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Nathan Boidman of Davies Ward Phillips & Vineberg highlights how the recently enacted double tax agreement between Canada and Hong Kong affects multinationals and individuals investing in both countries.
Reprinted from Tax Notes International, January 28 2013, except as noted next:
This work, as originally published in Tax Notes International, Vol. 69, No. 4, January 23, 2013, contained 72 footnotes that (1) set out references to provisions of the relevant law, the Income Tax Act (Canada), R.S.C. 1985, Chap. 1 (5th supp.), as amended; the Inland Revenue Department, Hong Kong, Departmental Interpretation and Practice Notes, made under the Inland Revenue Ordinance , (as well as supplementary government materials); the new income tax treaty between Canada and Hong Kong; as well as to certain domestic law of or tax treaties of third countries; (2) provided references to certain other writings and (3) provided supplementary notes and comments. This version of the work does not contain any of those footnotes, as such, although certain aspects thereof have been worked into the text and links have been provided for certain of the materials cited or referenced. For those readers who would like to review the original version, it may be accessed through Tax Notes International website at: www.taxanalysts.com
The author would like to thank Patrice Marceau of DLA Piper, Hong Kong, for providing information and comments on a broad cross section of Hong Kong tax law referred to in this article. However, the author is solely responsible for the accuracy of the content of this article.
On November 11, 2012, in Hong Kong, Canada and Hong Kong signed an eagerly awaited double tax agreement. This article examines how and why the agreement will:
The agreement, based in part on the OECD model, will limit withholding tax rates on dividends to 5 per cent (on 10 per cent or greater inter-corporate shareholdings) and 15 per cent (in other cases), and to 10 per cent on interest and royalties. For qualifying Hong Kong residents, that will reduce Canada’s domestic rate of 25 per cent (only applicable, in the case of non-contingent interest, to such payments to affiliated parties). But since Hong Kong does not generally tax such outbound flows (except perhaps royalties), those treaty rates will generally not affect Canadian investors in Hong Kong.
The agreement will also offer typical protection against local tax on cross-border operations unless they are carried on through treaty-defined permanent establishments, and it will exempt capital gains not associated with real property or natural resources or with the conduct of a PE. But that largely mirrors domestic rules. The agreement also contains many typical OECD style provisions, including an agreement for information exchange and anti-treaty-shopping rules.
Finally, the major beneficiary from a Canadian standpoint will be Canada’s multinationals, which will be eligible (under Canadian domestic rules) to receive dividends from Hong Kong subsidiaries without liability to Canadian tax. This will arise under Canada’s foreign affiliate rules as explained below.
The agreement will enter into force once instruments of ratification have been exchanged and will generally have effect in the year following ratification (for Hong Kong, April of the year following ratification).
I. Threshold Matters Regarding ‘Residency’
Tax treaties usually allocate tax revenue between the countries involved. And what one country gives up in tax revenue, the other country picks up. That effect generally flows from the manner in which the treaty identifies those entitled to its benefits. Except for those treaties that have adopted US style limitation on benefits rules, that turns on the manner in which typical (article 4) rules for determining residence status for the treaty operate.
The norm is to denominate the status in terms of whether a person is generally liable to tax in the relevant country (be aware of the unusual application of this notion in Canada where foreign trusts are involved) which the Canadian Supreme Court in Crown Forest (Crown Forest Industries v The Queen 95 DTC 5389 SCC) said entails being subject to the broadest basis for taxation under the laws of the relevant country.
Since the broadest system of taxation in most countries taxes worldwide income, taxpayers that meet that test would ordinarily pay tax on foreign-source income and generally be accorded a credit for taxes paid to the source country or include in income and have an exemption under an exemption regime. And when a treaty serves to reduce source-country tax that reduces the amount of credit, the country of residence must grant and increases its tax revenue regarding the relevant taxpayer and the associated income.
