Société Générale Valeurs Mobilières, 2017 FCA 3: Brazil treaty tax sparing credit is limited by Canadian tax on net income

2017 FCA 3 · Federal Court of Appeal

Author: Sas Tullo

Canada’s 1984 tax treaty with Brazil contains a “tax sparing” rule: a Canadian resident earning certain Brazilian income is treated as having paid Brazilian tax even where Brazil, to attract investment, did not actually collect it, and Canada must give a foreign tax credit for that notional tax. The question in this case was how big that credit can be. The bank argued for a credit measured by Canadian tax on the gross Brazilian bond interest; the Crown said the cap is the Canadian tax actually attributable to the net income after the costs of earning it. The Tax Court sided with the Crown on a preliminary question of law, and in a short judgment from the bench the Federal Court of Appeal agreed. For anyone relying on tax sparing provisions in older treaties, the case fixes the arithmetic.

Facts

In the course of a Tax Court appeal by Société Générale, the Crown sought a determination of questions of law under subsection 58(1) of the Tax Court of Canada Rules (General Procedure), and the matter was set down with the appellant’s consent (para 1). The questions were argued on agreed hypothetical facts: a Canadian resident earns bond interest arising in Brazil that Brazil may tax under Article XI of the Convention between Canada and Brazil (1984); the taxpayer also earns income from other sources taxable in Canada; and Article XXII(3) deems the taxpayer to have paid Brazilian tax equal to 20 percent of the gross bond interest (para 7). Paris J. answered the questions in the Crown’s favour (paras 2 and 8).

Issues

Whether the amount of Canadian income tax described in the second sentence of Article XXII(2) of the treaty as “appropriate to the income which may be taxed in Brazil” is the Canadian tax on the gross interest deemed taxed in Brazil, or the actual Canadian tax on the net income from Brazil, and, in the latter case, what test determines the amounts included in and deducted from that gross income (paras 4-5).

Holding

The appeal was dismissed with costs in both courts (para 15). The credit limit in Article XXII(2) is the actual Canadian income tax attributable to the income taxed in Brazil, computed on the net income arising from Brazil, and the amounts to be included and deducted are determined under subsection 4(1) of the Income Tax Act (paras 8 and 10).

The court’s reasoning

The Court began with the mechanism. The tax sparing provision requires Canada to limit its tax on certain Brazilian-source income so that Canadian taxpayers benefit from Brazil’s incentives; it does so by requiring a foreign tax credit “as if Brazilian tax were imposed even if the income was not taxed in Brazil” (para 3). The operative limit is the second sentence of Article XXII(2): the deduction “shall not, however, exceed that part of the income tax as computed before the deduction is given, which is appropriate to the income which may be taxed in Brazil” (para 6).

Société Générale’s position was that the Tax Court erred in limiting the credit to actual Canadian tax on net bond interest, and that the relevant amount is the gross interest multiplied by the Canadian tax rate. The Court characterised this as a question of law reviewable for correctness, citing Housen v. Nikolaisen, 2002 SCC 33 (para 9). It held that Paris J. had correctly determined the questions and adopted his reasons (para 10).

Two submissions were addressed directly. The first was that the Tax Court’s interpretation was inconsistent with the clear language of the provision. The Court disagreed: the ordinary meaning of the text “takes into account not only the gross income which may be taxed by Brazil, but also the actual Canadian tax as computed under the Income Tax Act, which is based on net income” (para 12), and that interpretation was the one most consistent with the text, context and purpose of the provision (para 13). The second was that, had the drafters intended a net-income limit, they would have used the language found in many other Canadian treaties. The Court acknowledged that the Brazil treaty’s wording may differ from other treaties but held that this difference “is not a reason in and of itself to give the provision a different interpretation” (para 14).

Practical implications

The decision settles the computation of the tax sparing credit under the Brazil treaty and, by its reasoning, under any treaty whose credit article caps relief at the Canadian tax “appropriate to” the foreign-source income. The cap is the Canadian tax actually payable on that income, determined by attributing income and deductions to the Brazilian source under subsection 4(1) of the Act, rather than a notional figure obtained by applying the Canadian rate to gross receipts. For leveraged bond holdings, where interest expense and other costs are substantial, the difference can eliminate most of the benefit that a gross-income computation would have produced.

The judgment also illustrates two procedural points. A subsection 58(1) determination on agreed hypothetical facts can resolve a treaty interpretation question before trial, and the Court of Appeal treated the exercise as a pure question of law reviewed for correctness. And because the Court simply adopted the Tax Court’s reasons, the fuller analysis of Article XXII(2), including the role of the deemed-tax rule in Article XXII(3), is found in 2016 TCC 131, which should be read with this judgment. In my view the Court’s refusal to draw an inference from differences in wording across Canada’s treaty network (para 14) is the point of wider application: divergent drafting across treaties is not, without more, evidence that a different meaning was intended. Whether an application for leave to appeal to the Supreme Court of Canada was made is not verified here.

For advisers, the immediate lesson is arithmetic: when a treaty credits foreign tax that was never paid, the credit is still bounded by the Canadian tax that would actually be payable on the net foreign income, and the allocation of expenses to that income under subsection 4(1) will determine how much of the sparing benefit survives. The decision is short, but it removes an argument that had real money behind it for financial institutions holding Brazilian debt.

This comment is general information, not legal advice. The law may have changed since the decision; check the current text in the tax wiki.

Citation and links

Société Générale Valeurs Mobilières Inc. v. Her Majesty the Queen, 2017 FCA 3, reasons for judgment of the Court delivered from the bench at Toronto on 10 January 2017 by Woods J.A. (Pelletier and Stratas JJ.A. concurring), docket A-189-16. Reasons on the court’s site. Also on CanLII. Appeal from the determination of questions of law by Paris J. of the Tax Court of Canada, Société Générale Valeurs Mobilières Inc. v. The Queen, 2016 TCC 131, docket 2013-4035(IT)G.