From Israel to Canada: New Tax Treaty to Help Structure Investments
On December 21, 2016, the new Canada–Israel tax treaty entered into force. The new treaty was signed on September 21, 2016 in New York, and replaces the existing treaty that dates from 1975. For most purposes, the provisions of the new treaty took effect as of January 1, 2017.
Overall, the new treaty modernizes the rules applicable to Israeli investments into Canada. Consistent with developments in Canadian treaty policy over the last 40 years, the new treaty provides for several reductions and exemptions from Canadian withholding taxes for residents of Israel on income derived from Canadian sources. These changes should be extremely helpful in structuring investments from Israel into Canada, including acquisitions of operating businesses, investments in Canadian real estate, financings of Canadian businesses by Israeli lenders, and the licensing of intangible property into Canada.
WITHHOLDING TAX CHANGES
The changes to withholding taxes may be summarized as follows:
- The general rate of withholding tax on interest and royalties is reduced from 15 to 10 per cent (Canadian-source interest is generally exempt from withholding tax under domestic law when paid to an unrelated lender, so the reduction from 15 to 10 per cent will mainly affect situations involving related party loans. A separate provision reduces withholding tax on interest — other than participating interest — paid to an unrelated financial institution to five per cent; this change may facilitate loans by Canadian financial institutions to residents of Israel).
- The withholding tax rate for dividends paid to corporate shareholders holding directly at least 25 per cent of the capital of the company paying the dividends is reduced from 15 to five per cent (the general rate for portfolio investments remains at 15 per cent). The rate of Canadian branch tax is also reduced from 15 to five per cent for Israeli companies conducting branch operations in Canada.
- Royalties for the use of computer software, patents and know-how are now exempt from withholding tax as long as they are not paid under a rental or franchise agreement.
- Israeli based pension funds will now be exempt from withholding tax on dividends paid by a Canadian company in which they hold no more than 10 per cent of the capital or voting power.
- A governmental entity receiving dividends from a Canadian company will generally be exempt from withholding tax provided the governmental entity holds no more than 25 per cent of the capital or voting power of the Canadian company.
TAXATION OF CAPITAL GAINS
The new treaty’s provisions dealing with taxation of capital gains are generally similar to those in the 1975 treaty. In general, Canada will not tax a resident of Israel on sales of shares or equity interests in partnerships or trusts unless the shares or equity interests derive more than 50 per cent of their value, directly or indirectly from immovable property situated in Canada, either at the time of disposition, or at any time in the preceding 12 months. The 12-month trailing concept was not in the 1975 treaty, and indeed, is quite unusual for Canada’s treaties, although it is consistent with the approach taken to capital gains in the Organisation for Economic Co-operation and Development’s (OECD) recently-released multilateral instrument. The wording of the capital gains article in the new treaty also eliminates the argument, available under the 1975 treaty, that gains on shares of a holding company that holds another company that owns real estate in Canada would be exempt.
For individuals migrating from Canada to Israel, the new treaty contains some helpful provisions to avoid double taxation of gains that accrued while the individual was still a resident of Canada (these gains may be subject to a “departure tax” in Canada upon migration).
PRINCIPAL PURPOSE TESTS
The new treaty, like many recently signed Canadian treaties, includes a series of targeted principal purpose tests (PPTs). These rules operate to deny otherwise available treaty benefits with respect to specific sources of income if “one of the main purposes” of a relevant transaction was to obtain the benefits of the treaty. The new treaty includes PPTs in the articles providing benefits for dividends, interest, royalties, and quite unusually, capital gains. It is generally understood that these rules are aimed at treaty shopping, i.e., situations where an entity is established in a particular jurisdiction for purposes that include accessing treaty benefits that would not otherwise have been available to them.
There is, of course, a major ongoing project at the OECD, of which both Canada and Israel are members, to combat (among other things) so-called “treaty abuse”. In this regard, the OECD recently released a template multilateral instrument (MLI), which includes treaty shopping provisions, such as a more generally applicable PPT and a “limitation on benefits” provision. Depending upon the extent to which Canada and Israel choose to sign on to the MLI, and the extent to which they choose to adopt these provisions, the MLI provisions may effectively supplant the specific PPTs contained in the new treaty. However, as of this writing, the Canadian government has not made any announcement as to its position on the MLI. It is possible that an announcement may be included in the upcoming 2017 federal budget.
The new treaty contains an explicit rule, not common for Canada’s treaties, treating income earned through a fiscally transparent entity as income derived by a resident of a contracting state, but only to the extent it is so treated for purposes of taxation in that state. The new treaty also updates the “exchange of information” article, thereby facilitating exchanges of information between the two governments in a similar manner to the corresponding provisions in Canada’s treaties with other major trading partners. The time limit under which transfer pricing adjustments may be made has been increased from five years under the 1975 treaty to eight years, which is somewhat longer than the corresponding time limits in other Canadian treaties. However, competent authority agreements are to be implemented notwithstanding any time limits under the domestics of either Canada or Israel. Under the treaty, Canada and Israel specifically reserve the right to apply their domestic anti-avoidance rules (such as the Canadian general anti-avoidance rule) and thin capitalization rules.
Overall, the new treaty modernizes the applicable rules, and should assist in reducing impediments to investments between the countries.