2017-0724151C6 2017 CTF – Q8 – Principal Purpose Test

Principal Issues: Application of the Principal Purpose Test in Article 7 of the MLI.

Position: See response.

Reasons: See response.

Author: Thomson, Sherry
Section: Section 245, Articles 6 and 7 of Multilateral Instrument, New Article 29 of OECD Model

2017 CTF Annual Conference

CRA Roundtable

Question 8: Principal Purpose Test

Background

On June 7, 2017, Canada signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, commonly referred to as the Multilateral Instrument (“MLI”).  The MLI arose from the Report on Action 15 of the Organisation for Economic Co-operation and Development (“OECD”) Base Erosion and Profit Shifting (“BEPS”) Project.  The MLI is a mechanism by which jurisdictions can implement the treaty-related BEPS measures in a swift, co-ordinated and consistent manner. The MLI will enter into force on the first day following three calendar months after the day on which five jurisdictions have deposited notices of ratification with the MLI Depositary.

The minimum standard under the BEPS Report on Action 6, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, requires that countries adopt one of three alternative rules to address situations of treaty abuse:

a)    A principal purpose test (“PPT”);
b)    A PPT, along with a limitation on benefits provision (“LOB”); or
c)    An LOB provision, along with anti-conduit measures.

Paragraph 1 of Article 7 [Prevention of Treaty Abuse] of the MLI adapts the PPT as developed under BEPS Action 6 for multilateral modification of tax treaties as follows:

1. 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.

Under the provisions of the MLI, each jurisdiction is required to provide a preliminary list of reservations and notifications at the time of signature.  Canada expressed a statement that while Canada accepts the application of Article 7(1) alone as an interim measure, it intends where possible to adopt a limitation on benefits provision, in addition to or in replacement of Article 7(1), through bilateral negotiation.

Under Article 34 of the MLI, the MLI will enter into force in Canada (assuming four other jurisdictions have already ratified the MLI) on the first day following three calendar months after the day on which the MLI Depositary receives a notice of ratification from Canada.  However, the date on which the MLI will have effect with respect to a particular tax treaty depends on whether any of Canada’s treaty partners has also ratified the MLI, both Parties have listed the tax treaty as a Covered Tax Agreement as defined under Article 2 of the MLI, and whether one or both Parties have made one of the reservations available under Article 35. 

Under Article 35 of the MLI, (and assuming that neither Party has made a reservation under paragraph 7 of Article 35) the MLI will have effect with respect to a Covered Tax Agreement for withholding taxes on the first day of the calendar year following the latest day on which the MLI enters into force for both Canada and the particular treaty partner.  For all other taxes, the MLI will have effect for taxable periods beginning six calendar months (or sooner if both parties so notify the Depositary) after the latest day on which the MLI enters into force for both Canada and the particular treaty partner.

In the 2017 Budget, the Canadian government announced that it was pursuing signature of the MLI, and did so sign on June 7, 2017.  In order to implement the MLI, the Department of Finance will prepare a bill to be introduced in Parliament.  Assuming the bill receives Royal Assent, Canada will then deposit a notice of ratification with the MLI Depositary.

If this notice is deposited after December 31, 2017, and on or before September 30, 2018, the MLI will have effect for withholding taxes (assuming the treaty partner has also deposited its notice of ratification on or before September 30, 2018) on January 1, 2019.  If the notices of ratification are deposited after September 30, 2018, the MLI will have effect for withholding taxes no earlier than 2020.

For all other taxes, the MLI will have effect for taxable periods beginning six months (or sooner if the necessary notifications have been made by both Parties) on or after the latest day that the MLI comes into force for both treaty partners.  For example, if the MLI enters into force on January 1, 2019, the MLI will have effect for all other taxes no earlier than taxation years beginning after June 30, 2019 (i.e. January 1, 2020 for calendar year-end taxpayers).

On July 11, 2017, the OECD released the draft 2017 update to the OECD Model Tax Convention and Commentary.  The 2017 update has not yet been approved, and does not necessarily reflect the final views of the OECD and its member countries.

The draft 2017 OECD Model contains new Article 29 [Entitlement to Benefits].  Paragraph 9 of new Article 29 contains the bilateral “principal purpose test”, which was developed under BEPS Action 6, and is virtually identical to the PPT in Article 7(1) of the MLI.  Paragraph 182 of the Commentary to new Article 29 sets out examples that illustrate the application of paragraph 9 (i.e. the principal purpose test), with the caveat that the application of the principal purpose test must be determined on the basis of the facts and circumstances of each case.  Paragraph 182 also states:

“The examples below are therefore purely illustrative and should not be interpreted as providing conditions or requirements that similar transactions must meet in order to avoid the application of the provisions of paragraph 9.”

Paragraph 187 of the Commentary to new Article 29 sets out examples of treaty-shopping strategies commonly referred to as “conduit arrangements”, as well as arrangements that should not be considered to be conduit arrangements.

Questions

a)    Will the GAAR Committee review all situations where an auditor proposes to apply the PPT to ensure it is consistently applied and enforced?
b)    Can CRA confirm how it intends to apply the PPT of the MLI relative to the GAAR?
c)    Can CRA confirm whether the “object and purpose” clause in the PPT of the MLI will be interpreted consistently with the jurisprudence established under subsection 245(4) of the GAAR?
d)    What weight will the CRA give to the examples set out in paragraphs 182 and 187 of the draft 2017 OECD Model Commentary in determining whether a particular structure or transaction satisfies the object and purpose clause within the PPT of the MLI?

 CRA Response

 a)    The CRA expects that the MLI will not enter into force before 2019; however, the CRA is exploring methods of promoting consistency in the application of the PPT within the Agency.  In this regard the GAAR Committee may offer a useful model.  The Income Tax Rulings Directorate currently has no plans to stop considering applications for advance income tax rulings relating to anti-avoidance rules, and as long as that continues to be its practice, it would also entertain PPT rulings once the rules are in effect.

b)    How the PPT may interact with Canadian domestic anti-avoidance legislation may depend on how the statute implementing the MLI is drafted.  Currently, paragraph 4.1 of the Income Tax Conventions Interpretation Act states that section 245 of the Income Tax Act (the “Act”) applies to any benefit provided under a tax treaty.  As we indicated at the 2015 International Fiscal Association conference, the CRA continues to contemplate the application of the GAAR to transactions undertaken primarily to secure a tax benefit afforded by a tax treaty and, in fact, the GAAR Committee has approved the application of the GAAR to certain treaty abuse arrangements.  In appropriate circumstances, the PPT and the GAAR could apply as alternative assessing positions directed at a given transaction or arrangement.

c)    Whether granting a treaty benefit to a particular transaction or arrangement is in accordance with the object and purpose of the relevant provisions of a particular treaty will be a question of fact to be examined on a case-by-case basis.  Given the differences in wording between the PPT and the GAAR, it is yet to be seen how the case law established under subsection 245(4) will inform its application.  However, we cannot exclude their potential informative use at this time.  We note that the “object and purpose” test of the PPT must be read in conjunction with the new preamble inserted by Article 6 of the MLI.

d)    Since the draft 2017 OECD Model and related commentary have not yet been approved, the CRA will refrain from commenting on the examples in paragraphs 182 and 187 at this time.

Sherry Thomson / Lori Carruthers
2017-072415
November 21, 2017

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