That ‘‘liable to’’ test of residency is found in the agreement (in article 4(1)(b)) regarding Canada. This applies to any taxpayer, whether individual, corporation, trust, or estate (note that partnerships are not taxpayers under Canadian and Hong Kong law). But what is the treaty formulation when, as in Hong Kong, there is no general system of taxing the worldwide income of residents and, instead, tax is imposed on income earned in Hong Kong, regardless of the personal (residential/residency) status of the earner of the income?
In the agreement, persons who will be considered ‘‘residents of Hong Kong’’ (and therefore entitled to reduced Canadian tax, even though they generally will not be taxed in Hong Kong on the underlying Canadian source income) will be denominated by reference to, for individuals, whether they ‘‘ordinarily reside’’ in or spend more than 180 or 300 days (in specified periods) in Hong Kong, and for corporations as to whether they are formed in Hong Kong or are ‘‘centrally managed and controlled’’ in Hong Kong. For trusts, residence in Hong Kong would arise under article 3(1)(c) - which treats a trust as a ‘‘person’’ - and, if complied with, article 4(1)(a)(iv), which also looks to place of formation or management.
Thus, Canada has decided to enter into a double tax agreement that doesn’t merely shift tax revenue from Canada to the treaty partner country but will often serve to reduce the overall tax burden of a Hong Kong resident regarding Canadian source income.
It is curious that the agreement contains an anti-remittance basis taxpayer rule, in article 26(4) - under which treaty benefits will not apply to income that is only taxed if received in the country of residence (as might arise in the UK under its remittance basis rule for non-domiciled residents) - given that neither country has such a domestic rule.
II. The Biggest Winner: Canadian MNEs?
It is arguable - if not specifically demonstrable - that the biggest winner of the agreement will be Canada’s multinationals and other Canadians that operate or will be given incentives to operate in or from Hong Kong. Ironically, this will not be by reason of any particular provision in the agreement, but simply because an agreement has been entered into with Hong Kong. This is because Canada has a territorial or participation exemption system that is linked to treaty relationships between Canada and countries where Canadian-owned subsidiaries reside and operate or third countries where they operate. Under this system, dividends from a foreign subsidiary or other foreign corporation that qualifies as a foreign affiliate (FA) that operates in treaty countries may be exempt from Canadian tax. An FA entails as little as a 10 per cent ownership (within a related group) of any class of shares of a non-resident corporation (see section 95(1) and (4) of the Income Tax Act (ITA)).
That is Canada’s exempt surplus system, which exempts dividends received by Canadian corporations out of the active business income of FAs with such treaty links. The specific provision requires both FA residency under a treaty and under Canada’s common law. Regarding Hong Kong, the former will require that the FA be formed or managed and controlled in Hong Kong (given the article 4(1)(a)(iii) conditions for corporate treaty residency in Hong Kong), while the latter will require that it be managed and controlled in Hong Kong.
B. Hong Kong Operations
What is the magnitude of the tax savings potential in contrast to the pre-agreement situation? That turns on the nature and location of the operations involved. For operations in Hong Kong that are being carried on through a Hong Kong based FA of a Canadian corporation and are taxed at the standard Hong Kong corporate tax rate of 16.5 per cent, the potential savings are 8.5 per cent (or somewhat greater depending on the Canadian provinces to which the Canadian multinational enterprises pay tax). That is the tax that a Canadian corporation would pay on dividends from such profit absent the agreement (and now does pay on Hong Kong subsidiary profits) under the taxable surplus rules for profits from non-treaty country arrangements, which operate similarly to the US Internal Revenue Code (IRC) section 902 gross-up and credit rules, but through mechanics that differ by entailing grossed-up deductions for foreign taxes, having regard to Canada’s standard federal 25 per cent corporate tax rate.
Without the agreement, that 8.5 per cent differential would be picked up by Canada (as tax payable to Canada) on dividend payments by the Hong Kong subsidiary to its Canadian parent.
However, the level of benefit would be greater - up to 25 per cent (or somewhat greater depending on the province involved) tax rate savings - in at least two other situations when a Canadian multinational enterprise uses a Hong Kong corporation in its international structure.
