Article 29A

Administrative Policy

15 May 2019 IFA Roundtable Q. 8, 2019-0798841C6 - Active Trade or Business Test under the LOB Clause

Art. XXIX-A(3) Canada-US LOB clause exclusion would be unavailable to income derived by a Canadian subsidiary from an offshore connected-business FA

Canco (which is purely a holding company for FA carrying on business in a third country) pays a dividend to USco, which is owned by individuals resident in a non-treaty country but which is engaged in the active conduct of a trade or business in the U.S. FA is in the same business as USco and its activities are all connected to USco’s business. Would Art. XXIX-A(3) of the Canada-US Treaty be available respecting such dividend?

CRA noted that of the three tests set out in Art. XXIX A(3) –

  1. the US is engaged in the active conduct of a trade or business in the U.S.;
  2. the income is “derived from [Canada] in connection with, or incidental to, that trade or business (including any such income derived directly or indirectly by [the U.S. resident] through one or more other [Canadian residents] (the “connected test”); and
  3. the trade or business carried on in the U.S. is substantial in relation to the activity carried on in Canada giving rise to the income in respect of which treaty benefits are claimed -

the connected test will not be satisfied.

To the extent that this denial is not considered appropriate in the circumstances, the taxpayer may request special relief through the CRA competent authority under Art. XXIX-A(6).

8 September 2017 External T.I. 2014-0549771E5 - Article XXIX-A:3

a trust is related for purposes of Art. XXIX-A (3) of the Canada-U.S. Treaty to a corporation that is controlled by its corporate trustee

The sole beneficiary of a trust (the “Trust”) that is resident in the U.S. for purposes of the Canada-U.S.Treaty is the parent of a US group of entities (“US Parent”), and the Trust's sole beneficiary is a wholly-owned U.S. subsidiary of US Parent (“US Opco”). Canco, also in the group, carries on business in Canada. The US group of entities has funded the Trust which has then financed Canco by way of debt. May US Opco be considered related to the Trust for purposes of Art. XXIX-A, para. 3? After noting the relevance of domestic definitions of a term under Art. III, para. 2, CRA stated that "the phrase 'person related thereto' should take its meaning from subsection 251(2)." After then referring to the ss. 104(1) and (2) rules, it then stated:

Accordingly, the reference to the trust in paragraph 104(2) of the Act is a reference to the trustee having ownership or control of the trust property pursuant to paragraph 104(1) of the Act. Therefore, that trustee will be deemed to be an individual in respect of the trust property.

According to subparagraph 251(2)(b)(i) of the Act, “related persons” or persons related to each other includes a corporation and a person who controls the corporation, if it is controlled by one person. The trustee will be an individual in respect of the trust property and if the beneficiary is a corporation that is solely controlled by the trustee, the trust and the beneficiary will be “related persons” or persons related to each other for purposes of the Act. ...

As such, in the hypothetical scenario described, given that US Parent, which is the sole trustee of the Trust, wholly owns US Opco, being the beneficiary of the Trust, and thus controls US Opco, in our view, US Opco may be considered a “person related thereto” in respect of the Trust for the purposes of paragraph 3 of Article XXIX-A in connection with Canadian taxes to which the Treaty applies.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 251 - Subsection 251(2) - Paragraph 251(2)(b) - Subparagraph 251(2)(b)(i) a trust is related to a sub of its corporate trustee 74
Tax Topics - Treaties - Income Tax Conventions - Article 3 "person related thereto" defined by ITA meaning of "related person" 39

5 November 2015 Internal T.I. 2013-0496401I7 - XXIX-A(3) - Active Trade or Business Exception

connection test in XXIX-A(3) of U.S. Treaty satisfied by funding interest to a non-qualifying U.S. parent, on a loan whose use had nothing to do with a connected Canadian business, out of the cash flows generated by that business

To help fund the indirect acquisition of NR-Target (which was not resident in Canada or the U.S.) by Canco (an indirect subsidiary of non-resident "Parent"), US-Holdco1 (a U.S. resident which was not a "qualifying person") subscribed in U.S. dollars for Canco's shares and made the U.S.-dollar "Loan2" to Canco. Canco used U.S. dollars funded by XX and such U.S. dollar subscription and loan proceeds to make a capital contribution to NR-Holdco3 (an non-resident subsidiary held by it and a wholly-owned U.S. subsidiary) and a non-interest bearing U.S.-dollar loan to NR-Holdco4 (a wholly-owned subsidiary of NR-Holdco3). NR-Holdco4 used those loan proceeds and a capital contribution from NR-Holdco3 to acquire all the shares of NR-Target.

Canco made interest payments on Loan2 to US-Holdco1 ("Interest Payments"), which were funded out of cash generated from sales to US-Opco2 of products manufactured in Canada. US-Opco2 (a U.S. resident) primarily markets and distributes XX products in the U.S.

Is the requirement in para. XXIX-A(3) of the Canada- U.S. Convention that the Interest Payments be income be derived "from the other Contracting State (Canada) in connection with…that (US) trade or business" met based on a "funding approach"? Can this requirement only be met in respect of Canadian-sourced income?

