Treaty shopping and BEPS considerations in the M&A context
Every acquisition requires careful tax planning early on in the process, especially when dealing with cross border acquisitions. One important consideration when a foreign company plans to acquire a Canadian company is the impact of any tax treaties that currently exist between the two jurisdictions. Tax treaties effectively reduce tax that would be otherwise payable in order to prevent double taxation or to create incentives for international investment in Canada. Without a tax treaty, dividends paid by a Canadian subsidiary to a foreign parent will be subject to 25% withholding tax. A tax treaty can reduce this amount to 15% or sometimes even 5%. This creates an excellent tax savings opportunity if a foreign company that is resident in a tax treaty country acquires a Canadian company and plans on the Canadian subsidiary paying dividends to the foreign parent. However, the abuse of tax treaties can lead to a decrease in tax payable in unintended situations.
In the wake of the financial crisis of 2008, multinational corporations who were significantly reducing their tax liability through calculated cross-border tax planning were put under the microscope and the international community pushed to prevent abusive corporate tax planning. At the request of the G20, the Organisation for Economic Co-Operation and Development (OECD) developed and published its Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan) in July of 2013. The BEPS Action Plan is a highly ambitious and comprehensive plan that includes 15 actions meant to address a number of issues regarding international corporate tax planning. Specifically, BEPS Action 6 addresses treaty abuse and focuses on preventing “treaty shopping”.
“Treaty shopping” refers to the practice whereby a business is structured to take advantage of favourable tax treaties when treaty advantages should not be available. For example, a foreign corporation that is resident in a country that does not have a tax treaty with Canada could acquire a Canadian company directly and any dividends received would be subject to a 25% withholding tax. The foreign corporation may try to incorporate a shell company in a jurisdiction which does have a favourable tax treaty with Canada solely for the purpose of receiving the lower withholding tax rate on the distribution of dividends. BEPS Action 6 gives guidance and recommendations on how to structure tax treaties to prevent this exact type of abuse.
A discussion draft of BEPS Action 6 was first released on March 14, 2014 and submissions were accepted until April 9, 2014. A discussion draft on follow-up work for BEPS Action 6 was subsequently released on November 21, 2014 and submissions were accepted until January 9, 2015. A public consultation of BEPS Action 6 took place on January 22, 2015.
BEPS Action 6 states that one of its main goals is to modify existing domestic and international tax rules to more closely align allocation of income with the economic activity that generates the income. Put another way, BEPS Action 6 tries to ensure that only those corporations that have real activity within a country should be able to receive the benefits under a tax treaty with that country. As it is currently drafted, BEPS Action 6 identifies three different areas that need to be modified to achieve their goal:
1. Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances.
2. Clarify that tax treaties are not intended to be used to generate double non-taxation.
3. Identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country.
The model treaty provisions proposed include a number of limitation on benefit rules and a principal purpose test. Many commenters have suggested that the current form of these proposed provisions is drafted too broadly and may lead to unintended consequences. The OECD’s response to these comments and the impact the development of BEPS Action 6 has on tax planning considerations in cross border M&A transactions awaits to be seen.
