TAX NEWS - DECEMber 2009
Canada Tax: CRA provides guidance on structures involving hybrid entities
The CRA statements will be of critical importance to U.S. taxpayers owning Canadian unlimited liability companies (ULCs) or holding their Canadian investments through U.S. limited liability companies (LLCs). In certain cases, it will be necessary to take action before the Protocol is fully effective in 2010 or at least before the first cross-border payment of the new year.
Background
The Protocol contains two measures to address the use of hybrid entities: one relieving and one restrictive.
New article IV(6) of the treaty is intended to provide treaty benefits to owners of entities that are treated as fiscally transparent in the residence state, such as certain U.S. LLCs. Previously, no treaty benefits were available for Canadian-source income earned by such LLCs, since Canada views the LLC as a corporation and the members of the LLC, and not the LLC itself, are subject to tax in the U.S. Article IV(6) deems the U.S. resident owner of the fiscally transparent entity to have derived an amount of income, profit or gain for purposes of the treaty in circumstances where the treatment of the amount under U.S. tax law is the same as its treatment would be if the amount had been derived directly by that person.
While this provision is intended to be relieving, and is already in effect, its application to LLCs is still problematic (as discussed below) and care should be taken if a LLC is to be used to earn Canadian-source income.
In a restrictive measure, the Protocol will deny treaty benefits in two circumstances as from 1 January 2010. Treaty article IV(7)(a), in the inbound to Canada context, generally denies treaty benefits to a U.S. resident who is considered under Canadian tax law to have derived an amount of income, profit or gain through an entity that is not a resident of the U.S. if the entity is not considered to be fiscally transparent under the laws of the U.S. and the U.S. tax treatment of the amount is not the same as it would be if the entity were fiscally transparent. The typical example of this is a Canadian partnership that is treated as a "reverse hybrid" or Canadian corporation for U.S. tax purposes. Amounts subject to withholding that are paid to the partnership will be subject to a 25% Canadian withholding tax as from 2010 and no treaty benefits will apply in respect of Canadian-source business income or capital gains earned by the partnership. The CRA technical interpretation includes examples of the application of article IV(7)(a), but these are straightforward.
Article IV(7)(b) is more controversial and has given rise to the most interpretive issues. In the inbound context, it generally denies treaty benefits to a U.S. resident that is considered under the tax law of Canada to have received an amount of income, profit or gain from a resident of Canada if the entity is considered to be fiscally transparent under the laws of the U.S. and the U.S. tax treatment of the amount is not the same as it would be if the entity were not fiscally transparent. The typical example of this is a payment of dividends, interest, royalties or management fees (in some cases) made by a Canadian ULC to its U.S. resident owner. Such payments will also become subject to a 25% Canadian withholding tax. The owner of the ULC may also be denied treaty benefits in respect of the redemption or other purchase of the shares of the ULC by the ULC itself according to the CRA technical interpretation.
General comments on meaning of "same" treatment
There has been considerable uncertainty about the criteria to apply in determining whether the tax treatment of an amount would be the "same" in various circumstances for purposes of these new rules. In particular, whether or not an entity is fiscally transparent can change the geographic source of income and, thus, the eligibility of the recipient for foreign tax credits. In a welcome development, the CRA has now stated that the geographic source of the income is not generally a relevant criterion. The key criteria are character (as dividends or interest, for example), timing and quantum.
Payment of interest by Canadian ULCs
The most interesting of the CRA comments relate to the application of paragraph 7(b) of treaty article IV to certain structures. It is clear that the paragraph applies to deny treaty benefits to payments of interest from a wholly-owned ULC to its U.S. parent company since the payment is considered to be disregarded for U.S. tax purposes and, therefore, the U.S. tax treatment is not the same as it would be if the ULC was not treated as fiscally transparent. However, the CRA has determined that the U.S. tax treatment will be considered to be the same in the following circumstances:
1. The ULC has more than one owner and is, thus, considered to be a partnership for U.S. tax purposes. The fact that the interest expense of the ULC is also deductible by its owners for U.S. tax purposes is considered to be irrelevant in determining whether or not paragraph 7(b) applies.
