Tax Bulletin – Alta Energy: Industry Best Practices and the Impact on Treaty Interpretation
On August 22, 2018, the Tax Court of Canada released its decision in the Alta Energy case. This case concerns an appeal from a taxpayer resident in Luxembourg who claimed an exemption from Canadian income tax under Article 13(5) of the Canada-Luxembourg Income Tax Convention 1999 (the "Treaty"). The court decided in favour of the taxpayer and held that the capital gain arising from the sale of shares of a wholly-owned Canadian resource company by a Luxembourg S.A.R.L. was not taxable in Canada. The court also found that the General Anti-Avoidance Rule ("GAAR") did not apply to the transaction. This decision signals a tax planning opportunity to reduce the tax burden on the disposition of shares of Canadian resource companies held by Luxembourg residents under certain circumstances.
Background of case
In June 2011, Alta Energy Partners, LLC ("Alta USA"), a Delaware limited liability corporation, incorporated a Canadian Subsidiary ("Alta Canada") to develop the Duvernay shale property in northwestern Alberta. In April 2012, Alta USA underwent a restructuring and transferred the shares in Alta Canada (the "Shares") to Alta Energy Luxembourg S.A.R.L ("Luxco"). As of March 28, 2013, Alta Canada held leases and licences in 67,891 net acres in the Duvernay shale property (the "Property"). However, between 2012 and 2013, Alta Canada only drilled six wells on the Property. In September 2013, Luxco sold 100% of the Shares to Chevron Canada Ltd. resulting in a capital gain of over $380 million. Luxco argued that the gain was exempt from tax under the Treaty pursuant to Article 13(5). The Minister contended that the gain was not exempt from Canadian tax and that Article 13(4) of the Treaty applied.
The Treaty and the definition of "Immovable Property"
Article 13(4) of the Treaty states that Canada reserves the right to tax gains if they are derived by a resident of Luxembourg from the sale of shares in a company that derives its value principally from immovable property in Canada ("Immovable Property"). However, Immovable Property does not include property "in which the business of the corporation is carried on." In other words, an exemption exists to Article 13(4) whereby residents of Luxembourg will not be subject to Canadian tax if they dispose of shares in a company that derives its value from Immovable Property used to carry on the business of the company (the "Exemption").
Article 13(5) of the Treaty states that gains arising from the disposition of property will be taxed only in the country where the entity disposing of the shares is resident (i.e. Luxembourg in the Alta Energy case). However, Article 13(5) only applies when a capital gain is not otherwise taxable under Articles 13(1) to 13(4). Therefore, if an entity can claim the Exemption, it would be subject to Article 13(5) and any gain arising from the disposition of shares would be taxed in Luxembourg. Since Luxembourg does not tax capital gains arising from the disposition of shares of foreign corporations, the capital gain would be free of tax.
Generally, it appears that the Exemption test should be applied on an asset-by-asset basis. The Minister argued as much and took the position that each licence owned by Alta Canada should be considered separately to see if it qualified for the Exemption. Since Alta Canada only drilled six wells within certain licences on the Property, the Minister argued that the Exemption should not apply to the undeveloped part of the Property (i.e. the majority of the Property) as no "business" was carried on. However, the court disagreed and concluded that because the Exemption was meant to attract foreign investment, it is reasonable to assume that the Exemption was intended to apply to properties where resources were exploited "in accordance with the industry's best practices." The court found Alta Canada's cautious drilling technique to be reflective of the systematic and commercially prudent drilling practices commonly used in the industry. Specifically, the court held that it was the industry's best practice to determine the economic viability of a project before commencing full-scale production. The court also clarified that a resource corporation can claim the Exemption for an entire property even though qualifying business activities are only carried out on sections of that property. As a result, the court found the Exemption applied to Luxco's disposition of the Shares and that the gain should be taxed in Luxembourg in accordance with Article 13(5).
The Application of GAAR
The Minister also argued that GAAR should apply to this transaction, to deny the taxpayer the benefit of the Exemption. GAAR applies when three elements exist: a tax benefit, an avoidance transaction, and the avoidance transaction is considered abusive. While the court found there was a tax benefit, and that the restructuring qualified as an avoidance transaction, the court held that the transaction was not abusive. The Minister argued that the restructuring transaction abused the Treaty because the only purpose of the Treaty was to avoid double taxation, not to allow capital gains to escape taxation entirely. However, the court pointed out that if the sole purpose of the Treaty was to avoid double taxation, Canada could have insisted that Article 13(5) only apply in circumstances where the capital gain was otherwise taxable in Luxembourg. Since Canada did not choose this option, and Canada specifically chose to depart from the OECD Model Treaty provisions by including the Exemption in the Treaty, the court held that it was Canada's intention to give Luxembourg residents a more favourable tax treatment to encourage foreign investment. The court also concluded that the Minister could not use GAAR to rectify an "unintended gap in the Treaty" and that there is no limitation on benefits provision in the Treaty that would deny a holding corporation, resident in Luxembourg, access to treaty benefits because its shareholders are not themselves residents of Luxembourg.
As a result of these conclusions, the appeal was allowed and the matter was sent back to the Minister for reconsideration and reassessment in accordance with the court's reasons.
Future application of this case
Based on this decision, the Exemption will apply to the sale of the shares of a resource property that is exploited in accordance with industry best practices. While the term "industry best practices" is somewhat ambiguous, this decision indicates that the standard is meant to assess whether a property is developed in line with the commercial realities and generally accepted practices of a particular industry. Further, while this decision applies to the Canada-Luxembourg Treaty, the principles of considering the best practices of an industry when interpreting treaty provisions, and the limited application of GAAR to fill in unintended gaps in a treaty, could be applied to the interpretation of treaties in general.
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 Ibid at para 4
 Ibid at para 64
 The court noted that the OECD Model Treaty often serves as a baseline in Canadian treaty negotiations. The OECD Model Treaty does not carve-out immovable property in which the business of the company is carried on from the application of Article 13(4) (i.e. the Exemption).
 Ibid at para 91 and 98