The Canada Revenue Agency (“CRA”), on February 11, 2010, issued a Technical Memorandum on the application by Canada of the look-through rule in Article IV(6) of the Canada-U.S. Income Tax Convention (the “Treaty”) to U.S. limited liability companies (LLCs) and their members.1
Canada has traditionally taken the position that a U.S. LLC is a corporation for purposes of its domestic tax laws and has denied treaty benefits to U.S. LLCs on the basis that they are not liable to tax at the entity level.2
The Fifth Protocol to the Treaty contained a provision which was intended to provide relief for members, beneficiaries and partners of fiscally transparent entities including U.S. LLCs with effect from February 1, 2009.
The look-through rule in Article IV(6) of the Treaty does notchange the manner in which Canada views U.S. LLCs. Canada still regards the U.S. LLC as the taxpayer entity. It and not its members must file the requisite returns with Canada and claim any Treaty relief available to its members. Treaty relief afforded to payments to the U.S. LLC will be based on whether Article IV(6) will apply. It provides that:
An amount of income, profit or gain shall be considered to be derived by a person who is a resident of [the U.S.] where
(a) the person is considered under U.S. tax laws to have derived the amount through an entity (other than an entity resident in Canada); and
(b) by reason of the entity being treated as fiscally transparent under U.S. tax laws, the treatment of the amount for U.S. tax purposes is the same as its treatment would be if the amount had been derived directly by the person.
In Income Tax Technical News, No. 41 issued on December 23, 2009, the CRA published an example which provided evidence as to how it intended to apply this rule. See Figure 1.
Click here to see Figure 1.
U.S. LLC is a partnership for U.S. tax purposes. Canco is a regular non-hybrid Canadian corporation. It pays a dividend to U.S. LLC. Article IV(6) in conjunction with Articles X(1) and (2) (Dividends) and Article XXI of the Treaty will result in Canada levying a 6.5% rate of Canadian non-resident withholding tax on the dividend paid to U.S. LLC by Canco.
However, that is not the end to the story. On January 1, 2010, the anti-hybrid rules added by the Fifth Protocol which deny treaty benefits in respect of amounts of income, profit or gain received from or through certain hybrid or reverse hybrid entities in two broadly defined sets of circumstances came into effect. In some cases, these rules may strip away the benefits provided by Article IV(6).
The Anti-Hybrid Rules
Specifically, Article IV(7) of the Treaty, which contains the anti-hybrid rules, denies treaty benefits by providing that a U.S. person will not be considered to derive an amount of income, profit or gain where:
- the U.S. person is considered under the tax laws of Canada to have derived the amount through an entity (other than an entity resident in the U.S.), but by reason of the entity not being treated as fiscally transparent under the laws of the U.S., the treatment of the amount for U.S. tax purposes is not the same as its treatment would have been if the amount had been derived directly by that person (the “Source Hybrid Rule”).
- the U.S. person is considered under the tax laws of Canada to have received the amount from an entity that is a resident of Canada, but by reason of the entity being treated as fiscally transparent under the laws of the U.S., the treatment of the amount for U.S. tax purposes is not the same as its treatment would have been if the entity were not treated as fiscally transparent in the U.S. (the “Recipient Hybrid Rule”).
The Recipient Hybrid Rule will affect basic Canadian unlimited liability company (“ULC”) investment structures generally used by a U.S. resident to invest into Canada, as well as commonly employed hybrid financing arrangements in which a U.S. resident contributes capital and lends funds to its Canadian ULC subsidiary which is a partner in a Canadian partnership.
Among the criticisms raised regarding the anti-hybrid rules is the fact that they do not distinguish between deductible payments such as interest and royalties and non-deductible payments such as dividends from previously taxed earnings. In fact, the rules appear to discriminate against the latter type of non-deductible payments. The CRA has taken a unilateral step in a recent advance income tax ruling to attempt, in certain limited circumstances, to redress this balance.3
In that ruling, the CRA considered a fact situation in which Mr. X, a resident of the U.S. for purposes of the Treaty, owned all of the issued and outstanding shares of a U.S. S corporation (“S Corp”) which was treated as fiscally transparent for U.S. income tax purposes and otherwise qualified for treaty benefits under the limitation on benefits provision in the Treaty. S Corp was a member of a limited partnership (“LP”) organized under the laws of a foreign jurisdiction which did not carry on business in Canada. Other individual investors resident in the U.S. for purposes of the Treaty beneficially owned interests in the LP. LP was treated as fiscally transparent for U.S. tax purposes and was not a U.S. resident for purposes of the Treaty. LP owned all of the issued and outstanding shares of a Canadian unlimited liability company (“ULC”) which was treated as fiscally transparent for U.S. tax purposes.
