The clock is ticking for multinational enterprises and private equity firms with investments in the Canadian resource sector as anti-treaty shopping measures in the OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) begin to take effect.

Treaty-Based Holding Structures

Canada generally has the right, absent a treaty exemption, to tax gains realized by non-residents of Canada on dispositions of Canadian private company shares if the shares derive more than 50 percent of their value from Canadian resource property (i.e., petroleum and natural gas or mining rights in Canada) or real property situated in Canada, at any time during a 60-month period preceding the disposition. To avoid this tax burden, multinational enterprises and private equity firms investing in the Canadian resource sector have historically held their investment through an intermediary corporation resident in the Netherlands or Luxembourg. These structures generally benefit from tax-exempt capital gains on shares of a Canadian company that derive their value principally from "immovable property" situated in Canada (including resource property) used in connection with business operations (referred to below as the Immovable Property Treaty Exemption).

Corporate residency in an intermediary country has historically been all that is required to access the Immovable Property Treaty Exemption. In addition, countries such as Luxembourg and the Netherlands generally provide full or partial relief to the intermediary corporation from any local tax on the gain from the disposition of the Canadian company shares.

From a U.S. federal income tax perspective, entities formed in countries like Luxembourg and the Netherlands can be treated as transparent which can be beneficial for certain U.S. based taxpayers, including U.S. private equity investors.

On numerous occasions, the Tax Court of Canada and the Federal Court of Appeal have ruled favourably on treaty-based structures. Most recently, in Canada v Alta Energy Luxembourg S.A.R.L., 2020 FCA 43 [Alta Lux], the Federal Court Appeal affirmed the Tax Court's finding that the Canada-Luxembourg tax treaty was not abused when a Luxembourg S.A.R.L. sold shares of a Canadian resource company in circumstances where a large capital gain was exempt from Canadian taxation. For more information on Alta Lux, see Federal Court of Appeal Upholds Treaty-Based Canadian Holding Structure. The Crown has since applied for leave to appeal in the Alta Lux decision to the Supreme Court of Canada. If the leave application succeeds, the Supreme Court of Canada will hear the merits of the case and render a final decision on the use of treaty-based holding structures. Leave applications are discretionary and must meet the added threshold of possessing an issue of "national importance".

The Multilateral Instrument

The benefits of treaty-based holding structures have recently become harder to access due to the implementation of the MLI. The MLI results from the OECD/G20 Base Erosion and Profit Shifting Project aimed at tax planning strategies that artificially shift profits to low or no-tax jurisdictions. To date, 94 countries have signed the MLI, while several others have expressed an intention to sign. For Canada's treaty partners that have ratified the MLI, such as Luxembourg and the Netherlands, the MLI became effective for withholding taxes on January 1, 2020, and for other taxes, including capital gains, for tax years beginning on or after June 1, 2020.

The MLI contains a broad anti-avoidance "principal purpose test" (PPT) that can deny a treaty benefit, such as the Immovable Property Treaty Exemption, when obtaining the benefit was a "principal purpose" of a particular transaction or arrangement, unless granting the benefit is in accordance with the object and purpose of the applicable treaty provision. 

Important Questions as the MLI and PPT Begin to Take Effect

Multinational enterprises and private equity firms investing in the Canadian resource sector should consider how the MLI will affect their investment and whether they can improve their structure. Relevant considerations include:

  1. Do intermediary corporations have enough substance in the intermediary country to satisfy the PPT? 
  2. Are there any countries that have not signed on to the MLI that could be used to obtain more certain or preferable treaty benefits with Canada?
  3. Will the disposition of shares of a Canadian resource company necessitate reporting and withholding obligations under section 116 of the Income Tax Act (Canada), triggering a review by the Canada Revenue Agency (CRA)? 
  4. Are strategies available on the disposition of shares of the Canadian resource company to reduce any Canadian tax and potentially reduce or avoid the 25% withholding tax under section 116?
  5. Does the intermediary have an accrued gain or loss on the Canadian resource company shares and, if so, when is the gain or loss expected to be realized?
  6. Has the intermediary selected a Canadian taxation year?
  7. Should the intermediary implement a step-up transaction for Canadian resource company shares with accrued gains?
  8. What is the best structure for new investments in the Canadian resource sector where an intermediary is not expected to satisfy the PPT?

