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29 August 2018

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Canadian Tax Court Holds Gains on Shares Deriving Value from Oil and Gas Rights are Exempt under Tax Treaty with Luxembourg

The Tax Court of Canada issued a judgment on 22 August 2018 concerning whether gains from the transfer of shares deriving value from oil and natural gas rights situated in Canada are exempt under the Canada-Luxembourg tax treaty. The case involved Alta Energy Luxembourg S.a.r.l. (Alta Energy), which sold the shares of its wholly-owned subsidiary, Alta Energy Partners Ltd. (Alta Canada), to Chevron in 2013.

Alta Canada principally derived value from licenses and leases held in nearly 68,000 acres of the Duvernay shale formation in northwestern Alberta. Under the tax treaty, Article 13 (Capital Gains) provides that gains from the alienation of shares deriving value principally from immovable property situated in a Contracting State may be taxed in that Contracting State, although an exemption applies in respect of immovable property in which a company carries on its business (excluded property).

In its return for the sale, Alta Energy claimed that it qualified for the exemption, which the Canadian tax authority did not accept. The tax authority held that licenses and leases could not qualify for the exemption because they were a working interest that had, for the most part, been set aside for future drilling or extraction activities. Further, the tax authority put forward an alternative argument that if the working interest qualified for the treaty exemption, then Canada's general anti-avoidance rule should apply because the ownership structure of Alta Energy was put in place to obtain the treaty benefit (Alta Energy was put in place as the holding company for Alta Canada two years prior to the sale).

In its judgment, the Tax Court found in favor of Alta Energy. In coming to its decision, the court noted an earlier position paper of the Canada Revenue Agency from 1991, which included that "oil and gas reserves, mines, and royalty interests are excluded property if the owner is actively engaged in the exploitation of natural resources and if such assets are actively exploited or kept for future exploitation by such owner". The Court also took the view that the intent of the treaty negotiators was to treat resource property as excluded property when such property is developed in accordance with the industry's best practices and that the negotiators would not have intended that the exemption only applies where the reserve is fully exploited on a strict license-by-license basis. As such, the working interest is to be considered excluded property under the treaty.

With respect to the application of the GAAR, the Court found that the rationale underlying the exclusion in the treaty is to exempt residents of Luxembourg from Canadian taxation where there is an investment in immovable property used in a business and that the significant investment of Alta Energy met that rationale. Therefore, the Court concluded that the GAAR does not apply, and the claim for exemption is to be allowed.

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