On April 8, 2010, the Tax Court of Canada held that a U.S. limited liability company (LLC) was “liable to tax” in, and therefore a resident of, the United States for purposes of the Canada-United States Income Tax Convention (the Treaty). The case overturns the long-established position of the Canada Revenue Agency (CRA) that LLCs that are fiscally transparent for U.S. tax purposes cannot be U.S. residents for purposes of the Treaty, a position that had greater relevance prior to the Fifth Protocol to the Treaty (which did not apply to the taxation years at issue).
In TD Securities (USA) LLC v. The Queen, the Court concluded that TD Securities (USA) LLC (TD LLC) was a U.S. resident since the United States retained and exercised jurisdiction to tax the worldwide income of TD LLC on a comprehensive basis, notwithstanding that such taxation occurred only at the level of its U.S. resident member.
TD LLC was originally formed as a U.S. corporation, and converted into a Delaware limited liability company, a form of business organization that is recognized as a distinct legal entity separate from its members under Delaware law. For U.S. federal income tax purposes, TD LLC was generally disregarded as an entity (i.e., it did not make an election to be treated as a taxable entity). As a disregarded entity, all of TD LLC’s income (which included income from Canadian branch operations) was included in computing the income of Holdings II, a U.S. corporation that was the sole member of TD LLC and whose income was in turn included in the consolidated return of TD USA, a U.S. corporation that was the sole shareholder of Holdings II.
From a Canadian tax perspective, TD LLC was considered a corporation and was subject to Canadian branch profits tax on its income from the portion of its business that was carried on in Canada. For the 2005 and 2006 taxation years, the CRA assessed TD LLC for branch tax at the statutory rate of 25%, denying TD LLC the Treaty-reduced rate of 5% based on the CRA’s long held position that a fiscally transparent LLC is not a resident of the United States for purposes of the Treaty.
Article IV(1) of the Treaty defines a U.S. resident as any person that, under the laws of the United States, is “liable to tax therein by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature.” During the relevant taxation years, the Treaty did not expressly address or restrict the entitlement to relief with respect to income derived through a fiscally transparent entity.
The Crown argued that Article IV(1) of the Treaty is clear and unambiguous. Since TD LLC was treated as a disregarded entity for U.S. tax purposes, it was not “liable to tax” in the United States on its own account and therefore was not a U.S. resident for Treaty purposes. The Crown further argued that, even if TD LLC was considered to be liable to tax in the U.S. by virtue of its income being taxed in the hands of Holdings II, such liability to tax was not “by reason of...[TD LLC’s] domicile, residence, place of management, citizenship, place of incorporation or any other criterion of a similar nature” as required by Article IV(1) of the Treaty. Finally, the Crown maintained that a judgment in TD LLC’s favour could render redundant or meaningless the Fifth Protocol amendments relating to hybrid entities.
TD LLC argued that Article IV(1) must be interpreted by reference to Canadian law, and that the determination of whether a person is “liable to tax” in the United States for purposes of the Treaty differs from the determination of whether a person is itself subject to tax on its income in the United States. TD LLC’s position, in particular, was that Treaty benefits should apply because TD LLC was “liable to tax” in the United States to the extent that the United States retained and exercised jurisdiction to tax the worldwide income of TD LLC. Moreover such income had in fact been subject to tax in the United States.
As an alternative, TD LLC argued that Treaty benefits applied because the worldwide income (including the Canadian branch income) derived through TD LLC was taxed in the United States in the hands of Holdings II, which clearly was a Treaty resident. It maintained that benefits under the Treaty should apply in respect of the income derived through TD LLC by a U.S. resident, consistent with the ‘look-through’ approach endorsed by the Organisation for Economic Co-operation and Development (the “OECD”) and generally adopted by Canada and the United States with respect to income derived through other fiscally transparent entities.
Tax Court Decision
The Tax Court of Canada found that during the taxation years in issue the United States retained its jurisdiction to tax TD LLC on a comprehensive basis. The fact that the United States exercised such jurisdiction by taxing that income in the hands of Holdings II did not lead to the conclusion that TD LLC was not liable to tax or that benefits under the Treaty were therefore unavailable.
The Court observed that the Canadian and U.S. tax authorities had previously interpreted Article IV(1) of the Treaty liberally and pragmatically when considering whether treaty benefits should be available to entities that are not required to pay tax under the relevant domestic law. In this regard, it was noted that past Treaty amendments specifying that tax-exempts and governmental entities were “resident” for Treaty purposes were effected as “clarifications” rather than changes in law, and did not require Canadian and U.S. tax authorities to change their practice of granting Treaty benefits to such entities.