Some of the considerations relevant to these MLI and treaty-related questions are discussed below.

Satisfying the Principal Purpose Test

Investors in the Canadian resource sector must first determine whether they have, or can implement, sufficient substance in an intermediary country to satisfy the PPT. The answer to this threshold question will, in turn, inform the investors' future decisions. The PPT disallows treaty benefits, such as the Immovable Property Treaty Exemption, where:

  1. an arrangement or transaction has directly or indirectly resulted in a benefit under the applicable tax treaty; and
  2. it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of an arrangement or transaction;
  3. it is established that granting that benefit in the circumstances would be in accordance with the object and purpose of the relevant provisions of the tax treaty.

The PPT is subject to interpretational challenges in Canada as Canadian courts have applied an expansive interpretation to the phrases "one of the principal purposes" and "one of the main purposes". In order to satisfy the PPT, investors will likely need to establish substance in the intermediary country beyond legal residency. Examples include the presence of commercial activities or employees in the intermediary country, local expertise, or political, legal or regulatory reasons for being resident in or operating in the intermediary country.

Currently, the CRA has not provided any clear guidance as to how a taxpayer can satisfy the PPT. However, the CRA has struck a "treaty abuse panel" (TAP) that will presumably examine, on a case-by-case basis, whether enough substance has been created to satisfy the PPT. Investors into Canada must be prepared to establish that they satisfy the PPT as treaty-based holding structures will likely be scrutinized by the CRA.

Intermediary corporations claiming the Immovable Property Treaty Exemption will need to satisfy the PPT for taxation years beginning on or after June 1, 2020. For intermediaries with calendar year-ends, the PPT will be effective for taxation years beginning on or after January 1, 2021. 

Investors Who Cannot Satisfy the Principal Purpose Test

Although the clock is ticking, many inbound investments in the Canadian resource sector can currently benefit from the Immovable Property Treaty Exemption without the added burden of satisfying the PPT. Investors with accrued capital gains should consider triggering their gains. For some investors, this may mean expediting a sale to an arm's length party, while for others, it may mean considering an internal step-up transaction to crystallize a gain in reliance on the Immovable Property Treaty Exemption. Despite the decisions in Alta Lux (and other cases), the CRA continues to scrutinize step-up transactions.

For many corporate intermediaries that have not previously established a Canadian tax year-end, they may be able to select a taxation year beginning shortly before June 1, 2020, to maximize the time they have remaining to rely on the Immovable Property Treaty Exemption. Non-resident corporations can have different fiscal periods in Canada and their home country.

Investors in the Canadian resource sector with accrued losses face similar planning considerations. On the same basis that a capital gain from the disposition of a property is exempt from Canadian tax under the Immovable Property Treaty Exemption, a capital loss is generally unavailable for deduction against capital gains for Canadian tax purposes if the investor benefits from the Immovable Property Treaty Exemption. As a result, investors with accrued losses should generally not establish a Canadian tax year until on or after June 1, 2020, if a disposition is pending.

If the PPT applies and denies the Immovable Property Treaty Exemption for the intermediary, a loss that may not have been deductible for Canadian tax purposes before the PPT came into force may become available and useable for Canadian tax purposes to offset future capital gains. However, this strategy should be considered carefully if the intermediary has other investments with accrued gains. Furthermore, in order to fully use the loss, the intermediary corporation will need to make further Canadian investments such that the corporation will need to be maintained in the interim, leading to additional carrying costs.

Regardless of whether the Canadian investment has an accrued gain or loss, the investor will need to comply with the reporting and withholding obligations in section 116, including the requirement that the purchaser withhold 25 percent of the purchase price.

Although the amount withheld under section 116 can ultimately be fully or partially refunded on filing a Canadian income tax return for the year of the disposition, the cash flow burden can be mitigated through the following: (i) negotiating a reduction of the withholding amount based on the actual gain or available treaty exemption, (ii) implementing a recapitalization transaction before the sale where some of the transaction value (up the invested capital that the intermediary has in the Canadian resource company) is returned to the intermediary, or (iii) carrying out an internal sale of the shares of the Canadian resource company to a related Canadian resident that, in turn, would sell the shares to the third-party buyer. Care must be taken on an internal sale to a Canadian resident and, in particular, the type (share versus non-share) and amount of consideration received.

