The limits of sovereign immunity: a study and analysis of the Canadian income taxation of sovereign wealth funds.

• Author: Podolny, Michael

1. INTRODUCTION II. DEFINING SOVEREIGN WEALTH FUNDS i. The Question of Pension Funds III. CURRENT CANADIAN TAX TREATMENT OF SWFS i. What Could be Taxed? IV. CURRENT TAX TREATMENT IN U.S. AND OECD PRONOUNCEMENTS i. The United States ii. Integral Part vs. Controlled Entity iii. What Could be Taxed iv. OECD V. TAX TREATIES i. Why are Treaties Important? VI. POLICIES UNDERLYING CURRENT RULES i. Comity and the Doctrine of Sovereign Immunity ii. Reciprocity iii. Economics VII. POPULAR CRITIQUES AND CALLS FOR REFORM i. Removing Tax Exemptions ii. Maintaining the Status Quo VIII. EVALUATION AND RECOMMENDATIONS i. Equity ii. Neutrality iii. Administrative Efficiency iv. International Competitiveness v. Recommendations IX. CONCLUSION I. INTRODUCTION

   As news of deep government deficits occupies major headlines in North America, it becomes easy to forget that not all public entities are deep in debt and in dire need of financing. In fact, several countries around the world are flush with excess cash and continuously seek out profitable investment opportunities. Be it due to the desire for diversification, political influence, or profit Sovereign Wealth Funds (SWFs) have become the investment tool of choice for several cash-rich governments. Although, due to the obvious lack of transparency associated with foreign government financial dealings, exact figures are difficult to compute, estimates have placed the global amount of assets under management by SWFs between $2 trillion and $3.7 trillion at the end of 2007. (1) Naturally, today some of the largest SWFs are controlled by governments of 'developing' nations in Asia, Middle East and South America, while their investments reside in the more stable 'developed' economies of North America and Europe. Canada, much like the United States, thus finds itself in the interesting position of providing an attractive investment environment for SWFs. (2) Canada now faces the burden of configuring an effective taxation scheme--one which addresses direct investment in private assets by foreign government-owned investment vehicles.

   While a variety of difficult issues confront tax policy makers with regards to multi-national corporations, their complexity is compounded by the additional considerations of interjurisdictional immunity and comity which accompany dealings with foreign governments. Although guidelines for the management and operation of SFWs, the Santiago Principles, have been compiled through international cooperation, no equivalent principles have yet come to fruition regarding the appropriate taxation of these investment vehicles. (3) Instead, as the situation stands right now, each country has adopted a unique method of confronting the taxation of foreign government investments. Consequently, under the domestic laws of most developed countries, including Canada and the United States, SWFs enjoy preferential tax treatment over private multinationals with regard to certain investments. (4) Furthermore, tax treaties between nations may address the taxation of public entities and, accordingly, allow for a different set of perks to be enjoyed by SWFs. (5) As a result of such a complex mosaic of tax laws found in each country, few are able to effectively navigate and decipher the relevant tax rules and their underlying policy considerations regarding SWFs.

   This paper therefore aims to inform professionals and lawmakers, and fill a void in the current academic literature, by summarizing, critically assessing and making recommendations regarding the future of the Canadian taxation regime for Sovereign Wealth Funds.

   SWFs are introduced and defined in Part II. Their current treatment under Canadian tax law is described in Part III. Part IV surveys the equivalent tax rules pertaining to SWFs in the United States of America and the relevant pronouncements by the Organisation for Economic Co-operation and Development (OECD). The application of international tax treaties is covered in Part V. Following this survey of Canadian and international tax law, specific attention is given to tax exemptions enjoyed by SWFs on dividend income from arm's length equity holdings. The public policies underlying these exemptions and their major academic critiques are covered in Parts VI and VII, respectively. Lastly, the unique rules pertaining to SWFs are evaluated on their ability to meet the objectives of international tax policy in Part VIII. The section concludes with three recommendations concerning the future of SWF tax exemptions in Canada.

2. DEFINING SOVEREIGN WEALTH FUNDS

   Before delving into the unique characteristics of SWFs, one must accurately define the term. Ultimately, classifying a foreign investment vehicle as a Sovereign Wealth Fund will fall on Canada Revenue Agency, the Department of Finance and the federal courts that interpret tax provisions. Unfortunately, Canadian courts have not faced such a task to date and thus international sources must be surveyed for clues as to the nature of these investors.

