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1 August 2018

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Canadian Tax Court Holds Capital Gain of Dutch Incorporated Company is Taxable in Canada Based on Effective Management and Control

The Tax Court of Canada recently issued a judgment concerning whether a Dutch incorporated company with Canadian shareholders is considered resident in Canada and, therefore, subject to tax on its capital gains. The case involved a Dutch company, Landbouwbedrijf Backx B.V., which was incorporated in 1997 by two individual shareholders/directors (the Backxes) that owned and operated a dairy farm in the Netherlands.

In 1998, the Backxes sold the bulk of the Netherlands farm to a third party and immigrated to Canada. Prior to immigrating, the Backxes resigned as directors of the Dutch company (remained shareholders), with a relative resident in the Netherlands taking up the director role. After immigrating, the Backxes purchased a Dairy farm in Ontario, which was 51% owned by the Backxes and 49% owned by the Dutch company.

In 2009, the Backxes formed a new company under the laws of Ontario, Backx Dairy Farms Limited (Backx Limited), and transferred their interest in the farm to the new company. Shortly after, the Dutch company disposed of its interest in the farm to Backx Limited for proceeds of CAD 4.5 million, which resulted in a capital gain of approximately CAD 1.7 million.

After the transaction closed, Backx Limited disclosed the transaction, claiming that it was protected under the Canada-Netherlands tax treaty and that the gain was not subject to tax. However, the Canadian tax authority determined that the Dutch company was actually resident in Canada for tax purposes and, as a result, the transaction was not treaty-protected, and the gain was subject to tax.

In its judgment, Tax Court found in favor of the tax authority. In coming to its decision, the Court first looked at where the Dutch company was managed and controlled. The Court found that there was no evidence the director in the Netherlands had effective or independent management and control of the company, but rather it was the Backxes, as de jure directors, that managed and controlled the company.

The Court then looked at the provisions of the treaty regarding residence, noting that Article 4 (Resident) of the treaty includes that residence may be determined based on the place of effective management. Having concluded that effective management and control of the Dutch company was located in Canada, the Court then looked at Article 13 (Capital Gains), finding that the applicable provision is Article 13(7), which provides that gains from the alienation of any property other than that referred to in paragraphs 13(1) to (4) shall be taxable only in the State of which the alienator is a resident. As such, Canada is authorized to tax the Dutch company's capital gain.

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