The Court also noted other situations in which the Canadian tax authorities had administratively interpreted the Treaty in a liberal manner to make benefits available where doing so was consistent with the spirit of the Treaty, such as with respect to S Corporations (which are generally fiscally transparent for U.S. federal income tax purposes) and partnerships. The “sole anomaly” in this respect was Canada’s treatment of LLCs. In light of the “overwhelming consistency” of this approach, the Court held that it was not intended that an entity whose income was comprehensively taxed in the other contracting state would be denied the benefit of a treaty simply because its income was taxed by the other country at the level of its shareholders, members or partners.
In this vein, the Court noted that the Technical Explanation to the Fifth Protocol demonstrated a similar willingness on the part of the tax authorities to overcome certain technical deficiencies in the wording of the Treaty to deal with residence in “a workable manner to achieve a result consistent with its purpose and context”.
By analogy, the Court applied the approach adopted by the OECD in the 1999 OECD report entitled The Application of the OECD Model Tax Convention to Partnerships (the “OECD Partnership Report”) and in the commentaries to the OECD Model Treaty. The Court noted that neither Canada nor the United States had expressed a reservation or observation in respect of the OECD Partnership Report or related commentary to the OECD Model Treaty. The OECD Partnership Report had considered the case where a source state’s tax laws treat a foreign partnership as a taxable entity but the partnership is fiscally transparent under the tax laws of the partners’ residence country. The OECD’s position was that treaty benefits should apply to the income of the partnership based on the fact that the partners are liable to tax in respect of such income. The Court said that a similar conclusion in principle should apply to a fiscally transparent LLC.
The Court applied the above considerations as part of the context and purpose of the residence provision in the Treaty to decide the case in favour of TD LLC. Given that the Canadian source income of TD LLC had been fully taxed in the United States, the Court concluded that the context, object and purpose of the Treaty would not be achieved (and indeed would be frustrated) if such income did not enjoy the benefits of the Treaty. Therefore, the Court specifically held that TD LLC was entitled to Treaty benefits as a U.S. resident in its own right. The Court reasoned that TD LLC was a U.S. resident as it was “liable to tax” in the United States on the basis that its income was fully and comprehensively taxed in the hands of its sole member, Holdings II. The Court moreover held that such a basis for liability to tax is, as is required by Article IV(1) of the Treaty, “by reason of...[a] criterion of a similar nature” to the enumerated grounds in that Article.
In reaching its conclusions, the Court reiterated (as it has in other cases involving treaty interpretation) that the proper approach to interpreting a treaty is to follow the interpretive approach taken by other OECD countries, the OECD Model Treaty and related commentaries. In the Court’s view, this requires, in the case of determining the residence of a hybrid entity, that the source state (Canada in this case) read the text of Article IV(1) in the context of the relevant treaty as a whole, in the context of the object and purpose of the treaty, and in the context of how (if at all) the residence state chooses to fully and comprehensively impose tax under its domestic tax legislation, on the income of the hybrid entity. The Court noted that, in such circumstances, although Canada has the right to select the manner in which it taxes income in its domestic tax legislation, when applying the Treaty, Canada must consider, as part of the context, the manner in which the United States has imposed its domestic tax laws on that income (including at the level of the entity or its members). Thus, the Court agreed with TD LLC that the availability of Treaty benefits should not turn on whether TD LLC made a particular election under U.S. domestic tax law, particularly where such election would not have had any material effect on the extent to which the U.S. taxed its worldwide income.
The Court went on to address the Crown’s concerns that a ruling in TD LLC’s favour might allow LLCs in the future to choose between claiming Treaty benefits based on the reasoning in the case or the rules relating to hybrid entities introduced by the Fifth Protocol. Consistent with its textual, contextual and purposive approach to interpreting the Treaty for the 2005 and 2006 taxation years, the Court stated that the revised Treaty, including the Fifth Protocol amendments thereto, would be both part of the text and context to be considered when applying the Treaty in future cases. The Court moreover indicated that the factual context of interpreting the Treaty may have been different in a situation that involved an abuse, or where the income of the LLC had not been liable to tax in the United States in the hands of its parent.
This decision is important in that it overturns the long-standing position of the CRA that a fiscally transparent LLC cannot in any circumstance be a U.S. resident and access benefits under the Treaty. It also reaffirms the importance of interpreting the text of tax treaty provisions in light of their context and purpose. In particular, in interpreting the residence provisions of a tax treaty, the judgment is an example of what the Court refers to as “interpreting and applying the chosen language of the treaty to deal with residence in a workable manner to achieve a result consistent with its purpose and context”.
The Crown has until May 10, 2010 to appeal the decision of the Tax Court to the Federal Court of Appeal.