The Directorate responded:

The situation submitted involves essentially interest payments made by a Canadian payer to a US resident in respect of borrowed funds used to acquire shares of a corporation resident in a third country, where the interest payments were funded out of cash generated from sales of products it manufactured in Canada.

… Paragraph XXIX-A(3)…[inter alia requires:] …The item of income is derived from the source state (Canada) in connection with or incidental to that (US) trade or business (including any such income derived directly or indirectly by that resident person (US person) through one or more other persons that are residents of the source state (Canada)) ("Connected Test")

…[I]nterest paid or credited by a Canadian resident to a US person might be considered "derived in connection with" a US active business in the following circumstances:

  1. the interest is paid or credited in respect of an account payable issued by [sic] the US person in the course of carrying on its US active business,
  2. the interest payments are in respect of borrowed money used for the purpose of earning income from a business carried on in Canada that is upstream, downstream or parallel to the US active business ("Canadian-Connected Business"), or
  3. the interest payments are funded out of the cash flow from such a Canadian-Connected Business.

The last two assertions rely on an interpretation of the "connection standard" that allows it to be met based on either a "use test" or a "funding approach".

…[I]t is clear that the taxpayer cannot rely on the "use test" as the borrowed money was used to acquire shares of non-resident corporations. As for the "funding approach", it is not clear… whether the Canadian-Connected Business generated sufficient net cash flow in the relevant periods. To the extent of any shortfall…for example, the Interest Payments might be partially funded from foreign affiliate dividends… no relief would be available… .

....[Y]ou may want to suggest to the taxpayer to initiate a request for the grant of treaty benefits under [para. XXIX-A(6)].

2 December 2014 CTF Roundtable, Q. 7

U.S. business was "substantial" for para. 3 purposes with 50% of revenues and assets and 10% of employees

In what circumstances would CRA consider a US business to be "substantial" in relation to a Canadian business for purposes of Art. XXIX-A, para. 3 of the Canada–US tax Convention (the LOB Article)? CRA responded:

For the purpose of determining whether the US business was "substantial" in relation to the Canadian operations in the context of [various] rulings, a number of factors were considered which included, but were not limited to: the relative amount of assets and revenues, number of employees involved in each jurisdiction, and in certain circumstances the relative amount of income and compensation expenses. … [S]ome of the more significant comparative ratios are summarized below:


(US vs. CAN)

Situation A

Situation B

Situation C

Situation D

Revenues 4.9:1 1.6:1 13.5:1 0.5:1 Assets 5.6:1 1.1:1 21.0:1 0.5:1 # of Employees 4.0:1 1.6:1 38.8:1 0.1:1

To date… Rulings has not denied the availability of treaty benefits under Article XXIX-A(3) on the determination that the US business was not substantial in comparison to the Canadian activities.

2014 Ruling 2013-0511761R3 - Cross-border financing Canada - USA

interest paid to U.S. sister of LLCs carrying on same business eligible under para. 3

ForSub, which is a U.S.-resident wholly-owned C-Corp subsidiary of ForCo, an LLC, will acquire from ForCo an interest-bearing note (the CanSub Note) owing by an indirect wholly-owned ULC subsidiary of ForCo (CanSub). CanSub, through a partnership, carries on the same business operations as are carried on by wholly-owned LLC subsidiaries of ForCo. ForCo and ForSub are not "qualifying persons" (as defined in Art. XXIX A, para. 2 of the Canada- U.S. Treaty), and they will not file a consolidated income tax return.

Ruling that, by virtue of Art. XXIX A, para. 3, ForSub will be entitled to the Treaty benefits for interest on the CanSub Note.

22 May 2014 May IFA Roundtable, 2014-0526711C6 - Article XXIX-A(3) of the US Treaty

tcp gains on U.S. shares derived from Canada under para. 3

UK Parent owns US Parent, which owns US Holdco (whose shares are taxable Canadian property) which owns Can Sub. US Parent sells US Holdco. Does Art. XXIX-A, para. 3 of the Canada-U.S. Treaty (i.e., the LOB) apply, assuming US Parent is carrying on a business that is upstream, downstream or parallel to the business carried on by Can Sub, and would the gain be derived from Canada where Canada taxes it under domestic law? CRA responded:

[W]e would consider the gain realized in US Parent from the disposition of its US Holdco shares to be income derived from Canada for purposes of applying paragraph 3 of Article XXIX-A of the Treaty, since the value of the US Holdco shares would be principally derived from property that is "taxable Canadian property" as defined in subsection 248(1).

