Dutch company subject to Canadian income tax under central management and control test, court rules

By Kabir Jamal, Goodmans LLP, Toronto

A Netherlands-incorporated company whose sole director was resident in the Netherlands was nevertheless resident in Canada for income tax purposes because the company’s central management and control was exercised by its two Canadian-resident shareholders, Canada’s Tax Court ruled on July 24.

As such, the Court, in Landbouwbedrijf Backx B.V. v. The Queen (2018 TCC 142), concluded that the company was subject to Canadian income tax on its capital gains.

The case is a useful reminder that, subject to any applicable treaty rules on tax residency, foreign-incorporated companies seeking to avoid Canadian income taxation on their worldwide income should ensure that all significant management decisions are made outside of Canada.

In 1997, a Netherlands couple (the Backxes) incorporated a Dutch BV to facilitate the sale of a dairy farm located in the Netherlands. The Backxes were the BV’s only directors and shareholders.

Prior to their immigration to Canada in May 1998, the Backxes resigned as directors of the BV and the wife’s sister, who remained at all relevant times a resident of the Netherlands, was appointed as the BV’s sole director.

Following their immigration to Canada, the Backxes purchased an existing dairy farm in Ontario, Canada through a Dutch partnership, in which they held directly a 51% interest and the BV held directly the remaining 49% interest. In November 2009, to reduce the BV’s exposure to Dutch taxation, the Backxes incorporated an Ontario corporation, Backx Dairy Farms Limited (Backx Canada), and the BV sold its 49% interest in the partnership to Backx Canada for Cdn$4,500,000, resulting in a Cdn$1,740,000 capital gain. 

Under Part I of the Income Tax Act (Canada) (ITA), Canadian residents are liable to tax on their worldwide income. By contrast, non-residents are liable to tax on their “taxable income earned in Canada”, which includes a taxable capital gain from the disposition of a partnership interest, if at any time in the past 5 years more than 50% of the fair market value of the partnership interest was derived from real or immovable property situated in Canada, and provided that any income or gain from the disposition of the partnership interest is not exempt from Part I tax under an applicable tax treaty.

The BV took the position in its 2009 tax return that it was not resident in Canada and the capital gain that it had realized on the disposition of its 49% interest in the partnership was exempt from Canadian tax by virtue of Article 13(4)(b) of the Canada-Netherlands Tax Treaty, as being a gain was from the disposition of an interest in a partnership the value of which was derived principally from property (the farm assets) in which the business of the partnership was carried on.

At trial, the Crown took the position that the BV was resident in Canada and therefore liable to tax on its worldwide income (including the capital gain from the disposition of the 49% interest in the partnership) and, in the alternative, if the BV was found not to be resident in Canada, then the BV was liable for Canadian branch tax on the gain on the basis that such gain constituted earnings attributable to a permanent establishment in Canada.

Canada’s central management and control test

On the primary issue of tax residency, the Court found that the BV was resident in Canada for purposes of the ITA by virtue of being centrally managed and controlled in Canada.

The Court began by noting that central management and control is usually found to reside in the board of directors, even if the directors are under significant influence from shareholders or others, but that if significant management decisions are taken by persons other than the directors, the jurisdiction in which those persons reside or make such decisions may determine the tax residency of the company.

The Court also commented that, when seeking to rebut the presumption that de jure directors exercise primary responsibility for management and control of a company, “cogent evidence” is required to establish that the other persons have “effective” or “independent” management and control. 

The Court found on the facts that the Backxes, and not the wife’s sister, exercised effective management and control of the BV, stating that “it was the Backxes who assumed effective and independent control of the Appellant [the BV]. In most if not all instances, Ms. Van Gorp [the sister] was not even copied with the correspondence. This quite clearly suggests that she was a mere nominee who carried out clerical and administrative functions on behalf of the Backxes.”

The Court also noted the following factors in concluding that central management and control of the BV was located in Canada:

• The sister had no experience in farming and no prior business experience;
• The sister accepted the title of director to assist the Backxes with their tax planning, and received nominal remuneration;
• The sister had no responsibilities beyond administrative tasks which were generally implemented in accordance with instructions from the Backxes;
• The Backxes participated in the 1998 decision to have the BV invest in the partnership, but the sister did not; and
• The Backxes participated in the 2009 decision to dispose of the 49% partnership interest, and the sister only got involved after the plan had already been formed in order to to provide the appropriate corporate authorizations for the purchase agreement.

The Court also found that the tie-breaker rule in the Canada-Netherlands tax treaty had no direct bearing on the appeal. Even if the BV was found to be a resident of both Canada and the Netherlands, pursuant to Article 4(3), the BV would not be entitled to the benefits of Article 13 until the competent authorities of the two countries broke the tie.

Finally, having found that the BV was resident in Canada for the purposes of the ITA, the Court concluded that the Crown’s alternative argument relating to Canadian branch tax was not applicable.

Conclusion

This decision confirms the importance of where a foreign-incorporated company’s central management and control is exercised in determining the company’s tax residency under the ITA.

Companies incorporated outside of Canada hoping to avoid the harsh gaze of the Canadian income tax authorities are well advised to be mindful of who in fact exercises effective management and control of the company and the jurisdictions in which such decisions are made, and should ensure that the location of board meetings and other significant management decision-making processes is appropriately documented.

–Kabir Jamal is an associate in the Tax Group at Goodmans LLP, Toronto, and can be reached by email or at 416.597.5161. Kabir has experience in a wide variety of domestic and international taxation matters, including mergers & acquisitions, corporate reorganizations, corporate finance, tax litigation and dispute resolution as well as trusts and estates.