Canada and Alta Energy tax dispute: treaty shopping or valuation under restructuring

By Dr. J. Harold McClure, New York City

The Supreme Court of Canada on November 26 upheld a taxpayer-favorable February 12, 2020, ruling by the Federal Court in The Queen v. Alta Energy Luxembourg S.A.R.L.,2020 FCA 43. While the legal issue revolves around charges of treaty shopping brought by the Canadian Revenue Agency (CRA), the appropriate valuation of an enterprise at the time of restructuring could have been an alternative argument by the CRA.

Factual background

Alta Energy Partners is a US multinational that acquires and develops shale oil and natural gas properties. On June 13, 2011, it created Alta Energy Partners Canada Ltd. as its Canadian affiliate to carry out operations in Canada.

A restructuring of the Canadian operations was undertaken in 2012. As part of the restructuring, Alta Energy Luxembourg S.A.R.L. was incorporated and its shares were issued to a new Canadian partnership. The Luxembourg affiliate purchased the shares of the Canadian operations.

This Luxembourg affiliate was sold to Chevron for 680 million Canadian dollars (CAD) on August 1, 2013. Since its tax basis at the time was CAD 300 million, a CAD 380 million capital gain was reported to the Luxembourg tax authorities. This multinational did not report any portion of this capital gain as part of its Canadian taxable income for 2013.

The Federal Court decision noted the Canadian operations carried on shale oil business in the Duvernay shale oil formation situated in Northern Alberta. Alta Energy acquired various petroleum and natural gas licenses during the period from 2011 to 2013. During 2012 and 2013, the Canadian operations drilled four vertical wells and two horizontal wells. Five of these six wells were drilled after the Luxembourg affiliate acquired the shares of the original Canadian affiliate. The Federal Court decision stated:

At some point in 2011, the persons who indirectly owned the shares of Alta Canada were informed that the structure that had been adopted was not an ideal structure from a tax perspective because the exploration work was being done on properties in Canada. By late 2011, it was expected that the value of Alta Canada could increase substantially in the next few years. A restructuring was undertaken in 2012. As part of the restructuring, Alta Luxembourg was formed under the laws of Luxembourg and the shares of Alta Canada were transferred to it. The parties recognized that this transfer of shares was a taxable transaction. However, the Canada Revenue Agency agreed that the fair market value of the shares of Alta Canada at that time was equal to the adjusted cost base of these shares. Therefore, no capital gain was realized on the transfer of the shares of Alta Canada to Alta Luxembourg.

The Tax Court noted that the representatives of this multinational expected the market value of the Canadian operations would increase from CAD 300 million to CAD 400 million by 2013, stating:

the sale of the Shares from Alta USA to Alta Luxembourg gave rise to a taxable capital gain. Fortunately, for the Co-Investors, the CRA accepted that the fair market and the adjusted cost base of the Shares were equal at that time. If this had not been the case, US and Foreign Investors in Blackstone Capital Partners would have incurred Canadian tax in connection with that sale.

The fact that the CRA accepted the premise that the market value of the Canadian operations was only CAD 300 million at the time of the reorganization allowed this Canadian affiliate to report no capital gains in its 2012 tax return. The sale of the business in 2013 for CAD 680 million meant that a CAD 380 million capital gain would be recognized, with the issue being whether this was Canadian income or income taxable in Luxembourg.

Legal and valuation issues

The taxpayer asserted that the capital gain from the time of the reorganization to the time of the sales was exempt from Canadian taxation under the Canada-Luxembourg tax treaty. The CRA asserted that this treaty did not apply and that the transactions were abusive such that the general anti-avoidance rule applied. The Tax Court agreed with the taxpayer’s position.

The Federal Court of Appeals was asked to address whether the general anti-avoidance rule applied despite the way the treaty was structured. For a transaction to be abusive, the CRA must identify the relevant provision’s rationale and how the transactions abused that rationale. The key issue is whether the capital gain realized by a Luxembourg resident derived their value principally from immovable property in Canada unless the entity’s business is carried on in that property. The Federal Court of Appeals agreed with the taxpayer’s position.

The majority of the Supreme Court also agreed with the taxpayer’s position, although three justices filed a dissenting opinion. Six of the nine justices confirmed that Alta Luxembourg, as a resident in Luxembourg for purposes of the treaty, was entitled to the benefit of the exemption absent a specific anti-abuse provision within the terms of the treaty. These justices found that there was no such anti-abuse provision within the terms of the treaty. Three justices dissented on the grounds that this tax planning was tax avoidance due to the lack of economic connection with Luxembourg.

The economic question is: what was the value of the Canadian operations at the time of the 2012 reorganization? The favorable rulings by the Tax Court, the Federal Court of Appeals, and the Supreme Court held that any increase in enterprise value from the time of the 2012 reorganization to the August 1, 2013, sale represents Luxembourg income and not Canadian income. The CRA may have made a strategic mistake by accepting the premise that the fair market value of these operations in 2012 was simply the historical costs incurred in acquiring and developing the properties owned by the Canadian affiliate at the time of the transaction as the court proceedings noted the possibility of an increased value of operations as early as late 2011.

Publicly traded shale companies such as EOG Resources were experiencing rising market valuations as the world price of oil was approaching $100 a barrel. The market value of any oil company can be seen as its economic rent defined as the difference between expected future oil prices and the cost of production. Determining the market value depends also on the expected amount of oil that can reasonably be extracted given the enterprise’s oil-producing assets.

While it is reasonable to believe that the market value of Canadian operations rose from the time of the reorganization and August 1, 2013, it is also reasonable to believe that a reliable estimate of the enterprise’s value at the time of reorganization was greater than CAD 300 million. Had the CRA conducted a reliable evaluation of the market value of the Canadian operations at the time of the 2012 reorganization, part of the CAD 380 million in capital gains could have been deemed Canadian income even under the provisions of the Luxembourg treaty.