26 November 2013 CTF Roundtable, 2013-0507961C6 - Article XXIX-A LOB provisions

listed company with multiple classes; meaning of "substantial;" dividends to bankrupt; base erosion test
Q. 5(a) Super-voting shares

Where a company has multiple classes of voting shares, with one or more of the classes thinly traded or not at all, each class of shares should be considered separately when determining whether those shares are "primarily and regularly traded" for purposes of Art. XXIX-A(2)(c) of the Canada-U.S. Convention. A ruling request for such a company with a class of super-voting shares was withdrawn when CRA expressed its concern on this issue. In 2011-0429261R3, a "qualifying person" ruling under Art. XXIX-A(2)(c) was largely facilitated by the fact that the authorized share capital of the particular US corporation consisted only of a single class of publicly-traded voting common stock.

Q. 5(b)

Criteria for substantial business. In 2009-0349141R3, 2011-0424211R3 and 2012-0458361R3, where the issue was whether the size of the US business was substantial in relation to the Canadian operations under Art. XXIX-A(3), Rulings considered:

the relative amount of assets, revenues, income, compensation expenses, and the overall number of employees involved in the US business in comparison to those in respect of the Canadian activities.

Q. 5(b)

Dividends to bankrupt U.S. parent. Respecting dividends paid by a Canadian subsidiary corporation to its bankrupt US parent, Rulings confirmed the availability of Art. XXIX-A(3)

on the basis that the US person was viewed as being engaged in the active conduct of a trade or business in the US, despite the fact that business activities in the US had ceased as a result of the bankruptcy…while noting that the purpose of the dividend was to pay the US parent corporation's creditors… .

Q. 5(c)

Base erosion test in first year. In 2012-0471921R3, the ownership test in Art. XXIX-A(4)(a) was satisfied at the time that a dividend was proposed to be paid from a Canadian subsidiary to its U.S. parent. However, as the base erosion test under Art. XXIX-A(4)(b) was being applied in the first fiscal period of the US person, Rulings was unable to confirm whether the conditions of the base erosion test in paragraph (b) were satisfied throughout that fiscal period. Rulings confirmed the availability of Treaty benefits for the dividend, subject to the base erosion test being satisfied by the taxpayer for the current taxation year.

2013 Ruling 2012-0471921R3 - Deemed dividend on return of capital

base erosion test to be satisfied in current year

Canco and U.S. Holdco

Canco, which is an unlimited liability company, is wholly owned by U.S. Holdco, which is resident in the U.S. for purposes of the Canada-U.S. Income Tax Convention (the "U.S. Treaty"), but is not a qualifying person for purposes of the U.S. Treaty. The expenses of U.S. Holdco which are deductible in computing its income for Code purposes for the XX taxation year and which are paid directly or indirectly to persons who are not qualifying persons under the U.S. Treaty are less than X% of its gross income for such purposes, and it is expected that htis test will be satisfied for the XX taxation years.

Foreign Holdco and Foreign Sub

X% of the shares of U.S. Holdco are owned by Foreign Sub which, in turn, is a wholly-owned owned subsidiary of Foreign Holdco. Foreign Holdco and Foreign Sub are resident in Country 1 (not the U.S. or Canada), are not qualifying persons under the U.S. Treaty and are entitled to all the benefits of the Treaty ("Treaty 2") between Canada and Country 1. The common shares of Foreign Holdco are publicly traded on Exchanges 1, 2 and 3.

Proposed transactions

Canco will sell its investment in a Canadian business held through a Canadian LP to an unrelated 3rd party. It will distribute the net proceeds of disposition to U.S. Holdco by adding an amount to its paid-up capital account pursuant to the applicable provincial Company Act, and then distribute the amount of that addition to U.S. Holdco as a return of capital on its shares. The representation is made that "no income, profit or gain will arise or will be recognized under the taxation laws of the United States as a result of the[se] transactions…."



  • Art. IV, para. 7(b) of the U.S. Treaty will not apply to treat the s. 84(1) dividend arising to U.S. Holdco as not having been paid to it.
  • U.S. Holdco will be entitled to the benefits of the U.S. Treaty in respect of such dividend by virtue of Art. XXIX A, para. 4 provided that it satisfied the base erosion test in its XX taxation year.
Locations of other summaries Wordcount
Tax Topics - Treaties - Income Tax Conventions - Article 4 PUC increase and distribution 402

28 November 2010 Annual CTF Roundtable, 2010-0387001C6 - Canada-US Treaty LOB - Treatment of Interest

interest paid out of connected business

Canco has both qualifying active business income from a Canadian business that is connected with an active trade or business (the connected business) of its wholly-owning US parent (USco) and also non-qualifying income of some kind, and pays interest to USco (which is not a qualifying person) on a debt owing to USco. CRA indicated that it will treat an interest payment from Canco to USco as being derived by USco in connection with USco's active trade or business in the United States for purposes of Art. XXIX A, para. 3 of the Canada-US Convention if

(1) the payment is in respect of indebtedness that was incurred exclusively for the purpose of earning income from Canco's connected business, or (2) Canco can establish that the interest payment was funded out of the earnings of the connected business.

17 May 2012 IFA Roundtable, 2012-0444151C6 - Hybrid Partnerships and Branch Tax Liability

The two partners of a partnership which has elected to be a domestic corporation for Code purposes are: a corporation which is resident in the U.S. for purposes of the Canada- U.S. Income Tax Convention; and a corporation resident in a non-Treaty country.