Moving forward, investors who do not expect to satisfy the PPT may no longer benefit from maintaining their current treaty-based holding structure as the annual carrying costs to maintain one or more intermediaries may be prohibitive relative to the expected tax benefits. It does not appear that any Canadian treaty partner, that has not signed onto the MLI, can afford the tax and commercial benefits now available through Luxembourg or the Netherlands.

Therefore, these investors should move towards a more simplified non-treaty based structure. To access the Immovable Property Treaty Exemption, reorganizations should be implemented immediately or, at the latest, before the end of a taxation year commencing prior to June 1, 2020. A simplified structure will generally include a foreign corporation holding the investment, as the applicable Canadian tax rate on capital gains for a foreign corporation (12.5 percent) will generally be less than the Canadian tax rate applicable to individuals and trusts.

For private equity investors, in particular, a careful review of the status of their limited partners is warranted to determine what treaty exemptions would otherwise be available. These include exemptions from gains for certain tax-exempt investors and exemptions for interest and dividends for certain pension plans. When U.S. treaty exemptions are available, use of a limited liability company is preferred as it would permit a look through test for U.S. residents accessing treaty benefits while also providing a favourable corporate tax rate for non-U.S. members. If underlying treaty exemptions are unavailable, other tax-efficient non-treaty based structures should be considered and should be discussed with a member of the Bennett Jones Tax group.

Investors Who Can Satisfy the Principal Purpose Test

For existing and new investors in the Canadian resource sector with a real and substantial economic or commercial presence in an intermediary country, through a head office or otherwise, accessing the Immovable Property Treaty Exemption will remain feasible. In that case, continued use of jurisdictions like Luxembourg and the Netherlands remain a viable planning option. These investors should consider what additional steps can be taken now to ensure the PPT is satisfied.

For new investments in Canadian resource companies with existing intermediary shareholders, the investor should consider acquiring the existing holding structure (including the intermediaries) to eliminate the need to establish new intermediaries. This could improve the argument that the PPT is satisfied relative to the case of incorporating new intermediaries only to make the investment.

Investors who seek to rely on the Immovable Property Treaty Exemption after the PPT is in effect are cautioned that a disposition of shares of a Canadian resource company will generally trigger reporting and withholding obligations under section 116 and review by the CRA (and possibly the TAP). Investors are therefore advised to keep detailed books and records in support of their position. If the CRA disagrees that the Immovable Property Treaty Exemption is available as a result of failure to satisfy the PPT, the matter will likely need to be pursued through tax litigation.

Investors can avoid section 116 compliance if the Canadian company's shares are listed on a public exchange. If a transaction under consideration involves the Canadian company's shares being listed on a stock exchange, any disposition by the shares should, if possible, be structured to occur when the Canadian company shares are listed. Similarly, section 116 compliance is not required where shares are disposed of through a Canadian amalgamation transaction, however, the consideration received on an amalgamation is restricted to shares of the amalgamated company (i.e., no cash). In both cases, the holder of the shares may have to self-assess their position, however, reporting and withholding under section 116 should not be triggered. If section 116 compliance is unavoidable, the investor should try to reduce the cash flow burden of section 116 withholding as much as possible, as discussed above.

For all taxpayers that rely on the common law mind and management test for tax residency, COVID-19 travel restrictions have introduced new challenges and issues. For a discussion of these issues, see Managing the Tax Residency of Foreign Affiliates in the Face of the COVID-19 Restrictions.


The various effective treaty-based tax planning strategies that are available today will soon become unavailable for many investors in the Canadian resource sector and become more difficult to access for others. Although the clock is ticking, there still remains time to implement transactions in order to obtain treaty benefits before the MLI (and the PPT) comes into effect for capital gains and other tax purposes. Given the shift, it is now a good time to consider how to optimize your organizational structure to minimize taxation and other costs going forward.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.