I. Case Overview

Company A, a U.S.-based company specializing in shale oil and natural gas acquisition and development, set up a wholly-owned subsidiary, Company B, in Canada in 2011 and started operations there. From 2011 to 2012, Company B acquired around 62,000 acres of shale oil reserves in Canada, gaining the rights to explore, drill, and extract hydrocarbons in the area. In 2012, Company A restructured by establishing a holding company, Company C, in Luxembourg and transferring the shares of Company B to Company C for CAD 300 million. Since the market value of Company B’s shares at the time of the transfer equaled their historical cost, no capital gain was recognized, which the Canada Revenue Agency (CRA) accepted.

From 2012 to 2013, Company B expanded its holdings to 67,581 acres in the Canadian shale oil formations and drilled four vertical wells and two horizontal wells. In 2013, Company C sold its shares in Company B for approximately CAD 680 million, realizing a capital gain of over CAD 380 million. Company C argued that, under Luxembourg law, this gain was not taxable in Luxembourg, and under Article 13(4) of the Canada-Luxembourg Tax Treaty, the gain was also exempt from Canadian tax. The CRA disagreed, arguing that the transaction should be subject to the General Anti-Avoidance Rule (GAAR) and denied the tax treaty exemption. Company C appealed to the Tax Court of Canada, which ruled in its favor. The CRA then appealed to the Federal Court of Appeal, which upheld the lower court’s decision, dismissing the CRA’s appeal. The CRA subsequently took the case to the Supreme Court.

II. Key Point of Dispute

(1) Excluded Property

Under Canadian tax law, gains from “taxable Canadian property” are subject to Canadian tax unless they are considered “treaty-protected property.” The CRA argued that Company C’s shares in Company B were taxable Canadian property because more than 50% of their value was derived from real property located in Canada.

Article 13(4) of the Canada-Luxembourg Tax Treaty states that if a resident of one country derives gains from the transfer of shares primarily valued from real property located in the other country, and the shares represent a significant interest in the company, the country where the property is located has the right to tax those gains. The treaty provides exceptions, stating that “real property” does not include property through which a company, partnership, trust, or estate carries on business (excluding rental property). A significant interest is defined as holding more than 10% of any class of shares or capital in the company. Company C argued that although more than 50% of the value of Company B’s shares was derived from Canadian shale oil assets, these assets were used for business purposes, qualifying them as “excluded property.” Thus, the gains should be exempt from Canadian tax under the treaty.

The CRA argued that not all of Company C’s business was conducted through these assets, so the shares did not qualify as “excluded property” under the treaty, making the gains taxable in Canada.

(2) Treaty Abuse

According to Canada’s anti-avoidance rules in Section 245 of the Income Tax Act, there was a “tax benefit” and an “avoidance transaction” in this case. The dispute was whether Company C had abused the tax treaty, warranting the application of GAAR.

The CRA argued that the purpose and intent of the treaty were to prevent or reduce double taxation on activities that could be taxed in both countries. They claimed that Company C had no substantial economic connection to Luxembourg and lacked a genuine business purpose there. Since Luxembourg did not tax the gains, granting Company C the treaty benefits would undermine Canada’s tax treaty network, benefiting only Luxembourg investors. Therefore, the CRA argued that Company C had abused the Canada-Luxembourg Tax Treaty.

The Tax Court of Canada determined that the focus of GAAR analysis should be on the specific provisions of the treaty, not its general purpose. The exception clause in the treaty aimed to exempt Luxembourg residents from Canadian tax when investing in real property used for business purposes. Thus, GAAR did not apply.

The Federal Court of Appeal agreed, stating that the principles of Articles 1, 4, and 13(4) of the treaty are that if a person (including a legal entity) is considered a resident of Luxembourg under the treaty, and the shares’ value is derived primarily from real property used for business (excluding rental property) in Canada, the gains from those shares are exempt from tax. Company C’s actions did not constitute treaty abuse, and GAAR did not apply.

III.Final Ruling

The Supreme Court of Canada dismissed the CRA’s appeal against the Federal Court of Appeal’s ruling. The Supreme Court based its decision on a two-step analysis to determine whether Company C’s actions constituted treaty abuse: first, considering the purpose and intent of the Canada-Luxembourg Tax Treaty provisions, and second, determining whether the transaction violated those principles.

The Supreme Court concluded that the purpose and intent of Articles 1 and 4 of the treaty are centered on residency status for treaty application. As long as a resident, according to Canadian or Luxembourg law, is fully liable for tax due to their residency, they are entitled to treaty benefits. The treaty does not require Luxembourg residents to have significant economic ties to Canada. The purpose of Articles 13(4) and 13(5) is to promote international investment by exempting residents of one country from tax on gains from selling business property or shares primarily valued from such property in the other country. Since Company C was a resident of Luxembourg and the shares in Company B were transferred accordingly, there was no treaty abuse. Applying GAAR to deny treaty benefits would undermine the certainty and predictability that the treaty aims to provide.

IV. Insights for International Businesses

Conduct Thorough Tax Policy Research: When engaging in similar transactions, companies should research Canadian tax law and the Canada-Luxembourg Tax Treaty, especially when significant appreciation of Canadian assets is expected or when planning to transfer shares in a Canadian subsidiary. Understanding exception provisions helps clarify cross-border tax obligations and potential application of international tax rules. In this case, the court ruled there was no treaty abuse, and GAAR did not apply, so the source country should not tax the gains.

Stay Updated on Tax Treaty Developments: Companies should stay informed about changes in host country tax treaties and their interpretations, including initiatives like the OECD-led BEPS (Base Erosion and Profit Shifting) and the “Two-Pillar” solutions. Even though the principal purpose test (PPT) was not part of all tax treaties at the time of this case, cross-border investors should consider various countries’ stances on treaty shopping and treaty abuse when establishing special purpose vehicles (SPVs).

Understand Dispute Resolution Channels: Companies should familiarize themselves with the legal procedures for resolving tax disputes in the host country and use available legal tools to protect their interests. Besides domestic legal remedies, companies should also understand the mutual agreement procedures available in tax treaties between China and the host country.