefit is one of the principal purposes of the arrangement or transaction. The CRA can make that examination on proposed transactions in the context of an Advance Income Tax Ruling Request.

Situation (b): Non-Treaty Country in Ownership Chain

The statement in the facts, that Foreign MNC chose to add HC into the structure “for non-Canadian tax reasons”, is not determinative of whether or not the purpose test in the PPT is met. In that respect, we refer to the comment in paragraph 181 of the Commentary which indicates that “purposes related to the avoidance of domestic law should not be used to argue that obtaining a treaty benefit was merely accessory to such purpose”.

The inference described in situation (a), that FE having no apparent role other than to serve as a holding company appears to suggest that one of the principal purposes for its creation and residence in that jurisdiction was to benefit from Treaty 1, is also applicable in situation (b).

The comments made in the response to situation (a) above, about not being in a position to express a view on whether it is appropriate to extend the benefits of the tax convention to FE in the circumstances extend to situation (b).

Only a detailed analysis of the facts and circumstances, including the existence of bona fide non-tax reasons for the structure, the activities of the entities involved and the overall context and timing of the different transactions inform the determination of whether in a real life situation, one of the principal purposes of adding HC into the overall structure and the overall arrangement was to benefit from the 5% withholding tax rate in Treaty 1. That might also be relevant in establishing whether granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of Treaty 1or not. Here again, the conclusion would depend on the facts and context in a real life example.

As noted in CRA document 2022-0926361C6, in addition to the GAAR and the PPT, the CRA will consider, where appropriate, the taxpayer’s corporate residency, the application of judicial doctrines and anti-avoidance rules, either domestic or in the relevant bilateral tax treaty.

Angelina Argento
2024-100764
May 15, 2024

Response prepared in collaboration with the TAP Committee

FOOTNOTES

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

1 See www.oecd.org/tax/treaties/explanatory-statement-multilateral-convention-to-implement-tax-treaty-related-measures-to-prevent-BEPS.pdf

2 See www.oecd-ilibrary.org/taxation/preventing-the-granting-of-treaty-benefits-in-inappropriate-circumstances-action-6-2015-final-report_9789264241695-en . In particular, refer to pages 5 to 64 and especially paragraph 14 of the commentary.