Canada: Application and interpretation of the principal purpose test

February 27 2018

On June 7 2017, Canada signed the OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), which will affect more than 70 of Canada's existing tax treaties. With respect to treaty abuse, Canada has chosen to implement the minimum standard by adopting the principal purpose test (PPT) without adopting the simplified limitation of benefits. In addition, Canada filed a notification that it accepts the PPT as an interim measure and that it intends, where possible, to adopt a limitation-on-benefits provision, in addition to or to replace the PPT, through bilateral negotiations.

Generally, the PPT operates to deny a treaty benefit where it is reasonable to conclude that obtaining such a benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless granting that benefit would be in accordance with the object and purpose of the relevant treaty provisions.

Due to limited guidance, there is uncertainty as to the application and interpretation of the PPT. For example, it appears that the taxpayer may have the burden of proof to demonstrate that a treaty benefit is in accordance with the object and purpose of the relevant treaty provisions. However, the contracting states, as negotiators of treaties, are in a much better position to determine the object and purpose of each provision and, accordingly, the contracting states arguably should have the burden of proof to demonstrate that a particular treaty benefit is not in accordance with the object and purpose of the relevant provisions.

Additional uncertainty arises from the fact that Canada already has a domestic general anti-avoidance rule (GAAR) and that there is potential overlap between such a rule and the PPT. Although both rules may be relevant where treaty benefits are involved, the threshold for application and the potential consequences are different under each rule. The GAAR is intended to prevent abusive tax avoidance, including if a tax benefit arises because of a misuse of the provisions in a tax treaty. Unlike with the PPT, Canadian courts have held that before GAAR can be applied the minister must establish that it cannot be reasonably concluded that a tax benefit is consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer. It therefore remains to be seen how the GAAR and PPT will inform or interact with each other given the notable difference as to which party has the burden of proof.

Where GAAR cases may be informative in interpreting the PPT is with respect to determining whether there is a 'benefit' or 'arrangement or transaction' because these are not defined terms in a tax treaty. In Canada, undefined terms in tax treaties may be informed by domestic law.

Lastly, at a recent Canadian tax conference, the Canada Revenue Agency stated that in appropriate circumstances the PPT and the GAAR could apply as alternative assessing positions and that it would consider issuing PPT rulings once the MLI is in effect.