It has been a long standing administrative policy of the Canada Revenue Agency (“CRA”) that United States (“US”) limited liability companies (“US LLCs”) are not entitled to benefits under the Canada-US Income Tax Convention (the “Treaty”). This policy is based on the view that disregarded US LLCs are classified for Canadian tax purposes as corporations that are not US residents under the Treaty, since the US LLCs are not themselves liable to pay income tax under US law. Prior to changes to the Treaty on ratification of the Fifth Protocol in December, 2008 the CRA was not prepared to treat a US LLC as fiscally transparent and look through the US LLC in the same way as the CRA looks through a partnership, to the residence of the members of the US LLC.
The practical effect of this policy was that US LLCs could not benefit from relief under the Treaty that was available to US residents operating or investing in Canada. One such form of relief is the reduced branch tax rate (5% instead of 25%) permitted under the Treaty on business income earned through a permanent establishment in Canada.
However, on April 8, 2010, the Tax Court of Canada (“TCC”) upheld the taxpayer’s appeal in TD Securities (USA) LLC v. The Queen (“TD Securities”) on the basis that, despite its flow-through status, TD Securities (USA) LLC (“TD LLC”) was a resident of the US and could, therefore, benefit from the reduced branch tax rate under the Treaty. The changes to the Treaty under the Fifth Protocol have resolved this situation for US LLCs with the same fact situation as TD Securities for 2009 and subsequent years by looking through the US LLC to the residence of the members. However, the years under appeal in TD Securities pre-dated the ratification of the Fifth Protocol. This judgment supports claims for benefits under the Treaty to US LLCs for years prior to the implementation of the Fifth Protocol.
The CRA has decided not to file an appeal. Therefore, the TCC’s judgement in TD Securities is now final. However, the CRA released a statement on July 7, 2010,1 in which it took the position that, notwithstanding the TCC’s decision in TD Securities, the CRA continues to be of the view that a US LLC that is treated as fiscally transparent for US tax purposes is not a US resident for purposes of the Treaty. Nevertheless, in light of the decision, the CRA may provide relief under the Treaty to a US LLC for years prior to 2009 in certain circumstances. Where the CRA determines that relief is available, the CRA expects that there will be corresponding adjustments to any foreign tax credits claimed in the US that relate to the refunded Canadian taxes.
Subject to relief under a tax treaty, non-residents of Canada that carry on business in Canada are subject to Canadian income tax under Part I of the Income Tax Act (Canada) (the “ITA”) on the income from their Canadian business activity. Part XIV of the ITA provides that a non-resident carrying on business in Canada will be liable for an additional “branch” tax of 25% of its Canadian net after-tax income, which may be reduced under a tax treaty. This tax is a proxy for the non-resident withholding tax on dividends that would have been payable if the non-resident had used a Canadian subsidiary to carry on business, rather than a branch, and the subsidiary paid a dividend to the non-resident.
TD LLC is a New York based US registered broker dealer organized under the laws of the State of Delaware. As a US LLC, it had elected to have any income it received flow tax-free through to its sole member TD Holdings II Inc. (“Holdings II”), at which level it was taxed on a consolidated basis with the income of the ultimate parent company, Toronto Dominion Holdings (USA) Inc. (“TD USA”)2. TD USA is a wholly-owned direct subsidiary of The Toronto-Dominion Bank.
TD LLC maintains a permanent establishment in the form of a branch office in Canada to service its US clients (“TD Canada Branch”). TD Canada Branch’s profits for 2005 and 2006 were reported by it in its Canadian tax returns. The Treaty expressly provides that the rate of Canadian Part XIV tax for Canadian branches of US residents is reduced from 25% to 5%. TD LLC claimed the reduced rate of Canadian branch tax of 5% under the Treaty in respect of the 2005 and 2006 income of TD Canada Branch.
The CRA assessed TD LLC to deny it the benefit of the 5% US Treaty branch tax rate. This assessment was based on the determination that TD LLC, as a fiscally transparent entity, was not a “resident” of the United States, as it is required to be to benefit from the Treaty. This meant that TD USA was unable to claim a full foreign tax credit on its consolidated US return under the US Internal Revenue Code (the “Code”).
TD LLC appealed the CRA’s decision to the TCC.
Whether TD LLC is a “resident” of the US for purposes of the Treaty?
The CRA argued three main points:
- The meaning of the phrase “resident of a contracting state” used in the Treaty is clear and unambiguous. The meaning of the language chosen by Canada and the US to define to whom the Treaty applies cannot be interpreted in an expansive or purposive way to entitle TD LLC to Treaty benefits.