C. Hong Kong Base for Foreign Operations
One situation is when the MNE is carrying on business in another treaty country that has a low or no tax rate on operating profit, or doesn’t otherwise tax or heavily tax the profits being earned there, but would prefer to establish an operating subsidiary or use an existing one that is formed under the law of another country - say Hong Kong - or a subsidiary that is managed and controlled there. Provided there is management and control in Hong Kong so that residence is established from the Canadian common law standpoint and treaty standpoint in Hong Kong, such profits could be repatriated to Canada free of tax under the exempt surplus rules.
Without the agreement, the differential between the Canadian 25 per cent standard rate and the taxes, if any, paid abroad would be picked up by Canada (as tax payable to Canada) on dividend payments by the Hong Kong subsidiary to its Canadian parent. To be clear, that strategy would only be effective if, even with mind and management in Hong Kong, the third country profits are not considered by Hong Kong to be earned in Hong Kong (see Section II.D of this article) so as to attract the Hong Kong 16.5 per cent corporate tax rate.
D. Hong Kong as a Lending/Licensing Centre
The second situation would see a Canadian-owned Hong Kong subsidiary making interest-bearing loans to, or licensing intangibles to, another group operating subsidiary in a high-tax country with which Canada has a treaty. From the Canadian standpoint, such income, although generically passive in nature and normally attributable to the Canadian parent under Canada’s controlled foreign affiliate (CFA)/foreign accrual property income rules, should normally qualify for re-characterization from FAPI to active business income under ITA section 95(2)(a)(ii), and thus potentially be eligible for exempt surplus treatment on repatriation to Canada.
Provided such payments are deductible in the host operating company, qualify for low or no withholding taxes in that country (under either domestic law or double tax agreement with Hong Kong), and are eligible for treatment in Hong Kong as foreign-source income (or as income not related to carrying on business in Hong Kong), there would be little or no foreign taxes payable abroad and none in Canada, under the exempt surplus rules on repatriation to Canada. Without the agreement, the differential between the standard Canadian rate and any taxes paid abroad would be picked up by Canada (as tax payable to Canada) on dividend payment by the Hong Kong subsidiary to its Canadian parent.
However, the proviso regarding exempt treatment in Hong Kong cannot be taken for granted. Hong Kong taxes the profits or income of a person (without regard to residence) that are derived from carrying on a business in Hong Kong and are considered to arise in or have their source in Hong Kong. The base requirement (whether a business is being carried on) is determined under case law principles, while the second (source) is determined under a combination of such law and statutory law.
In such context the position of a Canadian-owned Hong Kong subsidiary to finance (with loans) third- country operating subsidiaries could, for ‘‘simple loans of money,’’ be advantageously governed by a ‘‘source of credit’’ notion regarding lending operations. For a full discussion, see Inland Revenue Department, Hong Kong, DIPN No. 13 (Revised), ‘‘Profits Tax, Taxation of Interest Received,’’ Dec. 2004. Given that the determination of whether a business is being carried out can be quite uncertain, certainty would be sought on being able to show that even if a business is being carried on, the interest paid by a third-country operating subsidiary would not have a Hong Kong source. As indicated above, that objective apparently can be achieved when there is ‘‘simple’’ lending if the Hong Kong subsidiary does all its banking outside Hong Kong, because that would lead to conformity with the rule that looks (in the case of simple lending) at the ‘‘source of the funds’’ that have been lent as determining the source of the resulting interest payment. The source (of funds) would not be seen to be Hong Kong if the places/accounts from which loans are made are not in Hong Kong. The objective of not paying Hong Kong tax on the intercompany interest income of the Hong Kong subsidiary seems achievable when simple lending is involved.
When a Hong Kong subsidiary acts as a group licensor of intellectual property, there is, again, the two-prong test, although with statutory extensions. Here, the determination under the first test may, again, be uncertain - but under the second it should be clear. Such activity should not engage the deeming rules of section 15(1)(a) of the Inland Revenue Ordinance relating to royalties received for providing the use of property in Hong Kong (see para.71 of DIPN 49). Depending on the circumstances, licensing intangibles to the Canadian group’s operating subsidiary in third counties might be taxable in Hong Kong. Hong Kong tax will apply if the licensed intangibles have been developed in Hong Kong, but will not apply if developed by a group member outside Hong Kong and purchased by the Hong Kong licensing subsidiary. In other circumstances, including sub- licensing, exposure to Hong Kong tax might arise.