2. The ULC makes a payment of interest to a U.S. company that is related to its U.S. parent, such as a grandparent or sister company. The fact that the recipient is part of a U.S. consolidated group including the owner of the ULC, such that the interest income and expense eliminate on consolidation, is also irrelevant.
At the May 2009 International Fiscal Association Seminar, CRA officials appeared reluctant to accept that paragraph 7(b) would not apply to these two scenarios. Although they have now accepted that the provision will not apply, their comments at the CTF Conference and in their subsequent technical interpretation indicate that the application of the general anti-avoidance rule (GAAR) also must be considered. At the CTF Conference, CRA officials stated:
- "It is not possible to make any categorical statements regarding the application of GAAR to the restructuring of cross-border interest payments."
- "The GAAR may apply if the ULC is part of a financing arrangement that results in, among other things, duplicated interest deductions or an internally generated interest deduction in one country without offsetting interest income in the other country."
These statements raise a number of questions on which further guidance would be helpful. For example, the position that a deductible interest payment made by a ULC, that is a partnership and fiscally transparent for U.S. tax purposes, is not subject to paragraph 7(b) may be inconsistent with the example in the technical explanation to the Protocol involving a Canadian company that receives payments (distributions, interest or dividends) from a USLP of which it is the (an) owner.
Although the CRA's GAAR caveat around "a financing arrangement that results in, among other things, duplicated interest deductions or an internally generated interest deduction" does not seem unreasonable, there is no express indication of purpose to that effect in the treaty or the technical explanation and to our knowledge no such statement has been made by the Department of Finance. It is also interesting to reconcile such a policy with recent developments in Canadian tax policy in the context of outbound taxation, particularly the repeal of section 18.2 of the Income Tax Act. This leaves taxpayers and their advisors in the challenging position of having to deal with tax policy that is apparently quite nuanced and largely unstated.
Payment of dividends by Canadian ULCs
The application of paragraph 7(b) of treaty article IV to the payment of nondeductible amounts, such as dividends, is widely considered to be unintended. However, it is clear that the payment of a dividend by a ULC to its U.S. parent will be subject to a 25% withholding tax as from 2010 (whether or not the ULC has more than one owner) and examples of this are contained in the technical explanation.
At the CTF Conference, the CRA described two alternative methods to avoid the 25% withholding tax:
1. The ULC would capitalize its retained earnings, resulting in a deemed dividend for Canadian tax purposes under section 84 of the Income Tax Act. The ULC would subsequently return capital, which is not subject to Canadian withholding tax under domestic law. Since the deemed dividend would be treated the same for U.S. tax purposes (i.e. ignored) whether or not the ULC was fiscally transparent, paragraph 7(b) should not apply and the dividend should be eligible for the lower treaty rate of withholding. A ruling on this transaction is known to have been issued but has not yet been published.
2. The ownership of the ULC would be transferred to a holding company in a country, such as Luxembourg. The Luxembourg entity would be a disregarded entity for U.S. tax purposes. Provided the holding company meets the residence and beneficial ownership requirements of the Canada-Luxembourg tax treaty, the provisions of that treaty should apply to the dividend.
With respect to the GAAR, the CRA made the following comment with respect to these two alternatives, notwithstanding the text of the treaty and the example in the technical explanation indicating that paragraph 7(b) applies to dividends paid by a ULC to its owner or owners: "The application of GAAR would depend on all the facts and circumstances. However, we would not normally expect GAAR to apply if the ULC is Used by USCo to carry on an active branch operation in Canada and USCo and the ULC enter into the above-noted arrangement so as to continue to qualify for the 5% withholding tax on the distribution of ULC's after-tax earnings to USCo." It is unclear from this statement whether or not the CRA would seek to apply the GAAR to these transactions if the ULC is a holding company.
It is also unclear whether or not alternative 1 is available if the shareholder of the ULC is a fiscally transparent LLC, since article IV(6) of the treaty may or may not apply to the earning of "deemed" income when the income is not recognized under U.S. tax law. (This issue is discussed further below.)
In its technical interpretation, the CRA stated that paragraph 7(b) could apply to a deemed dividend arising under section 212.1 of the Income Tax Act in circumstances where the shares of one ULC are transferred to another ULC for shares of the transferee. It is unclear why the application of paragraph 7(b) to this situation should differ from the situation described in alternative 1 above. Therefore, caution is recommended with respect to any transaction that differs in any material respect from the facts described by the CRA.