Under the proposed transactions described in the ruling, during its 2010 taxation year, ULC proposed to increase the paid-up capital in respect of its shares held by LP by an amount equal to the amount of cash it intended to distribute to LP. Subsequently (and as a separate transaction), ULC proposed to reduce its paid-up capital by the same amount, and distribute cash equal to the amount of the paid-up capital reduction to LP as a return of paidup capital on its shares. These transactions would take the place of the payment of a cash dividend to LP.
At the time of the paid-up capital increase, ULC would be deemed for Canadian tax purposes to pay a dividend to LP equal to the amount of the increase. That dividend would be subject to Canadian non-resident withholding tax. The subsequent paid-up capital reduction would not be subject to Canadian non-resident withholding tax. The ruling assumes that for U.S. tax purposes, no amount of income, profit or gain would arise or be recognized as a result of the paid-up capital increase, regardless of whether ULC was or was not fiscally transparent. The ruling also assumes that the paid-up capital increase would not affect the U.S. tax treatment of any subsequent distribution on the ULC shares, including the return of paid-up capital carried out as the final step of the proposed transactions.
The ruling states that, based on the specific circumstances, the anti-hybrid rules would not apply to treat the deemed dividend as not having been paid to or derived by the members of LP. It is also of note that the ruling provides comfort that the Canadian general anti-avoidance rule (“GAAR”) would not apply in such circumstances to redetermine the tax consequences of the proposed transactions. The ruling also confirms that the dividend deemed to be received by LP for Canadian tax purposes on the paid-up capital increase would be a dividend derived by its members in proportion to their respective shares of the income of LP for the purposes of determining entitlement to the reduced withholding tax rates under Article X (Dividends) of the Treaty.
At the 2009 CRA Roundtable held during the Canadian Tax Foundation Annual Conference on November 24, 2009, the CRA was asked to comment on this type of arrangement in the context of a basic fact situation in which a U.S. company (“USCo”) owns a Canadian hybrid ULC that carries on business in Canada. The CRA confirmed that as long as the deemed dividend on the paid-up capital reduction would be disregarded for U.S. tax purposes (regardless of whether or not ULC was treated as fiscally transparent), then the anti-hybrid rules would not apply. The CRA also commented that while the application of the GAAR would depend on the facts and circumstances of a particular situation, it would not normally expect the GAAR to apply if the ULC is used by USCo to carry on an active business in Canada and USCo and the ULC enter into the arrangement in order to continue to qualify for the 5% reduced rate of dividend withholding tax under the Treaty on the distribution of ULC’s after-tax earnings to USCo.
U.S. Limited Liability Companies
Two recent CRA positions put the type of planning described above, as well as other circumstances in which a payment is deemed to be made to a U.S. resident for Canadian tax purposes, at risk, however, where a U.S. LLC is the shareholder of the Canadian entity in respect of which the deemed payment arises. The first is a Technical Interpretation issued on December 15, 20094 and the second is the Technical Memorandum described above.5
The first of these documents addressed what appeared on its face to be a relatively innocuous question. Company A, resident in Canada and a regular non-hybrid corporation, had borrowed funds from Company B, a U.S. LLC not resident in Canada and fiscally transparent under U.S. tax laws. Interest was deducted by Company A but not actually paid to Company B. At the end of the second year following the first year in which interest was deducted, it was proposed that Company B would transfer the right to receive interest to Company C, a newly formed corporation eligible for benefits under the Treaty. In the third year following the first year in which interest was deducted by Company A, it was entitled to elect for Canadian tax purposes to avoid including interest previously deducted in its income. The election is a joint election made by a debtor and its creditor. The question asked was which of Company B or Company C should file the election with Company A. The CRA answered, not surprisingly, that Company B, the original lender, was the appropriate entity to file the election with Company A.
