Written by Wade Ritchie, Jared Mackey, Greg Johnson and Darcy Moch
On November 26, 2021, the Supreme Court of Canada (the SCC) released its highly anticipated decision in Canada v Alta Energy Luxembourg SARL, 2021 SCC 49 [Alta Energy Lux], that addressed treaty-based holding structures and the application of the general anti-avoidance rule (GAAR). In a 6-3 majority, the SCC held that the GAAR did not apply to the transactions at issue which resulted in the taxpayer, Alta Energy Luxembourg S.A.R.L. (Alta Lux), not being subject to Canadian tax on the gain realized on the sale of its Canadian oil and gas subsidiary based on the provisions of Canada-Luxembourg Tax Treaty (the Lux Treaty).
This decision is confirmatory news for taxpayers that have historically relied on treaty-based holding structures to hold their interests in Canadian real and resource property. Importantly, the decision will generally only benefit taxpayers who realized treaty-protected gains in taxation years beginning prior to June 1, 2020, including as a result of internal tax basis "step up" transactions, since as of June 1, 2020, many of Canada's bilateral tax treaties, including the Lux Treaty relied upon in Alta Energy Lux, are subject to treaty-shopping limitations imposed by the OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the MLI).
Facts and Background
Alta Energy Partners, LLC (Alta US LLC), a Delaware LLC formed in 2011 by a Texas-based oil and gas firm and a New York-based private equity firm, incorporated Alta Energy Partners Canada Ltd. (Alta Canada) in Alberta, as a wholly owned subsidiary of Alta US LLC, to carry on an unconventional shale oil business in the Duvernay shale formation in northwestern Alberta. The shares of Alta Lux constituted taxable Canadian property for purposes of the Income Tax Act (Canada). In the course of a 2012 restructuring, Alta US LLC sold all of its shares of Alta Canada at cost to the then newly-formed Alta Lux, which was wholly-owned by a new Canadian partnership.
In 2013, Alta Lux sold Alta Canada to Chevron Canada Ltd., an arm's-length purchaser, and realized a capital gain in excess of $380 million which, absent relief under the Lux Treaty, would have been fully taxable in Canada as a disposition of taxable Canadian property. Alta Lux claimed relief from Canadian taxation under Articles 13(4) and (5) of the Lux Treaty, pursuant to which gains derived by a resident of Luxembourg from the alienation of shares of a company deriving their value principally from immovable property situated in Canada in which the business of the company was carried on (the Immovable Property Treaty Exemption), are exempt from Canadian income taxation and are instead taxable only in Luxembourg. Under Luxembourg tax laws, the gain qualified for a full exemption.
The Minister denied the Immovable Property Treaty Exemption and Alta Lux appealed to the Tax Court. The Tax Court held that the Immovable Property Treaty Exemption applied and GAAR did not. The Crown then appealed the Tax Court's GAAR decision (but not the Tax Court's findings regarding the application of the Immovable Property Treaty Exemption) to the Federal Court of Appeal, where Alta Lux was again successful in arguing that the GAAR did not apply. For more information on the Tax Court and Federal Court of Appeal decisions, please see the following Bennett Jones insights:
- Tax Court Affirms Treaty-Based Canadian Holding Structure; and
- Federal Court of Appeal Upholds Treaty-Based Canadian Holding Structure.
The Supreme Court of Canada's Decision
The SCC considered whether the GAAR prevented Alta Lux from relying on the Lux Treaty to shelter its gain from Canadian taxation. In order for the GAAR to apply there must be (1) a tax benefit; (2) an avoidance transaction; and (3) the avoidance transaction must have been abusive. Alta Lux conceded the existence of a tax benefit and an avoidance transaction. Accordingly, the only issue in dispute at the SCC was whether the transactions undertaken to benefit from the Lux Treaty were abusive. The majority of the SCC held that where tax provisions are drafted with "particularity and detail," a largely textual interpretation is appropriate in light of the Duke of Westminster principle, which states that "taxpayers are entitled to arrange their affairs to minimize the amount of tax payable." The SCC also explained that tax avoidance is not tax evasion, and tax avoidance should not be conflated with abuse—designing a transaction for a tax avoidance purpose and not for a bona fide non-tax purpose "does not mean that it is necessarily abusive within the meaning of the GAAR." Furthermore, the majority explained that courts should not conflate the abuse analysis with a morality analysis—judges should not make value-based decisions of what is right or wrong based on theories about what tax law ought to be or ought to do. For more information on the SCC's comments regarding the Duke of Westminster principle and distinguishing (1) tax avoidance and tax evasion and (2) and immorality and abuse, please see the Income Tax Update from the Supreme Court of Canada: The GAAR Does Not Apply to Treaty Shopping.
The majority emphasized the dual contractual and statutory nature of tax treaties and the importance of considering the contractual element when applying the GAAR to tax treaties to focus the analysis on whether the tax planning at issue is consistent with the compromises made by the contracting states.
Regarding the residency rules in Articles 1 and 4(1) of the Lux Treaty, the majority noted that it was open to Canada and Luxembourg to define corporate residency based on either of the two broadly accepted international corporate residency methods: (1) the "legal seat" rule or (2) the "real seat" rule. Canada and Luxembourg chose to use the legal seat rule to determine corporate residency for the purposes of the Lux Treaty, under which corporate residency is determined by focusing on where a corporation was incorporated, as opposed to the real seat rule that focuses on where a corporation is effectively managed. The Minister, despite agreeing that Alta Lux was a resident of Luxembourg for the purposes of the Lux Treaty, argued that Alta Lux should not be entitled to treaty benefits because it did not have "sufficient substantive economic connections" to Luxembourg. The majority rejected the Minister's "sufficient substantive economic connections" argument and concluded that the object, spirit and purpose of Articles 1 and 4(1) of the Lux Treaty is "to allow all persons who are residents under the laws of one or both of the contracting states to claim benefits under the [Lux] Treaty so long as their resident status could expose them to full tax liability (regardless of whether there is actual taxation)."
