PREVOST UPHELD - DUTCH INTERMEDIARY IS BENEFICIAL OWNER UNDER TREATYTitle for Article 1
By: Mathieu Champagne & Laura-Emanuela Gheorghiu

On February 26, 2009, the Federal Court of Appeal issued its decision in The Queen v. Prévost Car Inc., 2009 FCA 57 confirming the earlier decision of the Tax Court of Canada that a Dutch holding company was the "beneficial owner" of dividends for the purposes of the reduced withholding tax rate under the Canada-Netherlands Income Tax Convention.

More specifically, this case raises two issues of treaty interpretation which may be of interest to international tax practitioners. The first, as indicated above, concerns the interpretation to be given to the term "beneficial owner", found at article 10(2) of the OECD Model Tax Convention ("Model Convention"). The second raises the question of whether national courts should rely on evolving OECD commentary for guidance when interpreting bilateral treaties which are based on the Model Convention, and if so to what extent.

In essence Prévost Car is about tax authorities attacking treaty shopping. In 1995, Volvo (a resident of Sweden) and Henyls (a resident of England) jointly purchased all of the outstanding shares of Prévost Car ("Prévost"), a Canadian resident corporation incorporated in the civil law province of Quebec. The two companies incorporated a Dutch corporation, Prévost Holding B.V. ("PHB.V.") through which they held the shares of Prévost. Whereas under their respective treaties the companies would have had to pay either 10% or 15% tax in Canada on dividends from Prévost, their Dutch-based holding company was only subject to a 5% tax on dividends under that nation's treaty (were no treaty to apply the general Canadian withholding tax rate of 25% would have applied). Furthermore, any dividends paid by PHB.V. to Volvo and Henyls would not be taxed in the Netherlands.

Not liking this outcome, the Canadian tax authorities taxed both Volvo and Henyls directly on the dividends distributed to PHB.V. on the basis that they were the "beneficial owners" of those dividends. The outcome of the case thus centered on the interpretation to be given to the term "beneficial owner".

The Tax Court of Canada ("Tax Court") - the Canadian Court of first instance - found that the "beneficial owner" of dividends is the one to receive them for its own use and enjoyment, thus assuming the risk and control of the dividend received. The Court held that there was no need to pierce the corporate veil provided that the corporation was not just a conduit for another with no rights to personally use or apply the funds received. In adopting this approach, the Tax Court rejected a definition that would have looked solely at who can ultimately benefit from the dividends paid.

Despite some irregularities in Prévost's books identifying Volvo and Henlys as its shareholders (instead of PHB.V.), and PHB.V. having no physical offices or employees, and mandating another company to pay its interim dividends, PHB.V. was nevertheless held to have enough discretion over the use of its funds (the Board had to vote to issue dividends) to not be considered a conduit for its shareholders. This conclusion was sustained even though a Shareholder Agreement between Volvo and Henlys set out that Prévost dividends would be paid each quarter. The Court found that although the agreement may bind the shareholders, PHB.V. itself was not bound by these terms. As a result Volvo and Henlys were spared from paying Canadian tax on dividends paid by Prévost to PHB.V.

The Tax Court's definition of "beneficial owner" was endorsed on appeal. The Federal Court of Appeal - the Canadian appellate court in tax matters - approved of the definition primarily because it accorded with subsequent OECD Commentaries and the OECD Conduit Companies Report. The Federal Court of Appeal found that the worldwide use of the Model Convention and the general acceptance of using its Commentaries to interpret existing bilateral conventions allowed for this approach.

Indeed, the Court found that later commentaries, in other words, those released after a treaty has been signed, could be used to interpret the treaty as long as "they represent a fair interpretation of the words of the Model Convention", did not conflict with Commentaries in force at the time the treaty was signed, did not relate to a provision that had been subsequently and substantially amended, and was not one to which the treaty partners had registered an objection. The Federal Court of Appeal thus chose to apply the 2003 Commentaries to an agreement contracted to by the parties in 1987; a full 16 years earlier.