Canadian-source income of U.S. LLCs
Paragraph 6 of treaty article IV, as well as amendments to treaty article X, were intended to address the lack of treaty benefits to LLCs on Canadian-source income, profit and gains. Recent comments of the CRA indicate that paragraph 6 may not operate as expected. In certain cases, owners of LLCs may still be disadvantaged relative to owners of interests in a partnership or an S-corporation.
The technical interpretation contains a number of examples of Canadian-source income or gains earned by a LLC that is owned by a U.S. corporation or corporations. The CRA states that paragraph 6 should apply in respect of dividends, interest and royalties paid by a Canadian corporation to the U.S. LLC. Therefore, the members of the LLC should be considered to have derived the income and be eligible for the appropriate treaty rate in respect thereof. Similarly, the technical interpretation states that if the LLC disposes of the shares of the Canadian company, the members may claim treaty benefits under article XIII of the treaty, thus potentially eliminating any tax owed by the LLC in respect of the capital gain under Canadian domestic law.
On the other hand, the CRA has also stated that the LLC will continue to be viewed as a corporation and as the relevant taxpayer, and this has implications in certain circumstances. At the CTF Conference, officials described the application of the treaty in circumstances where a LLC is carrying on business in Canada. In the example, the LLC has four owners: a U.S. corporation, a U.S. resident individual, a Bermuda resident corporation and a U.S. tax-exempt entity. Since paragraph 6 deems the members of the LLC to have derived the LLC's income for purposes of the treaty, one might have expected the members of the LLC to be considered to be carrying on the business directly and to be taxed in Canada on their share of the income as they would be if the LLC was a partnership. A U.S. resident individual would pay tax at individual tax rates but would not be subject to branch tax. Instead, the CRA maintains that the LLC will pay corporate tax and branch tax on its income regardless of the nature of its shareholders. However, the branch tax will be reduced to the 5% treaty rate in respect of the portion of its income allocable to its U.S. corporate shareholder. The income allocable to the U.S. resident individual and the foreign corporation will be subject to a 25% branch tax. The income allocable to the tax-exempt entity will be exempt from branch tax. (This position seems questionable since the treaty provides no relief from the taxation of business profits earned by a tax-exempt entity in the other state (see article XXI, paragraph 4 of the treaty). On the other hand, insofar as the branch tax is a proxy for the nonresident withholding tax applicable to dividends, this is the correct result, but one that is difficult to reconcile with the treatment of the portion of branch tax considered allocable to the U.S. resident individual.) Note that in the case of individual shareholders, had they structured their investment into Canada through an S corporation, the branch tax payable by the S corporation would be limited to 5%.
The application of paragraph 6 is also uncertain in circumstances where an item of income exists under Canadian rules but not for U.S. tax purposes. In a 1 June 2009 technical interpretation, the CRA stated that a dividend paid from a ULC, Canco, to a U.S. S corporation, USco, would not be considered to be derived by the owners of the S corporation under paragraph 6 since "in light of Canco's fiscal transparency… for United States income tax purposes, the shareholder will not be considered to have derived a dividend (i.e., an amount of income) through USco." It was noted that the S corporation would be entitled to treaty benefits in its own right, in respect of a dividend received before 2009. As from 2010, paragraph 7(b) would apply to the dividend. However, at the CTF Conference, the CRA stated with no discussion of this issue that, given the effective dates of paragraph 6 and paragraph 7(b), "an amount paid or credited to a U.S. LLC by a Canadian ULC prior to January 1, 2010 and after January 31, 2009 would be eligible for treaty-reduced rates to the extent that the amount is considered, by Article IV(6), to be derived by a resident of the U.S. who is a "qualifying person" as that term is defined in Article XXIX-A(2) of the Treaty."
Conclusion
While the CRA comments are helpful, many interpretive issues remain where Canadian-source income is earned through or from a hybrid entity. In particular, the scope of paragraph 7(b) of treaty article IV has narrowed, but the policy surrounding that provision and the application of the GAAR to structures that are not within its scope is perhaps even less clear than previously.
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