CRA indicated that a member of the partnership can access benefits under Article X(6) of the US Treaty ("partnership-level benefits") to the extent that the partnership could have claimed such benefits had the partnership been the entity subject to Canadian branch tax. Although the partnership would not so qualify as a "qualifying person" as defined in Art. XXIX A(2) of the US Treaty due to the absence of share capital for the partnership, "partnership-level benefits" under Art. X(6) may apply to business profits earned by a US-resident partnership through a Canadian permanent establishment in accordance with the "active trade or business" test under Art. XXIX A(3), or, if treaty benefits are granted by the Canadian competent authority, under Article XXIX A(6).

2012 Ruling 2012-0435211R3 - Article XXIX-A(3) of the Canada-US Tax Convention

US Holdco in Chap. 11 receives dividend

Holdco, which had been a listed U.S. company, was taken private by L5, which is a fund whose members are not known. Holdco and its subsidiary, USCo (neither of which carry on a business of making or managing investments) filed a Chapter 11 Plan (following their filing of a petition in bankruptcy), and a Plan Administrator was appointed. Although a Canadian subsidiary of Holdco (Canco) ceased to sell assets to securitization trusts when the group financial difficulties became severe, it continues to earn income from obligations to it of those trusts, including the receipt of deferred purchase price.

Canco will pay three cash dividends to Holdco, its sole shareholder. "Through the Plan Administrator under the Plan of Liquidation, Holdco will have full discretion and control over the Dividends throughout the period during which the Dividends are paid."

Rulings that the benefits of the Canada-U.S. Treaty will apply to the dividends pursuant to Art. XXIX-A, para. 3, and that the rate of withholding under Art. X will be 5%. In the summary, CRA noted that the dividends will be derived by the parent "in connection with an active trade or business carried on in the United States that is substantial in relation to the activity in Canada that gave rise to the income."

2012 Ruling 2012-0458361R3 - Cross-Border Financing

ECo, which is fiscally transparent for U.S. purposes and resident in the U.S. (a.k.a., Country 1) but is not a qualifying person (as defined in Art. XXIX-A of the Canada- U.S. Convention), makes a loan (the "Charlie Debt") bearing non-participating interest to CCo, which is a CBCA corporation and affiliated with Eco. (Both Eco and CCo are indirect wholly-owned subsidiaries of a public company (ACo), which is resident in Country 2.) ECo is a wholly-owned subsidiary of DCo, which is resident in the U.S. but is not a "qualifying person (as so defined). ECo acts as a lender to various affiliates in various countires (although no financing has been provided to CCo to date), and raises much of the necessary financing through public issuances of debt and commercial paper. CCo uses the proceeds of the Charlie Debt for an income-producing purpose.

Ruling that Art. XXIX-A of the Canada-U.S. Treaty will apply so that the benefits of the Treaty will apply to DCo in respect of any interest paid on the Charlie Debts, and Art. XI, para. 1 of the Treaty will apply to reduce the Canadian withholding tax rate to nil for any interest paid by CCo to ECo.

Locations of other summaries Wordcount
Tax Topics - Treaties - Income Tax Conventions - Article 4 derivative benefit re loan interest 309

28 June 2010 External T.I. 2009-0329511E5 - United States - Dividend Withholding Rate

S-Corp a qualified person if meets base erosion test

A U.S. resident citizen is the sole shareholder of a U.S. Subchapter S corporation (S-Corp), which is the sole shareholder of a U.S. LLC (which is fiscally transparent for U.S. purposes) ). US LLC is the sole shareholder of Canco, which is not fiscally transparent. Would the Treaty limit Canada's taxation of a dividend paid by CAnco to US LLC to 5% of its gross amount? CRA responded:

The CRA generally treats an S-Corp as a corporation and a resident of the United States under the Treaty. … Under subparagraph 2(a) [of Article X], the S-Corp would be considered to own the shares of Canco owned by the US LLC. ... The S-Corp will be a qualifying person if it satisfies the ownership and base erosion tests set out in clauses 2(e)(i) and (ii). As 50 percent or more of the aggregate vote and value of the shares of the S-Corp are not owned, directly or indirectly, by persons other than qualifying persons, the ownership test in clause 2(e)(i) [of Article XXIX A] is met. However, whether or not the base erosion test in clause 2(e)(ii) of Article XXIX A is met is a question of fact that can only be determined after an examination of the gross income and the deductible expenses of the S-Corp for the relevant time period.

12 April 2010 External T.I. 2009-0317941E5 - Canada-US Tax Convention - Article XXIX A

meaning of "paid or payable...directly or indirectly" in Art. XXIX A of Cda-US Treaty

How will CRA interpret "paid or payable...directly or indirectly" in Art. XXIX A(2)(e) and (4)(b) of the Canada-U.S. Convention? CRA responded:

The CRA will interpret the words "paid or payable...directly or indirectly" contained in Articles XXIX A(2)(e) and (4)(b) of the Treaty consistent with the approach we have taken in interpreting those words under subparagraph 95(2)(a)(ii) of the Act. For example, for the purpose of applying Article XXIX A(2)(e) or (4)(b) of the Treaty, a payment by a company to a qualifying person will be considered to be made indirectly to a non-qualifying person if there is a sufficient link between the payment and a subsequent payment by the qualifying person to a non-qualifying person (e.g. back-to-back arrangement).