In conclusion, the Prévost Car decision seems to implicitly recognize a separate existence for holding companies as beneficial owners of dividends, even if the latter are ultimately flowed through to their shareholders, provided that, through its directors, the company exercises some discretion over the funds in the interim. Should the courts be uncertain as to what this means, they should look at current OECD Commentary for guidance.

As for the potential of applying the Tax Court's definition to the term "beneficial ownership" in other articles of the Model Convention, such as those dealing with withholding tax on interest and royalties, it is at best very limited. Regardless of how similar a structure could be to the one analysed in Prévost Car, in the end, the default position does not change. Corporations which are simply conduits for funds are not the "beneficial owners" of these funds. Thus, had there been a contractually "predetermined or automatic flow of funds" in Prevost Car, a fundamental characteristic of back-to-back financing arrangements for example, the Canadian courts may well have found that PHB.V. was a conduit for its shareholders.

IMPORTANT NOTE TO US INVESTORS INTO CANADA USING HYBRID ENTITIES
By: Mathieu Champagne

Canadian unlimited liability companies ("ULCs") have been used by US-resident investors into Canada for a variety of reasons, including to finance Canadian activities. The benefit from the use of ULCs results from their hybrid nature. Although viewed as normal corporate bodies in Canada, ULCs may be fiscally transparent in the US if certain conditions are met. Moreover, payments received from ULCs by a resident of the US, such as interest and dividends payments, generally benefit from reduced withholding tax rate under the Canada-US Tax Convention (the "Treaty").

As of January 1, 2010 new anti-hybrid rules will come into force and seriously jeopardize the tax effectiveness of structures using fiscally transparent ULCs. Following the provisions of new paragraph IV(7)(b) of the Treaty, payments received from fiscally transparent ULCs may loose the benefit of the reduced withholding tax rates under the Treaty and be subject to the general 25% Canadian domestic withholding tax rate.

As a consequence, there may the a trend to interpose a foreign intermediary in current structures into Canada. This foreign intermediary could be formed in a favorable treaty country as a replacement to or as a holding company for a ULC. Hybrid instruments may also prove to be an interesting alternative. These instruments may take various forms but essentially the intent is to receive equity treatment on the US side of the border and debt treatment on the Canadian side. Other alternatives may also be considered, including "unchecking" the box for US purposes so that a ULC is not fiscally transparent anymore in the US or restructuring the flow of funds so that payments originating from ULCs are paid to affiliates of the US-resident investors in a third country with a favorable tax treaty with Canada.

US-resident investors into Canada should consider reorganizing their activities in order to avoid, or at least minimize, the impact of these anti-hybrid measures while taking into consideration the tax consequences of such reorganizations both in Canada and in the US.

US-resident investors are encouraged to contact their Gowlings tax professionals in order to discuss the available options.

A COMPLICATED SIMPLIFICATION - NEW RULES FOR THE SALE OF TAXABLE CANADIAN PROPERTY BY NON-RESIDENTS
By: A. Brent Kerr & Simon Labrecque

Commencing January 1, 2009, new tax rules apply when non-residents of Canada sell taxable Canadian property such as shares of a private Canadian company. The new rules are intended to streamline tax compliance for non residents who are protected from Canadian tax by an international tax treaty. Some taxpayers will benefit from the changes, but many will be disappointed with the changes, and buyers may find that they face increased risk of liability for tax.

Generally, non resident sellers are required to apply for clearance certificates, and tax must be withheld while the clearance certificate request is being processed by the tax authorities. Processing times have steadily increased over the past few years, and non-resident sellers are finding that their sale proceeds are being tied up for extended periods of time. It is not uncommon to wait three months for a clearance certificate and in some cases much longer.

The need for changes to these rules had been the subject of representations to the federal Department of Finance, particularly by the private equity and venture capital industry for which these rules are particularly troublesome. When the Department of Finance announced that these rules would be modified, many interested parties had hoped that these compliance and withholding tax requirements would be eliminated, at least in situations where treaty protection was available to the seller. Unfortunately, such is not the case.

