Canada Tax: New Canada Revenue Agency (CRA) guidance on "same treatment" under treaty FTE provisions

The Canada Revenue Agency (CRA) has expressed its views on a number of important issues relating to the interpretation and application of the "same treatment" condition in the fiscally transparent entity (FTE) provisions in paragraphs IV(6) and (7) of the Canada-United States Income Tax Convention.

These views were expressed at the roundtable discussion at the Canadian Tax Foundation's Annual Conference on 24 November, and in an Internal Memorandum just released by the CRA. These statements set out very helpful guidance, including a number of structural examples, and will likely be well received by most taxpayers.

In general terms, the Memorandum confirms that the CRA will approach the "same treatment" issues in a similar manner to that applied by the US under the regulations relating to the application of section 894(c) of the Internal Revenue Code, as noted in the Technical Explanation to the Protocol that introduced the FTE provisions. Thus, the focus of the inquiry will be on comparing the timing, character and quantum of the relevant amounts, on the alternative assumptions specified in the FTE provision being applied.

The Memorandum also provides the CRA's views on a series of more specific questions in this regard, which may be summarized as follows:

Timing
- In general, timing will be considered the "same" if the recognition of the compared amounts falls into the same taxable year for US purposes.
- In addition, where the US taxpayer is deriving the amount through what is regarded as a partnership for US tax purposes, the timing will be considered the "same" even if the recognition of the compared amounts falls into different taxable years for US purposes by reason of a difference in the year-end dates of the taxpayer and the partnership, provided the partnership income is recognized in the taxpayer's year following the partnership's year.


Character
- Similarity of character will depend on comparing US treatment as to generic source, not geographical source.
- Similarity of character will not be present where there are two different, but equally taxable or non-taxable characterizations for US tax purposes.

For example:
     . The physical receipt of interest from a Canadian ULC by a US accrual-basis taxpayer would be disregarded if the ULC is disregarded, but regarded as a non-taxable receipt (since it had been previously accrued) if the ULC were not fiscally transparent.
     . A disregarded ULC receives and distributes dividends from a regarded Canadian corporation (i.e., "back-to-back dividends," Example 11 in the Memorandum). The fact that the US would consider the US taxpayer to have received dividends from the underlying regarded corporation would not assist in concluding that the "same treatment" condition is met with respect to the dividends paid by the ULC, since these are different amounts from a Canadian perspective.
- Similarity of character will not depend on differences in the identity of the payer resulting from fiscal transparency — for example, where a royalty paid by a ULC would be treated as having been paid by its US member if it were disregarded for US purposes, versus as having been paid by a Canadian corporation if it were not fiscally transparent (Example 12).


Quantum
- The quantum of an amount will not be considered different simply because of differences in the currency or exchange rates to be applied to translate the amount into US dollars for US tax purposes.
- The quantum of compared amounts will be determined on a gross basis, without regard to losses, deductions or credits that may be available under the US Code, including:
     . Deductions that may be available to members of entities (including two-member ULCs) treated as partnerships for US tax purposes (Example 8)
     . Deductions that may be available in the computation of the consolidated taxable income or losses of a group of corporations (Example 9)

The Memorandum also expresses the view that "same treatment" would be present in the context of amounts derived through an entity treated as a partnership for US purposes where the US taxpayer is allocated its share of the income of the partnership on a net basis, provided the relevant amount is accounted for, as such, by the partnership in making its computation of the allocated net income. On the other hand, the Memorandum notes that the attribution of an entity's income to a US taxpayer pursuant to the US CFC or PFIC rules would not assist in concluding that "same treatment" is present.

While these and other items of guidance in the Memorandum are very helpful, a careful consideration of the facts and analytical and avoidance considerations in each particular case will remain essential.

For example, on the analytical side, the Memorandum states that gains from the disposition of shares of a disregarded ULC by a US taxpayer to a third party will not be affected by the FTE provisions, on the basis that such gains should not be considered to be derived "through" or "from" the entity (Example 10). However, a different conclusion may apply with respect to gains arising from a redemption or repurchase of the shares, and in certain other cases.

Another pitfall that should be noted relates to the CRA's views on the application of Canadian branch taxes. The CRA indicated during the roundtable discussion that income derived through a fiscally transparent US LLC by US individuals or non-US persons would not benefit from any rate reduction under the treaty.

The Memorandum does not express any views with regard to the avoidance considerations that may be relevant in particular circumstances. However, the CRA indicated during the roundtable discussion that the general anti-avoidance provision would normally not be applicable by reason only that the taxpayer's arrangements were structured or restructured so as to avoid the application of the FTE provisions.

For example, the CRA noted that a two-step distribution by a ULC (step one being an increase to the ULC's paid-up capital (resulting in a deemed dividend under subsection 84(1) to which paragraph IV(7)(b) does not apply because the deemed dividend would be treated in the same manner for US purposes even if the ULC were not fiscally transparent — being as a "nothing"), followed by a distribution on a reduction of such capital, implemented instead of simply paying a one-step dividend) would normally not be challenged.

While this type of planning (and variations on that theme) may not be universally applicable, in the sense that it would not facilitate distributions to US LLCs (because no relief would arise under paragraph IV(6)), it does provide the advantages of practical simplicity and having been approved by the CRA in a ruling issued to Ernst & Young.

The CRA also indicated during the roundtable discussion that the interposition of a third-country entity to receive dividends from a ULC would normally be accepted (although they also expressed a cautionary caveat on the issue of determining whether the interposed entity would be regarded as the "beneficial owner" of the relevant amounts).

However, the CRA also expressed its view that the general anti-avoidance provision may be applied where the relevant arrangements result in, for example, a duplication of deductions, or in an internally generated deduction in one country without an inclusion in the other. Arguably, the use of the word "may" in this context is important, because even arrangements that might result in an internally generated deduction in one country without an inclusion in the other might be considered to be perfectly acceptable where so-called "double non-taxation" does not ultimately arise under the structure taken as a whole.

With this and certain other guidance, taxpayers and their advisers will be in a much better position to evaluate their options for structuring or restructuring their affairs in a manner that complies with the FTE provisions that take effect on 1 January 2010.