8 December 2009 TEI Roundtable Q. 4, 2009-0347701C6 - Qualifying person & multiple shares

The correspondent noted that in Canada, if each class of shares of a public company with multiple classes must be considered separately for purposes of satisfying the de minimis or 10-percent tests in the U.S. tax regulations (treated as being applicable for Canadian purposes under para. 2(c) of the "qualifying person definition) very few Canadian corporations with multiple classes of voting shares will be considered "qualifying persons" for purposes of the LOB clause. CRA stated:

…each class of shares must be considered separately for the purposes of satisfying the de minimis and the 10 percent test. We understand that this interpretation is in line with the views of the U.S. tax authorities.

28 May 2009 Internal T.I. 2009-0319161I7 - Canada-US Treaty - Article XXIX A(3)

CRA will therefore interpret the term 'registered securities dealer' to mean:

  • a 'registered securities dealer' for the purposes of the Income Tax Act (Canada); or
  • a 'dealer in securities' for the purposes of Section 475 of the Internal Revenue Code and whose dealings as such are regulated under US federal or state-level securities legislation.

Income Tax Technical News No. 41, 23 December 2009 under "5th Protocol to the Canada-US Tax Convention – Limitation on Benefits," Q. 4 - Example.

sale of shares of USco carrying on parallel business

Assume that USco carries on an active business in the United States (other than an investment business). USco owns all of the shares of Canco, a corporation resident in Canada, which carries on an active business in Canada that is parallel to USco's active business. The active business carried on by USco in the United States is substantial in relation to the active business carried on by Canco.

1) Canco distributes a portion of its after-tax income from its active business to USco in the form of dividends on its shares

Since USco and Canco carry on parallel business activities and the dividends are paid out of the after-tax earnings from Canco's business, we would consider the dividends received by USco to be derived in connection with USco's active business.

2) USco sells the shares of Canco and realizes a taxable capital gain

Since the value of the Canco shares (and thus the taxable capital gain) is derived from an active business in Canada that is parallel to the active business carried on by USco in the United States, we would consider the taxable capital gain on the disposition of the shares of Canco to be derived in connection with USco's active business.

17 July 2008 IFA Roundtable, 2008-0272361C6 - Limitation of Benefits

look-through of fiscally transparent entities for qualified person purposes

Will CRA look through LLCs and other entities that are fiscally transparent for US purposes, in applying paras. 2(d) and (e) of "qualifying person" of Art. XXIX A of the Canada-U.S. Treaty? CRA responded:

The principles of new paragraph 6 of Article IV of the Treaty will be taken into account by the CRA when applying the ownership and base erosion provisions of Article XXIX A. Therefore, the CRA will "look through" an entity that is viewed as fiscally transparent under the domestic laws of the residence State (other than entities that are resident in the source State) when applying the ownership/base erosion test in paragraphs 2(d) and 2(e) of the definition of "qualifying person" of Article XXIX A. The CRA recommended that the [Technical Explanation] reflect this interpretation.


Steve Suarez, "Canada to Unilaterally Override Tax Treaties with Proposed New Anti-Treaty-Shopping Rule", Tax Notes International, 3 March 2014, 797-806.

Comment on Jim Wilson article (below)/inappropriateness of main purpose test in new anti-Treaty shopping rule (p. 804)

As noted by that learned author (who with more than 30 years of CRA experience would certainly understand the tax authority's perspective), overreliance on a purpose test (particularly one with as low a threshold as the proposed rule) without reference to some normative standard for determining abuse leads to all kinds of benign transactions potentially being denied treaty benefits and an unacceptable level of uncertainty for taxpayers. A key purpose of tax treaties is to offer tax benefits to encourage transactions that otherwise would not occur. If the signatories' intent is to modify taxpayers' behavior by offering treaty relief, why should pursuing that relief be treated as evidence of mischief per se? As discussed above with reference to the proper definition of treaty shopping, the relevant question should not be whether one of the taxpayer's main purposes was to obtain a treaty benefit, but rather is the grant of that benefit in the circumstances consistent with what the treaty signatories intended?

Koichiro Yoshimura, "Clarifying the Meaning of 'Beneficial Owner' in Tax Treaties", Tax Notes International, November 25, 2013, p. 761.

Alternative OECD-suggested approaches to Limitations-on-Benefits clauses (p.767)
1. Approaches as Proposed in the OECD Commentary

Although the OECD model itself does not contain an LOB clause, the OECD commentary proposes possible approaches for a state to employ an LOB clause:


The look-through approach. Under this approach, a company will be denied treaty benefits if the company is owned or controlled, directly or through one or more other companies, by a third-state resident.

b. The subject-to-tax approach

. Under this approach, treaty benefits are granted only if the income received by a resident of the residence state is subject to tax in the residence state.

