This Article was first published by the Canadian Tax Foundation in (2011) 19:2 Canadian Tax Highlights.
Because Article IV(7)(b) of the Canada-U.S. Tax Treaty (the “Treaty”) generally results in a loss of treaty benefits on interest payments from a ULC to its U.S. parent (“USCo”) where the ULC is fiscally transparent for U.S. tax purposes, the USCo will generally restructure its cross border debt in order to avoid that result. A recent ruling is a reminder that the tax consequences in the US of such restructurings may differ depending on the circumstances.
Prior to Article IV(7)(b) coming into force on January 1, 2010, a U.S. investment into Canada would typically be made through a ULC that was disregarded by the US where the ULC was funded by debt of USCo, the interest on which was deductible in Canada and ignored by the U.S. Canadian withholding tax on the interest was generally reduced under the Treaty. This changed under Article IV(7)(b). Interest from ULC to USCo no longer benefits from Treaty rates where the ULC is fiscally transparent in the U.S. and the treatment of the interest by the U.S. is not the same as it would have been if the ULC was not fiscally transparent. A payment is considered to meet the “same treatment” test only where the quantum and the character of the payment and the timing of its inclusion is the same as it would be if the ULC was not fiscally transparent. The U.S. treatment of the interest paid to USCo is different depending on whether ULC is fiscally transparent. If it is, the interest is ignored. If not, the interest is included in USCo’s income for U.S. tax purposes.
To avoid the denial of Treaty benefits under Article IV(7)(b), cross border debt has been restructured by USCo assigning or refinancing it with an US affiliate (“USFinco”) which is treated as a corporation by the U.S. and is a member of USCo’s consolidated tax group. Because the ULC’s interest payment to USFinco following the restructuring is included in USFinco’s income regardless of whether ULC is fiscally transparent, Article IV(7)(b) should not apply. This has been confirmed in CRA rulings such as 2009-0348041R3 (the “Restructuring Rulings”). The CRA’s position appears to apply regardless of whether the interest is actually taxed in the U.S. The fact that ULC’s interest payment results in both income (USFinco) and expense (USCo’s Canadian branch) that will offset each other on a U.S. consolidated return does not appear to affect CRA’s view that the “same treatment” test is met. Where such an offset is permitted, the restructured debt allows USCo to retain Treaty benefits without increasing its net U.S. income.
Ruling 2010-0361591R3 (the “Recent Ruling”) is a reminder that the restructured debt may not always produce such ideal results in the U.S. In simplified terms, the Recent Ruling involved a debt between USCo and its wholly owned ULC which was a limited partner in a 2 tiered Canadian partnership (“LPs”). For U.S. tax purposes, the ULC was disregarded and the LPs elected to be treated as a corporation. The debt was likely part of a “double dip” structure to utilize losses and foreign tax credits in the US without reporting the underlying income. In order to avoid Article IV(7)(b), the ULC debt was refinanced by a USFinco. The CRA confirmed that Article IV(7)(b) would not apply to interest paid to USFinco on the refinanced debt. Unlike the Restructuring Rulings, the taxpayer in the Recent Ruling advised that the payment to USFinco that was otherwise deductible on consolidation would be restricted by the dual consolidated loss rules (“DCL rules”) and would result in the U.S. group having a net income inclusion. While that restriction did not appear to affect the ruling that the interest met the “same treatment” test for purposes of Article IV(7)(b), it would have represented a “cost” of the restructuring.
The DCL rules are complex. They generally restrict the U.S. deduction of a DCL incurred by a “separate unit” of a U.S. person if there is a “foreign use” of such loss. A DCL includes any loss of a separate unit, computed under US rules. A “separate unit” includes a ULC that is fiscally transparent in the U.S. A “foreign use” of a DCL occurs where the loss is “deductible” by a “foreign corporation” (or certain foreign persons). The definition of “foreign use” is broad, does not require that a deduction actually be claimed, can include both direct or indirect use and uses that arises from mergers or other asset transfers. Whether a loss is “deductible” is determined by foreign law. Whether a particular entity is a “foreign corporation” is determined by U.S. law. The DCL rules are subject to certain exceptions. For instance, the rule will not apply if a “domestic use election” is made agreeing that no “foreign use” of the loss will occur during a “certification period”. As well, the rule does not generally restrict the separate unit from claiming the deduction against it own income.
In the Recent Ruling, the restructuring to avoid Article IV(7)(b) likely resulted in the DCL rules applying because the interest payments to US Finco also resulted in USCo’s branch recognizing an expense that had been previously ignored by the U.S. resulting in or increasing a loss. For Canadian tax purposes, ULC likely did not incur a loss. A “foreign use” of such loss occurred because it could be deducted under Canadian law against income of a “foreign corporation” (i.e. ULC’s allocation of income from LP, treated as a foreign corporation by the US). Because there was an actual foreign use, the exception for “domestic use elections” was not available. As a result, the DCL rules applied to restrict USCo’s branch interest deduction. This result was based, however, on the structure involved and may not always apply to restructurings of ULC debt. Interest payments by a ULC “separate unit” will not, in and of itself, result in the DCL rules applying. The Recent Ruling, however, is a reminder that the U.S. tax consequences of a debt restructuring may differ depending on the circumstances.