Although some relief has been provided, the recent amendments to section 116 of the Income Tax Act (Canada) and the legal obligation to get a formal clearance certificate has been eliminated in many cases, in many cases not getting such a certificate could put buyers in a position of increased risk. It is therefore necessary for both buyers and non-resident sellers to familiarize themselves with the implications of these recent changes and to negotiate suitable terms and conditions for the sale of Canadian property. In all cases, the services of a tax professional should be sought as quickly as possible since the tax rules involved are complex and can have significant tax implications for both parties.

A Primer on Withholding Tax

To understand the impact of the new rules, a refresher on section 116 withholding tax may be useful.

Generally, the withholding tax rules in section 116 apply to non-residents of Canada who sell "taxable Canadian property". Sellers must notify the Canada Revenue Agency ("CRA") of the transaction, pay any required tax on the resulting gain, and file a Canadian tax return reporting the transaction. Typical examples of taxable Canadian property are real property located in Canada, shares of a Canadian company which are not listed on a recognized stock exchange, capital property used in a business carried on in Canada, and Canadian resource properties. In some situations, the shares of foreign corporations and interests in foreign partnerships and trusts can trigger Canadian withholding tax requirements. Certain property is excluded from section 116 withholding obligations, such as shares listed on a recognized stock exchange.

To ensure collection of the tax, the buyer is required to act as a withholding agent for CRA. The buyer is a guarantor of the tax as well in the sense that if the buyer fails to withhold the required amount, the buyer itself is liable to pay tax on behalf of the non-resident seller. As a result of the liability which could apply for failing to withhold from a non-resident seller, buyers should always make reasonable inquiries to determine whether the seller is a non-resident. If the buyer has made reasonable inquiries and has no reason to believe the seller is a non-resident of Canada, then the buyer need not withhold. However, if there is any question about the residence of the seller, the buyer should withhold tax from the purchase price.

Without a clearance certificate, withholding under section 116 is based on the gross purchase price payable to the non-resident without deduction. The general rate of this withholding tax is 25%, but a 50% rate applies for certain types of property. If the property is located in Quebec, an additional withholding tax of 12% applies. This withholding tax is often much higher than the actual tax owing.

Sellers who want to reduce the amount of withholding required under section 116 should apply for a clearance certificate. CRA will issue a clearance certificate upon payment of required withholdings at the same rate, but CRA allows the seller to deduct the cost of the property when calculating the amount owing with a clearance certificate. Invariably, therefore, the withholding under section 116 is lower with a clearance certificate. Indeed, where treaty protection is available, a clearance certificate may be issued without any payment of any amounts under section 116. Buyers need not withhold tax under section 116 if they receive a suitable clearance certificate issued by CRA. However, it is important for buyers to check the certificate limit specified in the clearance certificate to make sure it is at least equal to the gross purchase price, expressed in Canadian dollars. This is because a buyer is only protected from withholding tax for payments up to the certificate limit.

Under these rules there is some tension between buyers and sellers. A buyer will want to minimize its risk of liability, while the seller will want to minimize the amount of withholding. Some sellers will not be aware of the withholding requirements and may need cash from the sale to meet other commitments (such as repaying debt). It is generally in the interests of both parties to agree on the way the withholding and clearance certificate requirements will be dealt with and to discuss this in advance rather than waiting until after the agreement of purchase and sale is signed.

Unfortunately, experience has shown that it is often not possible to obtain a clearance certificate before a sale closes or within the limited period of time which the buyer has after closing to remit the withholding to the CRA. If withholdings are remitted to CRA without a clearance certificate it will usually represent a significant overpayment of tax. This forces the seller to file a tax return and wait for the assessment of that return before receiving a refund of the overpayment. This outcome is particularly undesirable in the case of non-residents who sell property which are exempt from tax in Canada by virtue of a tax treaty. For this reason, CRA has taken to issuing comfort letters allowing a buyer to defer remitting the withholdings until CRA has completed processing the clearance certificate application. These comfort letters are not contemplated by section 116. The recent changes to section 116 were introduced in a further effort to remedy this unfavorable outcome by removing the need to obtain a clearance certificate or to withhold tax at all where a treaty exemption is available.