The OECD commentary specifically states that this approach "does not offer adequate protection against…'stepping-stone strategies.' "

c. The channel approach

Under this approach, when a third-state resident has a substantial interest in the recipient, or exercises the management of or has control over the recipient, if a certain percentage of the income of that recipient is used to satisfy the claim by such third-state resident, the recipient will be disallowed the treaty benefits regarding such income.

Unlike the subject-to-tax approach, the channel approach does not look at whether the income received by the recipient is subject to tax in the residence state; instead, this approach looks at the payment deductible in computing the taxable income of the recipient in the residence state. The OECD commentary states that the channel approach "appears to be the only effective way of combating 'stepping-stone' devices."

Direct conduit (p. 769)

Please refer to Figure 1...regarding direct conduits. ...[B]ecause the wholly-owning parent company of the recipient (the company resident of State A) is a third-state resident, the recipient would not satisfy the LOB clause in the Japan-U.S. treaty... .

[Insert Figure 1]

Direct conduit (p. 769)

Please refer to Figure 2 [similar to Figure 4 below] regarding typical steppingstone conduits.

Deficiencies of base erosion test in Japan-U.S. Treaty in dealing with steppingstone conduits (p. 770)

… Under the base erosion test, if the total amount of expenses paid by the recipient (the company resident of State A) to third-state residents accounts for 50 percent or more of its gross income in the residence state (State A), the recipient will fail to satisfy the test, and it might appear that this test effectively deals with steppingstone conduits. However, if such expense payment is less than 50 percent of the gross income of the recipient, the company can still pass the test. The problem with the test is that depending on the size of the gross income of the recipient (which includes any income that is relevant or irrelevant to the transaction between the recipient and third-state residents), 50 percent of the gross income can be a huge amount, which creates enough room for tax avoidance. In other words, the base erosion test permits tax avoidance to the extent that the deductible amount does not reach 50 percent of the gross income of the recipient.

Deficiencies of OECD channel approach in dealing with steppingstone conduits (p. 770)

Unlike the base erosion test in the Japan-U.S. treaty, the example provision regarding the channel approach in the OECD commentary looks at the percentage of the amount to be deducted from a certain item of income of the recipient, not the gross income of the recipient, as payment to a third-state resident having a substantial interest in, or the management of or control over, the recipient. Although not completely clear from the language of the example provision, this provision calculates the percentage at issue without looking at the relationship between (a) the item of income of the recipient and (b) the payment made by the recipient to a third-state resident, and instead requires some interest or control over the recipient by the third-state resident. In other words, this provision calculates the percentage at issue by just allocating the entire cash outflow of the recipient to every item of income of the recipient on a pro rata basis. If true, the same criticism against the base erosion test in the Japan-U.S. treaty would also apply to this OECD example provision of the channel approach. If the overall cash outflow of the recipient is huge, it will decrease the percentage of the amount to be deducted from a certain item of income of the recipient as payment to a certain third-state resident and thereby create room for tax avoidance. Therefore, this OECD example provision of the channel approach would not work sufficiently, either.

3. Direct Conduits vs. Steppingstone Conduits

The above examination shows that, at least for typical direct conduits and steppingstone conduits, whereas an LOB clause cannot deal with steppingstone conduits sufficiently, it can handle direct conduits. If this is true for any direct conduits and steppingstone conduits, direct conduits could be excluded from the scope of beneficial owner and beneficial owner could focus on steppingstone conduits. To further examine this point, it is necessary to understand why an LOB clause can handle typical direct conduits while it cannot deal with typical steppingstone conduits.

When we look at the structures of both typical direct conduits and steppingstone conduits, the most notable difference is whether a third-state resident holds, vis-à-vis the recipient, shares in the recipient or debt claims. In my opinion, this difference determines whether an LOB clause successfully deals with those conduits.

Potential for abuse under steppingstone conduits (p. 771)

In contrast [to direct conduits], for steppingstone conduits, a third-state resident that has a debt claim can claim a payment of a predetermined amount at a specified date against the recipient, regardless of the decisions or thoughts of the recipient, its shareholders, or other creditors. Therefore, the third-state resident can effectively have legal control over when, and in what amount, payment should be made by the recipient to it. Since there is no majority voting system like a shareholders' meeting involved, a mechanism similar to the minimum 50 percent shareholding requirement of an LOB clause for direct conduits does not work here. Although the look-through approach and the channel approach of an LOB clause might seem similar in that both use percentage threshold tests, this is why the channel approach cannot sufficiently deal with steppingstone conduits.

Touchstone of legal control (p. 771)

Based on these analyses of typical direct conduits and steppingstone conduits, it becomes apparent that the factor that determines whether an LOB clause can sufficiently deal with those conduits is whether a third-state resident, despite the existence of an LOB clause, has legal control over the amount and timing of payment to it.