The CRA’s further comments in respect of Article IV(6) are, however, of more interest. The CRA states that the purpose of Article IV(6) of the Treaty is to extend treaty benefits to a U.S. LLC to the extent that interest is derived by a person entitled to treaty benefits in respect of an item of income. In the fact pattern considered, the election would have triggered a notional interest payment to U.S. LLC prior to the effective date of the lookthrough provision. Therefore, Canadian non-resident withholding tax would not have been reduced to the Treaty rate. Nothing is mentioned in regard to whether payments deemed made to a U.S. LLC after the effective date of the look-through provision would be considered to be derived by the U.S. LLC’s members.
The second document responds to this question. It addresses whether a fiscally transparent entity for U.S. tax purposes such as a U.S. LLC is eligible to claim benefits for its members under Article X or XI of the Treaty in respect of Canadian source dividends or interest in circumstances where the amount of income, profit or gain for Canadian tax purposes is disregarded under U.S. tax law or where the treatment of the amount for U.S. tax purposes is different than its treatment for Canadian tax purposes. The CRA had originally suggested that after February 1, 2009 and before 2010 (prior to the introduction of the anti-hybrid rules), a U.S. LLC would be able to claim treaty benefits for such dividends or interest from a Canadian hybrid ULC under Article IV(6).
The new document reverses this position. To illustrate, it uses the example of U.S. LLC which, in 2009, holds the shares of a Canadian hybrid ULC. U.S. LLC is fiscally transparent for U.S. tax purposes. ULC is a is disregarded entity under U.S. tax laws. In the example an amount of interest or dividends characterized as such for Canadian tax purposes is regarded as paid by the ULC to the U.S. LLC. For U.S. tax purposes, no amount characterized as interest or dividend would, however, be recognized in the hands of the members of the U.S. LLC. The members would instead include their share of the ULC’s earnings in the computation of their U.S. taxable income. In these circumstances, the CRA will not regard the payment of interest or dividends as derived by the members of the U.S. LLC for purposes of Article IV(6) of the Treaty. As a concession, due to the uncertainty surrounding the application of Article IV(6), the CRA will not apply its position for such payments made during 2009. It will not, however, accept claims made by a U.S. LLC after 2009 for treaty benefits where amounts of interest or dividends which are considered to arise under Canadian tax laws are disregarded for U.S. tax purposes.
The CRA has also looked at amounts treated differently under U.S. tax laws when compared with a Canadian characterization. The illustration provided assumes Company A, a regular non-hybrid Canadian corporation, is owned by U.S. LLC, a fiscally transparent single owner entity for U.S. tax purposes. Company A redeems shares held by U.S. LLC. The redemption results in a deemed dividend for Canadian tax purposes. The CRA will consider for purposes of Article IV(6) that the deemed dividend is derived by a U.S. resident member of the U.S. LLC even though the amount may be treated for U.S. tax purposes as proceeds of disposition or a return of capital. Similar treatment will be afforded to cash dividends paid by Company A even though under U.S. tax laws the amounts may be treated partly as dividends and partly as return of capital.
What does this new position mean for U.S. LLCs receiving payments or notional deemed amounts from Canadian corporations after 2009? Certain of these payments will be denied treaty benefits by reason of Article IV(7)(b) of the Treaty. But what of payments not caught by the anti-hybrid rules? The CRA ruling discussed above permits a Canadian hybrid ULC to pay dividend equivalents to a U.S. regular corporation or an S Corp otherwise entitled to treaty benefits. However, if the recipient is a U.S. LLC, the deemed dividend on increase of the ULC’s capital is disregarded for U.S. tax purposes. Therefore, the amount will not be considered derived by the U.S. LLC’s members. Article IV(6) will not apply to the deemed dividend which will be taxed at the 25% domestic Canadian non-resident withholding tax rate to the U.S. LLC. A similar result would appear to apply where a non-hybrid Canadian corporation and a U.S. LLC elect to have interest previously deducted by the corporation deemed to be paid even in circumstances where the anti-hybrid rules would not otherwise apply. Again, no item of income is recognized for U.S. tax purposes with the result that Article IV(6) will not apply to provide the look-through treatment. Other payments deemed to arise for Canadian tax purposes but not recognised for U.S. tax purposes will also come within the ambit of the new position. Therefore, it is essential that any planning involving Canadian subsidiaries, where the shareholding entity is a U.S. LLC, be carefully scrutinized to ensure that Treaty benefits are not, due to oversight, disallowed to the U.S. LLC and its members.