E. Other Possibilities
There can be other situations when a Canadian based group carries on foreign activities that give rise to active business income and which under the agreement, if the group is based in or linked to Hong Kong, can qualify for exempt surplus, and thus tax-free dividend receipt treatment. These could include third-party lending or licensing, or acting as a sourcing company in the Far East for Canadian importers of foreign made (perhaps contract-manufactured) goods. In each case it would have to be determined whether any of Canada’s expansive FAPI deeming rules or Hong Kong’s rules (above) for taxing profits would apply so as to undermine, at least from the tax standpoint, the strategy of deriving benefits for Canada’s MNEs from the advent of the agreement. This notion, that the mere advent or existence of a treaty can unleash tax benefits for an MNE under the domestic laws of its country, is not unique to Canada. A study of some 30 countries in 2011 showed similar law and effects in at least eight other countries (see ‘).
III. Other Winners
Unlike the situation just discussed in which it is the mere advent of the agreement that provides benefits to a taxpayer group, there are other situations when, as is more customary, it will be the terms of the agreement (alone or in conjunction with local or domestic law) that provide net benefits.
A. PE Protection
Because the domestic laws of both Canada and Hong Kong can have low thresholds for taxing direct cross-border business activity, the provisions of article 5, which contain a fairly standard PE rule, and of article 7, which will, conventionally, limit source-country taxation to profits allocable to a PE, are welcome additions to the tax scene. The only aspect of article 5 that seems to depart from the OECD model is that article 5(3) deems a ‘‘building site, a construction, assembly or installation project or supervisory activities’’ (in respect thereof) to be a PE if such activities last more than six months, whereas the OECD excludes such activities from PE status unless they last more than 12 months, but does not per se deem them to be PEs in the first place. Through article 7, the Canada-Hong Kong agreement follows the pre-July 22, 2010, approach of the OECD model treaty, and therefore differs in detail if not overall effects from the version added on July 22, 2010.
For Canadian companies, taxable on worldwide (directly earned) income, the higher rates in Canada as compared with those in Hong Kong, and the usual domestic foreign tax credit rules as (unnecessarily) reinforced by the agreement, means that the actual effect of the PE rule generally will not be to reduce overall tax, but rather to reduce or eliminate administrative hassles of having to comply with and file under Hong Kong law.
For Hong Kong companies carrying on business in Canada, the PE rule or the branch profits tax rule in article 10(6) can provide material overall tax relief. If there is no PE, a Hong Kong corporation can save the aggregate of:
That, when profits are not reinvested, amounts to roughly 45 per cent of pre-tax profit. Even if the profits were considered taxable in Hong Kong, there is still a net savings of a little under 30 per cent of pre-tax profits. If there is a PE, so that Canada can levy tax, the reduction of the branch profits tax rate by article 10(6) from 25 per cent to 5 per cent would reduce the overall Canadian tax on profits earned in the province of Ontario or Quebec from that 45 per cent to roughly 31 per cent. Here, even if Hong Kong were taxing such profits, there would be a savings in the area of 15 per cent.
B. Portfolio/Passive Investment Protection
The treaty rates for dividends, interest, and rent/royalties (see above) will, again, as in the case of the prior section, mainly benefit Hong Kong persons, particularly those whose activities do not incur tax on Hong Kong source profits.
Given the standard Canadian withholding tax of 25 per cent on dividends paid to non-residents if there is no Hong Kong tax imposed, the dividend article will produce net savings of 20 per cent of the dividend when a Hong Kong resident corporation receives a dividend from a Canadian resident corporation in which it owns 10 per cent or more of voting stock. The rate in that case is limited to 5 per cent (note that the 5 per cent rate will not apply if the shares of the Canadian company are owned through a partnership even if all the partnership interests were owned by qualifying Hong Kong corporations each with more than 10 per cent interest in the partnership). If that share-holding test is not met, so that the rate is 15 per cent, the savings will be 10 per cent.
