Softening the GAAR blow, Canada style: A case study on adopting a nuanced approach to GAAR principles

Manoj Rathi (2)General Anti-Avoidance Rules (GAAR) represents a set of rules that provide a tax authority the power to deny tax benefits when an arrangement is undertaken without any commercial purpose or substance (i.e., when the arrangement is planned to generate a tax benefit). GAAR, especially the Indian GAAR, is not limited in its application to specified abuse or mischief, it can also apply to any tax avoidance exercise which has been primarily designed for seeking tax benefit. To quote Senior Advocate Mr. S.E. Dastur in his recent article, “I daresay in the future, a substantial part of the litigation will center around Chapter XA of the Income-tax Act (concerning General Anti-Avoidance Rule) bearing in mind the very wide, if not wild, provisions which have been enacted.”

In recent times, strengthening the anti-abuse mechanism by way of Base Erosion and Profit Shifting (BEPS) measures and GAAR has been at the forefront of discussions of tax administrative authorities across the globe. As a result, the applicability of such measures has also been the subject of judicial discussion in some cases. For instance, a Canadian Court (the Court) recently had the chance to evaluate the taxability of the capital gains arising in the case of a Luxembourg entity transferring shares held by it in a Canadian subsidiary. Adopting a refreshing approach to the applicability of GAAR, the Court conducted a detailed evaluation of the facts of the case and after taking into consideration all aspects put forth by the taxpayer and the legislative intent behind relevant provisions, ruled in favor of the taxpayer, holding that no Canadian taxes would be leviable on the capital gains earned by the Luxembourg entity (Lux Co or taxpayer).

To summarize the facts in brief, two US multinationals desirous of acquiring and developing oil and natural gas properties in the USA (US investors), formed a joint venture in the USA (US LLC) for this purpose. Later, the US investors realized that there would be more potential in certain properties lying in Canada and accordingly, the US LCC set up a subsidiary in Canada (Canada Co) which obtained licenses to explore the identified locations for oil and gas. However, given the possibility of trigger of taxation in the hands of the US shareholders due to the Controlled Foreign Corporation (CFC) regime, the US LLC transferred its stake in Canada Co to Lux Co (set up by the US investor group for the purposes of holding the stake in Canada Co).

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In 2013, Lux Co transferred its stake in Canada Co to a third party. While the taxpayer sought relief from capital gains tax under the Canada-Luxembourg tax treaty [Article 13(5) specifically exempted capital gains from property such as the one in question, referred to henceforth as the excluded property rule], the Canadian tax authorities contended that the arrangement clearly invited the application of GAAR principles and a consequent denial of treaty benefits.

Canadian GAAR could be invoked when all of the following conditions are satisfied: i) Tax benefit arises from a transaction; ii) The transaction was not arranged for bona fide purposes other than to obtain tax benefit; iii) The transaction results directly or indirectly in a misuse of the relevant tax provisions. Interestingly, the taxpayer itself conceded that there was a tax benefit from the transaction and that the arrangement was indeed for no bona fide purposes other than to obtain the tax benefit.

However, the Court observed that Canada usually followed the OECD model for negotiating its tax treaties, which did not provide for an excluded property rule. Hence, including such rule in the Canada-Luxembourg tax treaty would have been a conscious decision by the Canadian government. The Court also appreciated the fact that Canada-Luxembourg tax treaty incorporated many more limited treaty shopping provisions as compared to those in other treaties such as the Canada-USA tax treaty. Keeping these aspects in mind and borrowing principles from past rulings on treaty shopping, the Court finally held that there was no misuse of the tax treaty provisions. In doing so, the Court also rejected the tax authorities’ arguments as to Lux Co being a mere conduit for its US parent. The Court, in fact, went on to appreciate the holding company structures generally adopted by MNCs wherein one corporation would be set up to hold investments in the region and later be liquidated with the proceeds being distributed to the shareholders.

The Court not only delved into the intricacies of the taxpayer’s business to understand if it could qualify for the excluded property rule, but also discussed the legislative intent of the treaty provisions in detail. The Canadian Court’s approach is one that would give foreign investors looking to set up shop in Canada some hope, when factoring in the rigors of the Canadian tax regime for their business prospects. More importantly, the ruling is a prime example of how the judicial system of a country should be more holistic in its approach instead of restricting themselves to unyielding parameters, giving a patient and detailed hearing to the facts of the appellant’s case before forming a conclusion.

India Outlook:

While the Indian GAAR tests are different and wider, such a nuanced approach from the Indian revenue authorities would certainly go a long way in strengthening investor confidence. This would be particularly relevant today when the international taxation landscape is set to change, with BEPS measures coming in and the provisions of the Multilateral Instrument (especially Article 6 – The Preamble and Article 7 – Principal purpose Test) presuming importance.

We have already seen some detailed and taxpayer-friendly discussions from the Indian judiciary in case of Vodafone International Holdings BV (Indirect transfer) and Infrasoft Ltd (software royalty) and here’s looking forward to many more, especially as GAAR enters its first cycle of assessments with the returns for FY 2017-18 (the first year of GAAR) having been filed recently.

 

The author of this blog is Manoj Rathi, Director, Direct Tax, EY India.

The blog is co-authored by Abhinav Banerji, Senior Consultant, Direct Tax, EY India