The 2009 Changes

The recent amendments to section 116 affect the withholding tax and clearance certificate rules for property that is not taxable as a result of a tax treaty. Generally, a buyer who qualifies under the new rules will not be liable for withholding tax, and thus will not have to withhold any amount from the purchase price. This treatment is favorable to sellers since it allows them to maximize their cash flow on closing. However, it is up to the buyer to determine if all the required conditions for the exemption from section 116 withholding are met at the time of purchase since under the rules the buyer will bear the financial risk of being wrong.

As a first step, the buyer must determine whether the non-resident seller is resident in a country with which Canada has a tax treaty. The buyer need only make a "reasonable inquiry" into the seller's residence. Since residence can be a difficult question of fact, it is not completely clear what would constitute a reasonable inquiry. If it turns out that the seller is not actually resident in a treaty jurisdiction, CRA might conclude that the buyer did not go far enough in making inquiries. If so, the buyer will still be liable. In addition, tax treaties often contain special rules to determine who qualifies as a "resident", including the so-called tie-breaking rules. These rules can require extensive analysis and factual knowledge on the part of the buyer. This analysis will often be hindered by the buyer's limited access to the seller's confidential information and therefore, the buyer may be missing key facts necessary to determine the seller's residence.

Second, the buyer must determine whether the property qualifies as "treaty-protected property". Under some tax treaties, this determination relies so heavily on facts that may be beyond the ability of the buyer to determine in any reasonable manner. Further, many kinds of property that are commonly subject to withholding tax under section 116, including real property (land and buildings), are not typically exempt from Canadian tax under Canada's tax treaties and therefore will not generally be entitled to the benefit of these new rules. Finally, making a determination that treaty-protected property is involved creates risk for the buyer since due diligence is not an acceptable defense to getting this determination wrong.

If the buyer feels confident that the seller is resident in a tax treaty jurisdiction and is selling treaty-protected property, and if the buyer is prepared to take the risk of being wrong, the buyer can choose not to withhold tax under section 116 from the purchase price. In that case, the buyer must file a Notification of an Acquisition of Treaty-Protected Property From a Non-Resident Vendor (Form T2062C) with the CRA within 30 days after the property is acquired. If the buyer does not file the required notification, the buyer will remain fully liable for withholding tax under section 116. If the buyer files the required notification, but has made a mistake in evaluating the residence of the seller or the status of the property, the buyer might also remain fully liable for the tax.

How These Changes Affect Buyers and Sellers

Buyers and non-resident sellers will both need to consider the new changes. Where sellers believe that treaty-protected property is involved, they may want to convince buyers not to withhold under section 116. Buyers will need to determine if they are prepared to complete the purchase without withholding. To do so, they will need to carry out due diligence enquiries and negotiate suitable contractual protection against the potential for tax liability, including interest and penalties. Buyers should consider obtaining suitable representations and warranties regarding the residence of the seller and the treaty-protected status of the property. Consideration should also be given to obtaining security for the withholding tax obligations or indemnification for liabilities that might be imposed on the buyer for failing to withhold.

Because of the complexity of the rules and the potential for liability on both buyers and sellers, a tax professional should be consulted early in the negotiation process, when the parties have the most flexibility to work out solutions to these tax issues. In addition, a tax professional may be required to provide advice, especially with regard to the residence of the seller or the status of the property under a tax treaty. Due to the intensive information requirements inherent in the new rules, and the potential liability remaining with buyers, the new rules may be more appropriate for transactions between related parties where there is a more open exchange of information and a greater ability to ensure that the buyer is protected from liability for tax. For others, especially more risk-adverse buyers, the option of requiring a clearance certificate from the seller just as was required in the normal course under the previous rules, and of withholding tax from the gross purchase price until the clearance certificate is received, generally remains the safest course of action.

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The authors would also like to thank Laura-Emanuela Gheorghiu for the initial drafting of this article