For interest income, Canada only imposes tax (at 25 per cent) on interest paid to affiliated non-resident parties or on contingent interest paid to unaffiliated non-resident parties. Article 11 will reduce that 25 per cent tax to 10 per cent, which will produce a net benefit of 15 per cent of the interest for Hong Kong residents who are not taxable and a 10 per cent benefit for those individuals (whose maximum Hong Kong tax is at 15 per cent) who are and an 8.5 per cent benefit for those corporations who are. Article 12 will have similar effects for rents and royalties (not involving immovables and article 6) derived from Canada by residents of Hong Kong. Their savings will either be 8.5 per cent, 10 per cent, or 15 per cent.
But in principle the agreement will not affect the net position of a Canadian investor in Hong Kong (leaving aside the FA situation discussed above). This is because, aside from royalties, Hong Kong would not ordinarily impose any tax on passive investment flows to a non-resident, and even if Hong Kong did apply its top rates - 16.5 per cent for corporations and 15 per cent for individuals - to a Canadian resident, that person would be entitled to reduce, by foreign tax credit, higher taxes payable to Canada.
In fact it would appear that the only situation when Hong Kong tax would arise would not bring the agreement into play because the Hong Kong tax would be lower than the taxes permitted by the agreement. That involves royalties paid to a non-resident for the right to use property in Hong Kong. In that case (absent affiliated party status), the tax would be 30 per cent of the standard rates - namely, 30 per cent of 16.5 per cent, or 4.95 per cent, for a Canadian corporate licensor, and 30 per cent of 15 per cent, or 4.5 per cent, for a Canadian individual licensor.
Finally, since neither Canada nor Hong Kong generally tax a non-resident on the sale of shares of companies the principal value of which is not derived from domestic immovable/real property or natural resource property, or of other property not used in carrying on business or not comprising or related to domestic immovables and so forth, and since article 13 of the agreement preserves domestic taxing rules on the sale of immovables or property used in carrying on a business, the agreement does not provide any net benefits in this area to residents of either state. Note that article 13 reflects a policy announced by Canada’s Department of Finance at the spring 2012 seminar of the Canadian branch of the International Fiscal Association that Canada’s treaties will no longer offer certain exceptions or exemptions (as seen in treaties with, for example, Luxembourg, the Netherlands, and the UK) from domestic law regarding, for example, the shares of companies whose value is derived principally from immovables in which a business - other than a real estate rental business, but including a resource business - is carried on or for some shareholdings not exceeding certain levels.
C. Dual Residence
A Canadian who takes up activities or lives in Hong Kong may seek to terminate tax residency in Canada and thereby benefit from the lower tax environment of Hong Kong — maximum 15 per cent tax, applicable only to Hong Kong-source income. If Canada asserts continuing residence, the person could consider the dual residence rules of the agreement.
However, it would appear that it is Hong Kong persons who have moved to Canada who may have the main interest in the dual residence rules. This is because commencing in the late 1970s and early 1980s, many high-net-worth Hong Kong individuals and their families have established educational, business, and residential ties to Canada, often while maintaining substantial or even greater ties to Hong Kong. Moreover, many such persons have withdrawn from or terminated most of their Canadian ties, sometimes after successful accession to Canadian citizenship.
Given Canada’s traditional case law facts and circumstances approach, referred to above, to determining residency (abandoned in the US in 1984, upon the enactment of code section 7701(b)), buttressed by a 183-day ‘‘sojourning’’ rule, it would not be surprising if many such Hong Kong high-net-worth individuals, who may be mainly based in and connected to Hong Kong, are uncertain as to their Canadian residency status, filing obligations, and tax exposure/liabilities on their worldwide income.
In such circumstances, the key question is whether, assuming the individual is resident in Canada, the dual residency tiebreaker rule in article 4 of the agreement will resolve his status in favor of Hong Kong. In that case the provisions of the agreement may substantially limit or eliminate Canadian tax liability. That requires, first, a determination that the individual meets the treaty requirements to be treated as a resident of Hong Kong. And second, it requires that the tiebreaker assign the party to Hong Kong.
