Canadian tax treaties – Now impacted by the MLI

Canadian tax treaties can now be impacted by a global convention designed to amend tax treaties in force to prevent Base Erosion and Profit Shifting. Also known as the Multilateral Instrument (MLI), this convention entered into force for Canada on December 1, 2019. This means that the MLI will start impacting many of Canada's tax treaties starting January 1, 2020. This will apply to withholding taxesas well as other taxes, for tax years beginning on or after June 1, 2020.

The MLI allows signatory countries to modify their bilateral tax treaties more efficiently rather than having to renegotiate individual tax treaties. The MLI incorporates the Organization for Economic Co-operation and Development's (OECD) anti-base erosion and profit shifting (BEPS) provisions. Some of the MLI provisions are mandatory, while others are optional. The mandatory provisions relate to the minimum standards established by the OECD (standards that all participating countries have agreed to adopt). Countries are free to choose among the optional provisions.

Under the MLI, Canada has committed to adopting the following minimum standards:

• The treaty preamble- clarifies that any covered tax treaty intends to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance.
• The anti-abuse rule - also known as the principal purpose test (PPT), states that a benefit under a tax treaty, where one of the principal purposes of any arrangement or transaction was to obtain a benefit under the treaty, can be denied.
• The minimum standard with respect to the dispute resolution features of its tax treaties.
• The mandatory binding arbitration as a mechanism to ensure the effective and timely resolution of treaty-based disputes.

As bilateral treaties are renegotiated, Canada will seek to introduce a more comprehensive Limitation of Benefits (LOB) article. Currently, Canada only has a handful of treaties with a LOB clause; the treaty with the United States has the most comprehensive LOB.

In addition, Canada intends to adopt the following MLI optional provisions:

• A 365-day holding period for shares of Canadian companies held by non-resident companies to obtain the lower treaty withholding tax rates on dividends. The holding period test essentially discourages short-term share transfer transactions and the ability to access treaty withholding tax rates.
• A 365-day test period for non-residents who realize capital gains on the disposition of shares or other interests that derived their value from Canadian immovable property. Currently, Canadian domestic legislation has a 60-month look-back rule to tax taxable Canadian property (TCP). Generally, our tax treaties do not have a similar look-back. This provision will align Canadian domestic law with our tax treaties to allow Canada to tax certain transaction that were previously exempted under treaty provisions.
• A mechanism for resolving dual resident entity cases. This provision employs an effective approach to resolving dual resident cases to prevent potential double taxation, while providing protection against companies and other entities that attempt to manipulate their tax residence to avoid or reduce their taxes.
• A provision that will allow certain treaty partners to move from an exemption system as their method of relieving double taxation, to a foreign tax credit system.

Impact on Canadian Companies

The MLI will significantly impact Canadian companies that operate internationally and how they structure cross-border transactions. Most notable will be on transactions structured with the main purpose of obtaining treaty benefits which may not meet the minimum standard provisions (i.e. the preamble or the PPT) of the MLI and will result is a loss of treaty benefits. Documentation around the business purpose of the transaction will be crucial. This will add an additional layer of complexity on cross-border tax transactions.

In addition, with the optional provisions being adopted, additional analysis must be undertaken, which was not previously required. For example, dividend payments, subject to a 25% withholding tax under Canadian tax law but were reduced to 5% or 15% under most treaties, are now subject to a holding period test. Canadian companies will need to document how this holding period test was met — no guidance is provided on this as of yet (for example will the Canada Revenue Agency amend their NR301, NR302 or NR303 forms to address this point).

There are now over 80 tax treaties with Canada that could be affected by the MLI measures. The MLI will not impact Canada's tax treaty with this U.S. as they are not a participant in the MLI. In addition, the MLI will not impact Canada's tax treaties with Germany and Switzerland which are currently being renegotiated – that said, it is expected that most if not all of the provisions above will find their way into these two treaties.

Please contact a member of BDO's International Tax Team with questions about the MLI and its impact on your business.