These examinations suggest two things. First, considering that a third-state resident would engage in conduit transactions only when it had legal control over the amount and timing of payment to be made by the recipient to it, one of the requirements for the beneficial owner should be that a third-state resident has legal control over the payment to be made by the recipient to the resident. Second, even for direct conduits in which a third-state resident owns less than 50 percent of shares in the recipient, if the third-state resident can have legal control over the amount and timing of payment to it, an LOB clause that relies simply on a majority voting system of shareholders would not be able to handle those direct conduits and such legal control is easily attainable by using various legal instruments.

Debt-like hybrid stock (p. 771)

…cases in which a third-state resident owns, vis-à-vis a recipient, debtlike hybrid stock that entitles the third-state resident to sufficient legal control over a dividend payment should be included in the scope of beneficial owner.

Sharing of LOB detriment with recipient-state residents (p.772)

When a third-state resident that owns a certain percentage of common stock is considered the beneficial owner of the payment to be made by the source company, to what extent should treaty benefits to the recipient be denied? Suppose that the third-state resident and an individual resident in the residence state own, respectively, 40 percent and 60 percent of the common stock in the recipient, which owns all shares in the source company. Suppose further that the third-state resident, though it only owns 40 percent of the common stock in the recipient, has legal control over payment to be made by the recipient through a shareholders' agreement. If we deny treaty benefits to only 40 percent of the dividends received by the recipient, this means that the recipient can enjoy treaty benefits for 60 percent of the dividends received. The treaty benefits will be distributed not only to the individual resident but also to the third-state resident, because under ordinary corporate law systems, all shareholders will be treated equally, so it would be impossible to distribute a different amount of dividends to shareholders who own the same common stock. In effect, the third-state resident is able to enjoy, though only in part, treaty benefits, which it is not supposed to receive, and the question whether this should be regarded as tax avoidance arises.

I believe that we would not have to consider this tax avoidance. The 60 percent of the dividends is paid out regarding the investment made by the individual resident, who is legitimately entitled to treaty benefits if he directly invests in the source company. From the perspective of the source state, to waive the right to tax for that amount is what is expected in the tax treaty, and there is no additional revenue loss as a result of this transaction.

Angela W. Y. Yu, Grace W. Loh, "Ambiguity in the U.S.-Canada Treaty's Publicly-Traded Test Should Be Resolved in Favor of Canadian Dual-Class Public Companies", Tax Management International Journal, 2011, p. 589

There are no valid policy reasons to prevent a dual-class public company from aggregating its share classes to satisfy; the publicly-traded test in Art. XXIX-A.2(c).

Elinore J. Richardson, Stephanie Wong, "Cross-Border Financing Into Canada More Difficult Under Canada's New LLB Provision", Corporate Finance, Vol. XVI, No. 1, 2009, p. 1734

Vern Krishna, "Limitation on Treaty Benefits: Part One", Canadian Current Tax, Vol. 20, No. 1, October, 2009, p. 1.

Edward Miller, "Potential Limitations of the Limitation on Benefits Clause in the Fifth Protocol to the Canada-U.S. Income Tax Convention", International Tax, CCH, December 2007, No. 37, p. 4.


12 August 2013 Consultation Paper on Treaty Shopping – The Problem and Possible Solutions:

Invitation for comments.

The Government invites comments from stakeholders regarding any element of this paper by December 13, 2013.

Definition of treaty shopping (S. 1).

"Treaty shopping" generally refers to a situation under which a person who is not entitled to the benefits of a tax treaty uses an intermediary entity that is entitled to such benefits in order to indirectly obtain those benefits. Such practice is generally considered to be an "improper" use of tax treaties.

Summary of Canadian judicial approach (S. 3).

In a short decision, the Federal Court of Appeal dismissed the Crown's appeal in MIL (Investments) on the basis that it was unable to find an object or purpose of the exempting provision of the Convention whose abuse would justify a departure from the plain meaning of the words of the provision. This decision is a particularly strong statement by the Federal Court of Appeal, indicating that the courts in Canada require further legislative direction before finding that treaty shopping is an improper (and abusive) use of tax treaties….

The narrow meaning ascribed to beneficial owner in Prevost Car Inc. means that the beneficial ownership requirement in this context is not sufficient to deny treaty benefits to an intermediary entity. In particular, even though the intermediary foreign holding company in this case was effectively a direct conduit (i.e., it did not pay tax on dividends received, distributed substantially all of its income to third country residents who owned it, and had no employees or activities other than with respect to the ownership of shares of a subsidiary), it was not denied treaty benefits on the basis of beneficial ownership….

[I]n Velcro Canada, 2012 D.T.C. 1100…the Court followed the decision in Prevost Car Inc.

Inappropriateness of treaty shopping (S. 5).

[T]reaty shopping effectively extends tax treaty benefits to residents of a third country without giving Canada the opportunity to negotiate terms that would reflect the tax system in that third country as well as Canada's bilateral relationship with it. This may also allow residents of that third country to enjoy Canadian tax reductions while remaining insulated from exchange of information provisions….