The notion of Hong Kong residency of an individual for treaty purposes was seen in Section II of this article to revolve around the requirement that there be the condition that the person either ‘‘ordinarily resides’’ in Hong Kong or spends 180 or 300 days there in specified periods. Leaving aside potential disputes over the first factor (given, as discussed above, that that notion is also a part of Canadian domestic law) and assuming an individual meets the requirement, there remains the terms of the tiebreaker, which read as follows:
2. Where by reason of the provisions of paragraph 1 an individual is a resident of both Parties, then the individual’s status shall be determined as follows:
(a) the individual shall be deemed to be a resident only of the Party in which the individual has a permanent home available and, if the individual has a permanent home available in both Parties, the individual shall be deemed to be a resident only of the Party with which the individual’s personal and economic relations are closer (centre of vital interests);
(b) if the Party in which the individual’s centre of vital interests is situated cannot be determined, or if there is not a permanent home available to the individual in either Party, the individual shall be deemed to be a resident only of the Party in which the individual has an habitual abode;
(c) if the individual has an habitual abode in both Parties or in neither of them, the individual shall be deemed to be a resident only of the Party in which the individual has the right of abode (in the case of the Hong Kong Special Administrative Region) or of which the individual is a national (in the case of Canada);
(d) if the individual has the right of abode in the Hong Kong Special Administrative Region and is also a national of Canada, or if the individual does not have the right of abode in the Hong Kong Special Administrative Region and is not a national of Canada, the competent authorities of the Parties shall settle the question by mutual agreement.
Given that there can be uncertainty and disagreement over the application of the various criteria in paragraph (a) and (b), it is possible that the tiebreaker will prove to be of clear assistance mainly to those Hong Kong persons who have maintained a right of abode in Hong Kong and have not taken up Canadian citizenship and therefore are not nationals of Canada within the meaning of article 3(1)(i). The problem when Canadian citizenship has been taken up is that the Hong Kong party may see his status determined, under paragraph (d), by the tax officials of the two jurisdictions. That would be unreliable and uncertain in advance.
Returning to Canadians who have moved to Hong Kong, assuming that they would not ordinarily relinquish Canadian citizenship, the full effect of the tiebreaker would turn on whether they have acquired the right of abode in Hong Kong. If not, and if the other criteria prove inconclusive, they will be assigned to Canada under the tiebreaker. If they have acquired the right of abode in Hong Kong, their status would be resolved by the competent authorities of the two jurisdictions. Finally, what is the implication that paragraph (d) does not contain the rule found (in section 4(3) and discussed next below) in the tiebreaker for persons other than individuals that where a person’s dual residence status is to be determined by the competent authorities or, until they do, ‘‘the person shall not be entitled to claim any relief or exemption from tax provided by this Agreement’’?
As just indicated, dual residence of a corporation will be resolved by the competent authorities, under article 4(3), which reads as follows:
3. Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Parties, the competent authorities of the Parties shall by mutual agreement endeavour to settle the question and to determine the mode of application of this Agreement to that person. In the absence of mutual agreement, that person shall not be entitled to claim any relief or exemption from tax provided by this Agreement.
That means that unlike some treaties (for example, the Canada-US treaty), such dual residence will not be resolved by reference to the place of incorporation.
Given that a corporation may be a resident of both countries under article 4(1) if it is incorporated in one and managed and controlled in the other, there could be many corporations that have dual residence status.
In light of the last portion of article 4(3) - that no treaty relief will be available until such status has been resolved - a key question in such circumstances is how and how quickly the resolution will be arrived at. In light of the broader ambit of Canadian taxation as compared with Hong Kong taxation (and Canada’s higher tax rates), what often will be at stake is a much higher tax burden that Canadian tax law will be able to impose on a corporation that it can treat as a Canadian resident than it can impose on one that is a resident, for the agreement, only in Hong Kong.
