Contributed By Fasken
Common Interest Privilege
Despite recent challenges by the Canada Revenue Agency (CRA), Canadian courts recently confirmed that certain communications between lawyers and their clients are immune from disclosure to tax authorities under the principles of solicitor-client privilege. In Canada, solicitor-client privilege is a right that receives generous protection from the courts, but which can be waived where communications between a lawyer and his or her client are shared with third parties. However, 'common interest privilege' or 'transaction privilege' may apply in circumstances where privileged information is shared with a third party with whom there is a sufficient common interest in completing a commercial transaction, and the privileged information in question is shared in order to further such interest.
In December 2016, the Federal Court of Canada allowed the CRA’s challenge against common interest privilege in Minister of National Revenue v Iggillis Holdings Inc. ('Iggillis'). In this case, the CRA brought an application to compel the production of a legal memorandum outlining the tax consequences of a particular transaction pursuant to subsection 231.7(1) of the Income Tax Act (Canada) (the ITA). Two tax lawyers, each representing one party to a commercial transaction, had collaborated to create the tax memo to facilitate the completion of the transaction. Subsection 231.7(1) permits a judge to compel the production of documents, except to the extent that such documents are protected by solicitor-client privilege.
Despite previous cases confirming the principle’s validity, the Federal Court concluded that common interest privilege was not a valid common law principle. In justifying its decision, the Federal Court relied upon:
However, in March 2018 the Federal Court of Appeal (the FCA) overturned the lower court decision, concluding that common interest privilege is still a valid principle in Canada. In its judgment, the FCA rejected the Federal Court’s reliance on Ambac, stating that the Federal Court should not have relied on US jurisprudence to determine the validity of common interest privilege in Canada. Rather, according to the definition of solicitor-client privilege under subsection 232(1) of the ITA, the Federal Court should have relied upon case law in Alberta and British Columbia, where the parties to the commercial transaction in question were resident. Courts in Alberta and British Columbia have found common interest privilege to be 'strongly implanted' in Canadian law. The court also noted that the parties had satisfied the requirement that there be 'sufficient' common interest in order to claim such privilege based on their mutual interest in a commercial transaction. Furthermore, the FCA indicated that the tax memo furthered the goal of completing the transaction and was, therefore, protected from disclosure to the CRA under common interest privilege. On 25 October 2018, the Supreme Court of Canada denied the CRA’s application for leave to appeal the FCA decision.
The FCA’s decision eliminated the uncertainty arising from the lower court decision regarding the applicability of common interest privilege, and ensures that tax planning advice from lawyers will continue to be immune from disclosure to the CRA. However, the case does illustrate that the CRA continues aggressively to seek access to the confidential tax planning communications between taxpayers and their tax professionals. Before proceeding with any transaction, clients should keep in mind that common interest privilege is simply a form of solicitor-client privilege, and that such privilege only applies to communications between lawyers and their clients. Privilege does not generally extend to other tax professionals who may be involved in the tax planning process. Clients should continue to exercise caution in how they share such privileged information, especially if they hope to rely upon common interest privilege in the future.
Status of BEPS and the MLI in Canada
Canada has been a strong supporter of the OECD Base Erosion and Profit Shifting initiative (BEPS) over the years and has played an active role in the whole project.
On 21 June 2018, the bill to implement the proposals contained in the Multilateral Convention to Implement Tax Treaty-related Measures to Prevent Base Erosion and Profit Shifting (MLI) was tabled in the House of Commons. By way of background, Canada had signed the MLI on 7 June 2017, and had announced its intention to adopt the minimum standards proposed by the OECD under BEPS, as well as mandatory arbitration for tax treaty disputes. The bill confirms the adoption of these minimum standards, along with other measures for which Canada had initially registered a reservation. Two of these measures are of particular interest.
MLI Article 8, paragraph 1: dividend transfer transactions
Most tax treaties signed by Canada call for a reduction in the domestic withholding tax rate on dividends from 25% to 5% when the beneficial owner of the dividends is a corporation subject to corporate tax in the contracting jurisdiction, and which directly or indirectly holds at least 10% of the voting rights (and, in some cases, the capital) of the Canadian corporation paying the dividend. Fulfilment of the 10% ownership test is determined when the dividend is paid.
By adopting the restriction described in paragraph 1 of Article 8 of the MLI, Canada agrees to apply the reduced withholding tax rate of 5% only if shares granting voting rights (and capital, where applicable) of at least 10% are owned throughout a 365-day period, including the day on which the dividend is paid. For the purpose of computing this period, no account shall be taken of changes of ownership that are a direct result of a corporate reorganisation, such as a merger or divisive reorganisation, of the corporation that holds the shares or the Canadian corporation that pays the dividend. This amendment will block surplus exit-planning strategies where the shareholding of a Canadian corporation has been modified within 365 days prior to the payment of a dividend, which has generally been easy to achieve from a Canadian tax point of view, as the gain on the sale of the shares of a Canadian corporation is not taxable unless more than 50% of the value of the shares is derived directly or indirectly from real or immovable property, resource property or timber resource property situated in Canada.
MLI Article 9, paragraph 1: capital gains from alienation of shares or interests of entities deriving their value principally from immovable property
Canadian domestic law stipulates a five-year test to determine taxation of a capital gain from disposition of shares or other interests in entities whose value is or was mainly (ie, more than 50%) derived from immovable property in Canada. Thus, if at any time during this 60-month period ending on the date of disposition of the shares, more than 50% of their value was derived directly or indirectly from an immovable property located in Canada, the capital gain from the disposition is taxable in Canada. By way of comparison, most tax treaties signed by Canada do not include a retroactive test. In fact, the value test is generally applied at the time of disposition. It has therefore been possible, subject to the general anti-avoidance rule (GAAR), to proceed to an asset 'stuffing' with a view to decreasing the relative value of the immovable property in Canada so that it falls below the 50% threshold.