Disadvantages of treaty renegotiation solution (S. 6.2).

However, even if it were possible to re-negotiate Canada's treaties with certain countries where conduit entities are common – a difficult task given that these countries may not wish to re-negotiate – other conduit countries may emerge. Accordingly, a treaty-based approach, on its own, would likely be ineffective as it would not serve as a timely response to the treaty shopping problem facing Canada today.

Advantages of domestic override (S. 6.2).

In contrast, if Canada were to adopt a domestic law approach, amendments could be implemented in a timely manner. Domestic law provisions to prevent tax treaty abuse are endorsed by both the OECD and the United Nations (the "UN"); [FN: For example, paragraph 9.4 of the Commentary to Article 1 of the OECD Model Convention states that countries do not have to grant the benefit of a double taxation convention where arrangements that constitute an abuse of the convention have been entered into and any such denial of treaty benefits may be achieved under either a domestic law or treaty-based approach.]…For clarity, if a domestic law approach were adopted, it would provide that the domestic law provisions prevail over tax treaties; however, it should be recognized that Canada's intention would be to clarify and codify its position concerning treaty shopping in a manner consistent with the OECD and UN Model Commentaries as well as the laws and practices of several other countries. FN refers to China, France, Germany, United Kingdom and United States.]

OECD treaty override approaches (S. 6.3).

The following types of rules are generally described in the Commentary to Article 1 of the OECD Model Convention:

  • The look-through approach disallows treaty benefits to a company owned or controlled, directly or indirectly, by persons who are not residents of a contracting state;
  • The subject-to-tax approach provides that treaty benefits in the country of source are granted only if the income in question is subject to tax in the country of residence; and
  • The channel approach disallows treaty benefits in cases where an intermediary company receives what would be treaty-protected income if more than 50% of that income is paid to satisfy claims (deductible amounts) of a person not resident in the country of the intermediary company and who has, directly or indirectly, a substantial interest in (or exercises management or control over) the company.

U.S. objective test approach (S. 6.3).

The OECD Commentary also sets out an approach for states wishing to address treaty shopping in a comprehensive way. This approach is essentially a US-style limitation of benefits (LOB) article, similar to Article XXIX A of the Canada-US Treaty. Under this approach, only persons satisfying specific and objective tests are eligible for treaty benefits....

Although more targeted and certain in application, this LOB approach can also be over-inclusive and generally contains a provision enabling contracting states to grant treaty benefits on a discretionary basis in appropriate circumstances. At the same time, this comprehensive and mechanical approach to dealing with treaty shopping can also be under-inclusive and, accordingly, domestic law measures may still be required to address treaty shopping cases.

Attractions of main-purpose test (Ss. 6.4, 7.1).

[G]eneral approaches, whether in the form of a main purpose rule or a more specific anti-conduit rule, are consistent with what the OECD considers abusive; therefore, the implementation of such a rule in Canada's domestic law should not be in conflict with treaty obligations. As indicated above, the ability to implement a general anti-treaty shopping rule in domestic laws would enable Canada to begin addressing treaty shopping much sooner than would be possible under a treaty-based approach….

The factual determination required under a main purpose test is similar to that required to make an "avoidance transaction" determination under the GAAR....

Thus, a main purpose test is relatively familiar to both Canada's treaty partners and Canadian tax advisors. On this basis, a main purpose test, if implemented in Canada's domestic laws, could strike a reasonable balance between effectiveness and certainty.

As indicated in section 6.4, another view is that a main purpose test involves a meaningful element of uncertainty, both for taxpayers and the government.

General approach with objective conditions (S. 7.2).

[A]nother general approach is to implement in Canada's domestic laws an anti-treaty shopping rule that is more specific. Such a rule would set out objective conditions which, if satisfied, would indicate the presence of treaty shopping. For example, such a rule could deny tax treaty benefits to an entity (a conduit) where:

  1. the entity is owned or controlled, directly or indirectly, by residents of one or more third countries;
  2. the entity pays, in the country in which it is resident, no or low taxes on the item of income earned in Canada (taking into account deductible amounts paid to third country residents and other relevant aspects of the tax system in the country where the intermediary is resident);
  3. the entity is not engaged in substantive business operations in its country of residence (other than managing investment income); and
  4. the third country residents referred to in (1) or (2) are not all resident in a country with which Canada has a tax treaty, and that treaty provides at least as much tax relief on the particular item of income as the particular tax treaty.

This approach contains elements from each of the look-through approach, the subject-to-tax approach, and the channel approach discussed in the OECD Commentary on Article 1. It also contains exceptions for entities meeting a substance test and entities controlled by third country residents which would have enjoyed similar tax treaty benefits (a so-called "derivative benefits test")….

[I]n order to maintain effectiveness, the exceptions to any specific and objective test must be designed such that they cannot be easily or artificially satisfied. To achieve effectiveness, this practical reality may involve tightening the conditions and placing greater reliance on a discretionary authority of the Minister of National Revenue to grant treaty benefits in appropriate circumstances.