The tax treatment of trusts, in the Canada-Hong Kong context, could be the object of a separate comprehensive analysis and commentary. In particular, the matter is governed by at least the following factors:
In the latter complex context, some of the aspects of the agreement that deal with trusts are of interest.
A trust should be treated as a treaty resident of Hong Kong and not of Canada in one of two situations. First, it should be so treated if either the trust has been ‘‘constituted’’ under Hong Kong law or is ‘‘being managed and controlled’’ in Hong Kong and does not have its ‘‘place of management’’ in Canada. Second, a trust should be so treated if it is dual resident under the agreement and the competent authorities have resolved the dual residence in favor of Hong Kong.
That should be the result. But Bill C-48 contains an addition to Canada’s Income Tax Conventions Interpretation Act (ITCIA) that would override the agreement and treat for purposes of the agreement, as resident of Canada not Hong Kong, any trust that is otherwise not resident in Canada but has engaged the new deemed residency rules noted above. It is clear that the criteria in article 4(1)(b) - which are questions of fact - do not include the contribution of property to a trust as a fact that triggers liability to tax in Canada. That is simply a criterion that the negotiators of the agreement did not include. It is reasonable to think that the Department of Finance knows this and that that is why an override rule is being added in the ITCIA. However, when regard is had to the following words from the department (in its explanatory notes of the NWMM version of the bill), it would seem that the government also wants it thought that the latter is not really an override:
[The notes related to the addition of the override rule.]
The Income Tax Conventions Interpretation Act contains rules that govern the interpretation of certain provisions of the tax treaties concluded by Canada. It is important that the tax treaties be applied consistently and in conformity with the intentions of Canada and its treaty partners. To make their consistent application easier, the Income Tax Conventions Interpretation Act sets out a number of interpretive rules and definitions.
The Income Tax Conventions Interpretation Act is amended to add new section 4.3. New section 4.3 clarifies that the law of Canada is such that, notwithstanding the provisions of a tax convention or the Act giving that convention the force of law in Canada, a trust that is deemed resident in Canada under new subsection 94(3) of the Income Tax Act will be a resident of Canada and not a resident of the other contracting state for the purpose of applying the convention. This amendment is intended to ensure the consistent application of Canada’s tax treaties in a way that conforms to one of their principal objectives, which is to prevent tax avoidance and tax evasion.
[Further notes related to the effect of the override rule on non-resident trusts.]
Under paragraph 1 of the resident article in Canada’s income tax treaties, a reference in such a treaty to a ‘‘resident of a Contracting State’’ means any person who, under the law of that State, is liable to taxation in that State by reason of the person’s domicile, residence, place of management or any other criterion of a similar nature. A person, in this context, would generally include a trust because of the usual definition of ‘‘person’’ in Canada’s income tax treaties. Because a trust to which subsection 94(3) applies is resident in Canada, and is liable to tax in Canada because of being resident in Canada, it will be considered a resident of Canada under paragraph 1 of the resident article in Canada’s income tax treaties, whether it is also considered to be resident, under the applicable treaty, in another country or not. An amendment to the Income Tax Conventions Interpretation Act, described elsewhere in this commentary, ensures that this result applies consistently across Canada’s tax treaties.
Sadly, those words don’t really show that the rule is not an override because, as already noted, the structure of article 4(1)(b) simply cannot be construed as a rule that triggers Canadian treaty residence of a trust by reference to contributions of property to it. In particular, the word ‘‘residence’’ in article 4(1)(b) obviously means factual residing/residency and not the legal residency resulting from a deeming rule tied to facts that are not pertinent to any notion of residency.
But perhaps more germane is that the offshore trusts that Hong Kong families have established for the benefit of family members who have moved to and remained in Canada most usually have not been formed under Hong Kong law and are not managed in Hong Kong, with the result that quite apart from the heavy handed Canadian approach such trusts could not meet the requirements for Hong Kong treaty residence status.
Finally, note that it is only when the stay in Canada of a Hong Kong person who has contributed property to a trust is less than five years that there would be no Canadian tax on the trust’s (non-Canadian-source) income at any time, even if there are remaining Canadian family members (who have interests in the trust) beyond that five-year period.