   Surprisingly, finding a single, agreed-upon definition proves to be a difficult exercise. The United States Treasury Department has defined an SWF as "a government investment vehicle which is funded by foreign exchange assets, and which manages those assets separately from the official reserves of the monetary authorities." (6) The aim of this definition is to separate the investment activities of these vehicles from those of the federal reserve, central bank or any other official public entity that exercised monetary policy. Although this definition sheds light on the nature of investments undertaken by these funds, it does not provide much detail into the level of government ownership and control the entity must possess before acquiring the label of an SWF.

   The International Working Group of Sovereign Wealth Funds (IWG), through the 2008 Santiago Principles, adds more clarity on this topic. Among the "key elements" of the definition, the Appendix to the Santiago Principles states that "SWFs are owned by the general government, which includes both central government and subnational governments." (7) Similarly, the OECD, in its proposed changes to the commentary of the 2010 OECD Model Tax Convention (OECD Tax Convention), believes that SWFs would be covered by a definition that includes "a 'statutory body' or an 'agency or instrumentality' of a state, a political subdivision or local authority." (8) In proposed paragraph 8.5 of the commentary on Article 4 of the OECD Tax Convention, it is recognized that SWFs are "special purpose investment funds or arrangements created by a State or a political subdivision for macroeconomic purposes." (9) It is perhaps this pronouncement that is most telling of the nature of these funds. They are state-owned but are not necessarily considered to be a direct part of the sovereign government.

   Sovereign Wealth Funds often identify themselves as such. Examples of commonly accepted sovereign wealth funds include the Kuwait Investment Authority, the Abu Dhabi Investment Authority, the Qatar Investment Authority etc. (10) Canada has its own SWFs, with the Alberta Heritage Savings Trust Fund serving as the Canadian representative of the IWG. (11)

   A few common characteristics of SWFs may be extracted from the abovementioned sources. Firstly, SWFs are 'owned' by a public entity. It may be reasonable to infer that this would mean ownership or control of at least 51 per cent of the fund. Secondly, SWFs are financed, or created, through public funds. The US treasury identifies two broad sources of financing for the funds as commodity export revenue and "non-commodity" sources such as the transfer of assets from official foreign exchange reserves. (12) It is not clear just what proportion of the assets should come from public financing. In one of its working papers on SWFs and Pension Funds, the OECD identifies that at the very least, the assets of the SWF should be guaranteed by the government in order to be considered 'publicly sponsored.' (13) Lastly, SWFs do not carry out or implement the monetary policy of the state. That is, while the treasury of any state may buy foreign currency or debt, these official arms of the government are never considered to fall within the classification of a SWF.

   i. The Question of Pension Funds

   As becomes obvious from the abovementioned common characteristics of SWFs, government-sponsored pension plans may fall within the same category--they are operated and financed by the government and their investment activity is not implementing monetary policy. Nonetheless, it seems that pension funds differ from SWFs. After describing SWFs in broad terms, IWG's Santiago Principles proclaim that their definition "excludes, inter alia, foreign currency reserve assets held by monetary authorities for the traditional balance of payments or monetary policy purposes, operations of state-owned enterprises in the traditional sense, government-employee pension funds, or assets managed for the benefit of individuals." (14) Thus, pension funds are not sovereign wealth funds although they may be subjected to similar tax treatment in many jurisdictions. In fact, the OECD specifically identifies the Canada Pension Plan (CPP) as one such reserve fund that should not be classified as an SWF. (15) It is stated that the CPP is not subject to a government guarantee and is independently managed. It relies on legislative authority to mandate personal contributions but the funds contained within it are not "government-owned" or "publicly sponsored" per se.

3. CURRENT CANADIAN TAX TREATMENT OF SWFS

   Canada does not have much jurisprudence on the topic of SWF taxation. (16) It seems that the starting point of any analysis in Canada is found within Information Circular 77-16R4. (17) Section 50 declares that "the Government of Canada may grant exemption from tax on certain Canadian-source investment income paid or credited to the government or...