- TD LLC could not be a “resident” of the US because it was not itself subject to tax in the US. This is because the Code’s “check-the-box” regulations permit US LLCs to elect between corporate and pass-through treatment. TD LLC did not file an election under the “check-the-box” regulations. Accordingly, under the Code, it is a disregarded entity and was not itself subject to tax on its income. Instead, all of its income was required to be included in the income of its sole member, Holdings II, as if the activities of TD LLC were carried on directly by Holdings II. The 2005 and 2006 income of TD LLC’s Canadian branch was included in the income of Holdings II in this manner under the Code.
- Even if TD LLC is considered to be liable to tax in the US by virtue of its income being taxed to Holdings II, that tax is 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 of the Treaty.
TD LLC’s position
TD LLC took the position that the phrase liable to tax was not a defined term in the Treaty and therefore, must be defined in accordance with Canadian law. TD LLC submitted that whether an entity is liable to tax does not necessarily mean that the entity is required to pay tax directly on its income under the Code. Tax was paid in the US on TD USA’s income not by TD USA directly but on a consolidated basis with its parent company, as permitted under the Code. The Court should, therefore, conclude that TD USA was liable to tax in the US and hence was a resident of the US.
TD LLC’s alternative argument was that, consistent with the commentaries to the relevant provisions of the Model Tax Convention on Income and on Capital of the Organization for Economic Co-operation and Development (the “OECD” and the “OECD Model Treaty”), a liberal interpretation to, and application of, the Treaty must be adopted in order to allow the Treaty to achieve its purpose. Therefore, the phrase “resident of a Contracting State”, must be interpreted in an expansive way to include a US LLC such as TD LLC.
The TCC ruled in favour of the taxpayer, TD LLC. The TCC held that the income of TD LLC should enjoy the benefits of the Treaty. TD LLC was a resident of the US and was “liable to tax” in the US on a comprehensive basis.
The TCC relied on the OECD Partnership Report and OECD Model Treaty Commentary, as well as case law on treaty interpretation. Justice Boyle took a purposive approach and held that TD LLC was entitled to treaty benefits on the basis that its income was subject to full and comprehensive US tax at the member level and, as such, it was liable to tax in, and therefore a “resident” of, the US for purposes of the Treaty.
The TCC emphasized that its decision,
“stands for no more than the proposition that, properly interpreted and applied in context in a manner to achieve its intended object and purpose, the US Treaty’s favourable tax rate reductions apply for years prior to the Fifth Protocol Amendments to the Canadian-sourced income of a US LLC if all of that income is fully and comprehensively taxed by the US to the members of the LLC resident in the US on the same basis as had the income been earned directly by those members.”
Justice Boyle reviewed the CRA positions regarding US LLCs and noted that, with the exception of US LLCs, CRA had been consistent in its interpretation of Article IV in determining treaty residence. He concluded that the treatment of partnership and US LLCs should be analogous. He also noted that the Treaty intended that the entitlement to treaty benefits for income earned by a fiscally transparent entity, such as a partnership or US LLC, be determined at the member level using a look-through approach.
He concluded that TD LLC must be considered a resident of the US for purposes of the Treaty, it must be considered to be liable to tax in the US by virtue of all of its income being taxed at the member level and it must be considered to be subject to full and comprehensive tax under the Code.
The TCC’s decision in the TD Securities case is important because it overturns the long-standing CRA position that a fiscally transparent US LLC is not a US resident for purposes of the Treaty. It also highlights the importance of the Fifth Protocol Amendments when interpreting the context and purpose of Treaty provisions. This decision could have implications for US LLCs that may have been denied or did not seek Treaty benefits for years prior to 2009. US LLCs with US resident members who were denied Treaty benefits due to the CRA’s US LLC policy may apply for refunds for overpaid tax, subject to the limitation periods in the ITA.
How then should a US LLC secure such benefits and recover potentially overpaid branch tax or withholding tax for periods prior to 2009 (pre-Fifth Protocol)? The CRA has adopted a restrictive view of the TD Securities case. It has indicated that it will provide the relief contemplated by this decision in very limited circumstances. The CRA has stated:
“Treaty benefits claimed by an LLC with respect to an amount of income, profit or gain will be recognized by the CRA only if the amount is considered to be derived, pursuant to Article IV(6) of the Treaty, by a person who is a resident of the United States and that person is a ‘qualifying person’ or is entitled, with respect to the amount, to the benefits of the Treaty pursuant to paragraph 3, 4 or 6 of Article XXIX A.”3
US LLCs should consult with a tax advisor to determine whether the TCC’s decision in TD Securities could be applicable to their situation and if so, how to best proceed to recover any excess taxes paid or withheld.