D. The Canadian Government
In this era of intense activity and initiatives by governments to receive information about recalcitrant taxpayers, the Canadian government certainly is happy to see its reach extended by the terms of the information exchange provisions of the agreement. Those in article 24 are virtually identical to the OECD model.
But it is interesting, if not curious, that after the agreement was drafted, a protocol was made - with both being signed on the same day (November 11) - that the exchange obligations do ‘‘not require the parties to exchange information on an automatic or spontaneous basis.’’ That protocol also stipulates that the exchange provisions will only have effect regarding matters arising after the agreement comes into force.
IV. Those Not Benefited: Treaty Shopping
Although there is no full-blown US style limitation on benefits provision in the agreement, there are four different approaches to the matter of treaty shopping, three of which may be seen as relatively innocuous or of no applicability under the current domestic laws of the two countries.
But the fourth, which is unusual though not unique in Canada’s treaties, is a ‘‘mini’’ anti-treaty-shopping rule set forth in each of the articles dealing with dividends, interest, and royalties and may have real teeth.
The rule in each of the three articles are virtually identical, one to the other, and all three can be viewed by examining one. The rule in the dividend article reads as follows:
Article 10 - Dividends:
7. A resident of a Party shall not be entitled to any benefits provided under this Article in respect of a dividend if one of the main purposes of any person concerned with an assignment or transfer of the dividend, or with the creation, assignment, acquisition or transfer of the shares or other rights in respect of which the dividend is paid, or with the establishment, acquisition or maintenance of the person that is the beneficial owner of the dividend, is for that resident to obtain the benefits of this Article. [Emphasis added]
This rule may be seen as responding to the decisions of the Tax Court of Canada and the Federal Court of Canada in MIL (see MIL (Investments) SA v The Queen 2006 DTC 3307, 2007 DTC 5437) to the effect that if Canada does not want residents of third countries to treaty shop into Canada, that must be made clear by the terms of a treaty.
It is unfortunate, however, that the rule is articulated in the confusing terms of there potentially being more than a single main purpose for a particular course of action. That flows from the phrase ‘‘one of the main purposes,’’ which conflicts with the essential nature of the notion of ‘‘main’’ - namely, that whatever is main renders any other similar or competing thing less than main.
It is obvious that the interplay of the terms of the agreement as described above and Hong Kong’s territorial tax system (and taxation limited to income associated with Hong Kong-source profits arising from a business carried on in Hong Kong) could make attractive the use of a Hong Kong corporation, by a person resident in a third country (that either does not have a treaty with Canada or does but that taxes directly earned passive income but not that earned by a foreign holding company), to make passive investments in Canada. In that respect it is interesting to speculate that these mini-anti-treaty-shopping rules have not been drafted to catch investment into Canada by a PRC resident through a Hong Kong corporation. That would be on the basis that PRC does have a treaty with Canada (which is being renegotiated and which should bring it in line, in terms of tax limitations, with the new Hong Kong agreement), and even if it didn’t, it has a type of CFC/subpart F rule that may tax, in the PRC, undistributed Canadian source passive income earned by a Hong Kong corporation owned by a PRC corporation.
V. Other Provisions of Interest
Aside from the aspects of the agreement discussed above, other provisions of note include the following:
Separately, of particular note is article 26(2)(a), which could be seen as reversing a recent Federal Court of Appeal decision72 by providing:
nothing in this agreement shall prevent a Party from: (a) imposing a tax on amounts included in the income of a resident of that Party with respect to a partnership, trust, company, or other entity in which a resident of that Party has an interest.
In plain language, this facilitates - for example, in the case of Canada - its applicability of its CFA/FAPI rules (referred to above) and ‘‘other income attribution’’ rules.
Overall, the advent of the Canada-Hong Kong agreement raises questions regarding its effects and consequences for both Canadian and Hong Kong residents, but, particularly for Canadian-based multinationals regarding their operations whether in Hong Kong or in other countries.