With paragraph 1 of Article 9 of the MLI, Canada is adopting a one-year retroactive look-back, ie, Canada is reserving the right to tax the capital gain if the 50% value threshold is exceeded at any time during the 365 days preceding the disposition.
The bill must now be adopted by the House of Commons and the Senate prior to receiving royal assent. The OECD must then be notified in order to confirm Canada’s ratification of the MLI. The MLI will then enter into force for Canada on the first day of the month following the expiry of a three-month period, measured from the date on which notice is given to the OECD. For example, if the notice is sent in December 2018, the MLI will enter into force for Canada on 1 April 2019.
The MLI provisions on withholding tax will then take effect between Canada and a treaty partner where the MLI is already in force on the first day of the next calendar year, ie, 1 January 2020. For other taxes, such as the capital gains tax on shares meeting the real property asset valuation threshold, the MLI will have effect for the taxable periods beginning after a six-month period (or a shorter period if the contracting states notify the OECD that they intend to apply such a period), ie, for the taxable periods beginning 1 August 2019.
Cameco – Developments in Transfer Pricing
Cameco Corporation v the Queen ('Cameco'), a significant decision of the Tax Court of Canada, was released on 26 September 2018. In this case, the taxpayer appealed reassessments wherein the CRA had sought to increase the taxpayer’s income over a three-year period by approximately CAD500 million.
The taxpayer was a Canadian corporation that was engaged in the exploration, development and sale of uranium products. In anticipation of a significant change in its business arising from the entry of Russian uranium into the global market, the taxpayer undertook a significant restructuring. This restructuring included the incorporation of subsidiaries in jurisdictions that levied income tax at significantly lower rates than Canada. The taxpayer acknowledged that a desire to reduce the global tax burden that would otherwise arise if it carried on all of its operations in Canada was one of the principal purposes for establishing its offshore structure.
In issuing its reassessments, the CRA had relied on three separate arguments. Firstly, it had alleged that certain transactions that had been undertaken by the taxpayer and its foreign subsidiaries amounted to a 'sham' and should be disregarded for the purposes of the ITA.
Secondly, the CRA took the position that, if the transactions in dispute were not a 'sham', then the transfer pricing rules set out in the ITA should be applied to recharacterise certain transactions undertaken by the taxpayer. Finally, to the extent that a particular transaction may not be subject to recharacterisation, the CRA took the position that the repricing provisions of the transfer pricing rules should be applied to adjust the taxpayer’s income for the period in dispute.
The CRA’s attempt to apply the transfer pricing 'recharacterisation' rule in Cameco is a particularly important development in Canadian tax law, because although the Canadian courts have issued numerous decisions on the 'repricing' rule within the transfer pricing rules, Cameco represents the first analysis of the application of the 'recharacterisation' rule.
The recharacterisation rule, which is set out in paragraphs 247(2)(b) and (d) of the ITA, provides that if a transaction or series would not have been entered into between persons dealing at arm’s length, and cannot reasonably be considered to have been entered into primarily for bona fidepurposes other than to obtain a tax benefit, then the transaction or series can be recharacterised. Specifically, the recharacterisation rule provides that the terms and conditions of the disputed transaction or series should be replaced with an alternative transaction with terms and conditions that would be agreed to by persons dealing at arm’s length.
Essentially, as Justice Owen stated in Cameco: "the assumption underlying [the recharacterisation rule] is that arm’s length parties would not enter into the transaction or series identified […] on any terms or conditions, but that in the circumstances there is an alternative transaction or series that arm’s length parties would enter into on arm’s length terms and conditions in place of the transaction or series."
Justice Owen ultimately determined that the recharacterisation rule did not apply to the disputed transactions. While he did conclude that the primary purpose of the transactions was to reduce Canadian tax, Justice Owen also found that the transactions largely mirrored transactions that were common between arm’s-length parties within the uranium industry. Therefore, the CRA had failed to demonstrate that the first condition of the recharacterisation rule was satisfied.
As for the CRA’s alternative position that the repricing rule should apply to the transactions, Justice Owen, largely relying on existing jurisprudence on the application of the repricing rule, found that the pricing methodology used by the taxpayer was consistent with the arm’s-length principle and that the repricing rule was therefore not applicable.
Finally, Justice Owen addressed the CRA’s position that the transactions in dispute amounted to a 'sham'. In alleging that they did amount to a 'sham', the CRA took a position that while the taxpayer may have established a formal offshore structure, the business activity purported to be carried on through this structure was, in fact, carried on in Canada.
Justice Owen rejected the CRA’s position on 'sham'. In doing so, he concluded that a finding of 'sham' requires an element of 'deceit', and that there was no evidence of such deceit in this case. Instead, Justice Owen concluded that the taxpayer had taken significant steps to ensure that its business was carried on in a manner consistent with the legal relationships that had been established within the offshore structure.
Both the clear rejection of the CRA’s position on what constitutes a 'sham', and the conclusions as to the proper application of the recharacterisation rule, suggest that Cameco represents a positive development for Canadian taxpayers who are part of an international structure that is designed, at least in part, to reduce Canadian taxes. The CRA has appealed the Tax Court decision to the FCA.