Canada tax: New tax treaty with U.S. may have unintended consequences for certain management fees
Beginning 1 January 2010, benefits under the Canada-U.S. tax treaty will be denied to U.S. residents receiving certain payments from a wholly owned Canadian unlimited liability company (ULC). This will be the case under new article IV(7)(b) of the treaty where the Canadian ULC is considered to be "fiscally transparent" or "disregarded" under U.S. tax law. ULCs are treated as corporations for Canadian tax purposes. This new provision applies if the U.S. tax treatment of the payment is not the same as it would be if the ULC was not disregarded for U.S. tax purposes. The provision may have wide-ranging implications, including unexpected consequences for cross-border management fees.
For example, assume a U.S. resident corporation wholly owns a Canadian ULC that is treated as a disregarded entity for U.S. tax purposes. The ULC makes various payments to its parent corporation. Because the payments are disregarded for U.S. tax purposes, article IV(7)(b) would apply such that the payments would not be considered to be income derived by a resident of the U.S. for purposes of the Canada-U.S. treaty. Therefore, if the payments were included in a category of income that is subject to withholding tax under Canadian domestic law, such as dividends, interest, royalties and certain management fees, no treaty relief would be available and the payments would be subject to the Canadian domestic withholding tax at a rate of 25%.
Most of the discussion of this provision has focused on its application to certain financing structures in which interest is paid by a ULC to its shareholder. The interest is deductible for Canadian tax purposes, but the interest income is disregarded for U.S. tax purposes. Such structures are believed to be the intended target of the provision. The provision also applies to nondeductible payments, such as dividends, although this result is widely considered not to have been intended.
Although less widely discussed, the provision also may apply to certain service fees paid by a ULC. Canadian domestic law imposes a withholding tax on a "management or administration fee or charge". This tax is rarely imposed because Canada's treaties usually provide an exemption from Canadian tax for business profits earned by the nonresident. However, where such payments are made by a ULC after 2009, no treaty relief would be available. The fees may be exempt from tax under domestic law, however, if they represent a reimbursement of specific expenses incurred by the nonresident for the performance of services that were for the benefit of the ULC.
Several methods can be used to determine the value of the services being rendered. The method chosen by the taxpayer could have an effect on the Canada Revenue Agency's analysis and, thus, the risk of the application of withholding taxes to the fees charged. The method to value management services that is most closely linked to a reimbursement for specific expenses, such as the "allocation of direct/indirect cost" method, may carry the least risk, whereas the comparable uncontrolled price method may attract the most risk as it carries no direct link to specific expenses.
Given the possible withholding tax consequences that may arise from new article IV(7)(b) of the treaty, businesses that receive payments from a ULC for management or administrative services should carefully consider this risk.