Next, the majority determined that the object, spirit and purpose of the Immovable Property Treaty Exemption in Articles 13(4) and (5) of the Lux Treaty is:
… to foster international investment by exempting residents of a contracting state from taxes in the source state on capital gains realized on the disposition of immovable property in which a business was carried on, or on the disposition of shares whose value is derived principally from such immovable property.
In reaching this conclusion, the majority emphasized that the Immovable Property Treaty Exemption is contained in only a small number of the world's tax treaties and the purpose of the inclusion represents a departure from the general theory of economic allegiance contained in other portions of Article 13 of the Lux Treaty, under which the parties to a treaty allocate the right to collect taxes to the contracting state most closely connected to the income and taxpayer. Instead, the majority stated that the main object of the Immovable Property Treaty Exemption is to attract foreign investment. Furthermore, Canada entered into the Lux Treaty knowing that Luxembourg could be viewed as a tax haven but did not insist on including a specific anti-avoidance rule aimed at preventing conduit corporations, such as Alta Lux, from obtaining treaty benefits. In the majority's view, the lack of such a specific anti-avoidance rule was deliberate and represented an important contextual and purposive element of the Immovable Property Treaty Exemption that further reinforced that the object, spirit and purpose of the Immovable Property Treaty Exemption was to economically benefit Canada by encouraging foreign investment as opposed to collecting tax revenues.
The majority of the SCC concluded that the object, spirit and purpose of the residency rules in Articles 1 and 4(1) of the Lux Treaty and the Immovable Property Treaty Exemption in Articles 13(4) and (5) of the Lux Treaty were not defeated or frustrated by the transactions at issue, and therefore the Minister failed to discharge her burden of establishing that the transactions were abusive. The majority held that the Immovable Property Treaty Exemption operated as intended to allocate taxing rights to Luxembourg for the gain realized by Alta Lux on the disposition of Alta Canada shares and the fact that less tax was payable in Luxembourg than would have been payable in Canada was not important as "the issue raised by GAAR is the incidence of Canadian taxation, not the foregoing of revenues by the Luxembourg fiscal authorities."
The Dissenting Judgement
The three dissenting judges concluded that the object, spirit and purpose of the relevant Lux Treaty provisions was to assign taxing rights to the state with the "closest economic connection to the taxpayer’s income." Since Alta Lux had no "genuine economic connections with Luxembourg," the dissent held that Alta Lux's reliance on the Immovable Property Treaty Exemption would frustrate the rationale of the provisions at issue and was therefore abusive. The dissent considered that Alta Lux's presence in Luxembourg "is not genuine—it is mere gossamer." In the dissent's view, Canada and Luxembourg could not have intended for the Lux Treaty to be used to provide a mechanism for residents of third-party states to indirectly benefit from the Lux Treaty by using a Luxembourg resident conduit corporation to invest in Canada.
Future Implications and the MLI
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 effectively amends the tax treaties between countries that have ratified the MLI, without each country needing to specifically renegotiate with each of their tax treaty partners.
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. For more information on the PPT and the MLI, please see the following Bennett Jones insights:
- The Multilateral Instrument and Canadian Tax Planning Considerations: The Clock is Ticking; and
- New Ratifications of the OECD's Multilateral Instrument Put Canadian Resource Holding Structures at Risk.
The MLI was not in effect when Alta Lux sold its Alta Canada shares to Chevron so was not relevant in this case, but would be relevant if a similar transaction were implemented today. Both the majority and the dissent of the SCC made comments that are likely to be relevant going forward.
The majority noted that Canada included discrete purpose tests in various tax treaties entered into with other countries at around the same time as Canada and Luxembourg entered into the Lux Treaty (e.g., Nigeria, Ukraine, Kazakhstan, Uzbekistan and Peru). These purpose tests were designed to deny certain treaty benefits where the purpose of a transaction was to gain access to such benefits. The majority of the SCC stated that the creation of a conduit corporation in Luxembourg to access the Immovable Property Treaty Exemption would most likely have been caught by such a purpose test. Notably, these purpose tests do not contain wording similar to the saving portion of the PPT, which prevents the PPT from applying where granting the benefit is in accordance with the object and purpose of the applicable treaty provision. Considering the majority's conclusions respecting the object, spirit and purpose of the Lux Treaty and the Immovable Property Treaty Exemption, it is open for taxpayers to argue that the PPT should not apply in circumstances similar to those in Alta Energy Lux due to the saving portion of the PPT.
Taxpayers investing in Canadian real and resource property through treaty-based holding structures should be aware of the additional risks and hurdles that the MLI has created. The SCC's decision in Alta Energy Lux, while helpful for taxpayers that utilized treaty-based holding structures before the MLI came into effect, provides less comfort for taxpayers with treaty-based holding structures in this new MLI world.
The Bennett Jones Tax group will continue to monitor developments in this area and would be pleased to assist as you look to identify and implement strategies in connection with the MLI and the SCC's recent decision in Alta Energy Lux.