Any structuring of investments by a Latin American investor into Canada through the U.S., or any acquisition of a U.S. business which either operates a Canadian business or which receives Canadiansourced payments, and any decision to acquire a Canadian business or to expand Canadian operations where business arrangements and particularly intercompany funding result in a U.S. resident receiving Canadian-sourced cash flows should include a review of how the Limitation on Benefits (“LOB”) rules in the recently revised Canada-U.S. Income Tax Convention (the “Treaty”) may apply.
Canada, by reason of its proximity to the U.S., has long been a destination of choice for U.S. businesses interested in expanding their operations. Even where a U.S. business has not itself entered the Canadian market, it may have entered into contractual arrangements with Canada that generate revenues sourced from Canada. A Latin American investor that acquires a U.S. target may not have focused on the Canadian operations or the cross-border arrangements which the U.S. target has in place.
Until recently, where a Latin American investor operated a U.S. business, when the opportunity arose to expand its operations into Canada through an acquisition or otherwise, the investor may well have considered that the arrangements should be concluded by its U.S. business in order to achieve North American synergies. Similarly, if a Canadian subsidiary of a foreign investor’s U.S. business had a need for funding, the solution would most likely have been to have the U.S. business (if profitable) advance the funds to the Canadian subsidiary. If contracts were to be entered into between Canada and a Latin American group, the Latin American parent might logically have had these arrangements contracted by its U.S. business.
Canadian and U.S. members of a controlled group will traditionally buy and sell goods and services across the Canada-U.S. border, as well as pay dividends, interest and royalties, reorganise business divisions involving transfers of shares or assets, and share costs and personnel.
Until recently, none of the Canadian-sourced cash flows which resulted from these activities were particularly problematic from a Canada-U.S. tax perspective so long as the U.S. recipient of the payments was entitled to the benefits of the tax treaty between Canada and the U.S. and the Canadian transfer pricing rules were not in issue.
Limitation on Benefits
The Fifth Protocol revisions to the Treaty include a comprehensive LOB provision which has application to U.S. claimants, with effect from February 1, 2009 in respect of withholding taxes, and for taxable years that begin after 2008 in respect of other taxes. With this change, the situation has become more complicated for Latin American-owned U.S. businesses receiving Canadiansourced revenues, whose returns from their North American operations may be affected if those U.S. businesses are denied treaty benefits under the new LOB provisions by Canada.
Under the former treaty, a U.S. corporation that had a wholly-owned Canadian subsidiary or that otherwise received Canadian-sourced payments, simply had to establish its entitlement to treaty benefits under the treaty residence rule. Where specific items of income were received by a US resident, such as dividends, interest or royalties, the resident was required, as well, to establish that it was the beneficial owner of those amounts.1
Even assuming that residence and beneficial ownership can be established, U.S. corporations that receive income from sources in Canada now have to meet additional requirements.2 Under these requirements, a U.S. resident that is a “qualifying person” is entitled to full benefits under the Treaty. A non-qualifying person that meets the active trade or business test or the derivative benefits test may still be entitled to benefits, limited, however, to the specific items of income to which those tests may be applied. Failing qualification otherwise, a U.S. resident may request the Canadian competent authority to grant the necessary benefits.
If a U.S. resident receives Canadian-sourced cash flows but is not eligible for treaty benefits by reason of the LOB rules:
- dividends, interest and royalty payments may be subject to the Canadian domestic nonresident withholding rate of 25% instead of reduced or zero treaty rates;
- the permanent establishment threshold which protects a U.S. business with Canadian activities from Canadian tax on business profits may not apply;
- sales of certain Canadian property may be subject to Canadian capital gains tax and reporting procedures.
In addition to natural persons, governmental entities and certain exempt organizations, a U.S. resident will be a qualifying person for purposes of the LOB provisions if it is:
- A public company or trust, i.e., any company or trust whose principal class3 of shares or units (and any disproportionate class of shares or units4) is primarily and regularly traded on one or more recognized stock exchanges.
The U.S. Treasury Department’s Technical Explanation of the Fifth Protocol, which Canada has endorsed,5 indicates that the concepts of “primarily traded” and “regularly traded” have the meaning they have under the U.S. Treasury Regulations.6
A “recognized stock exchange” means the NASDAQ System and any stock exchange registered with the Securities and Exchange Commission in the U.S. as a national securities exchange, any Canadian stock exchanges that are prescribed or designated under the Canadian taxing legislation, and any other stock exchange agreed upon by the U.S. and Canada. It should be emphasized that while shares of a U.S. resident company may be publicly traded, unless they are traded on a U.S. or Canadian exchange that appears on the list of recognized stock exchanges,7 the company will not qualify as a public company for purposes of these rules.8
None of the stock exchanges in Latin America are currently considered “recognized stock exchanges” for the purposes of this definition.
A subsidiary of one or more public companies where more than 50% of the aggregate votes and the value of the shares and more than 50% of the votes and value of each “disproportionate class” of its shares (excluding in each case debt substitute shares9) are owned directly or indirectly by no more than five publicly traded companies or trusts which are themselves qualifying persons. For example, a U.S. resident corporation which is owned by U.S. or Canadian companies listed on a recognized stock exchange would meet this test.
- A private company that meets both of the following tests:
- 50% or more of the aggregate votes and value of the company’s shares and 50% or more of the votes and value of each disproportionate class of its shares (excluding in each case debt substitute shares) are not owned, directly or indirectly, by nonqualifying persons; and
- less than 50% of its gross income (for U.S. tax purposes) for its preceding (or, if newly incorporated, its first) fiscal period comprise deductible expenses that are paid or payable, directly or indirectly, to non-qualifying persons.
In each case, all entities in a chain of ownership must be qualifying persons. However, Canada has confirmed that it will look through a fiscally transparent entity such as a U.S. limited liability company or a U.S. partnership to determine whether the relevant test is met.
While there is a need for significant clarification of a number of interpretative issues which arise relative to this test, it is not expected that it will assist U.S. businesses wholly or substantially owned by Latin American ultimate shareholders, whether or not publicly listed, as they will not, in any event, be able to meet this test.
A U.S. resident company that does not meet the public listing requirements for its shares, that is ultimately controlled by one or more Latin American or other foreign corporations, or that is controlled by a U.S. public company (itself a qualifying person) but which has a Latin American or other foreign owner inside the chain of ownership will not be a qualifying person.
Active Trade or Business Test
Where a U.S. business is substantially owned by Latin American investors, it will most likely seek to access benefits with respect to income derived from Canada by characterising it as received “in connection with” or “incidental to” an actively conducted U.S. trade or business. To qualify for benefits under this “active trade or business” test the U.S. business will have to establish its business activities are “substantial” in relation to the activity carried on in Canada that gives rise to the income for which treaty benefits are claimed. It is important to note that the active trade or business test must be applied separately to each item of income.
Trade or Business
The term “trade or business” is not defined in the Treaty, other than to exclude the business of making or managing investments (unless such activities are carried on with customers in the ordinary course of business by a bank, an insurance company, a registered securities dealer or a deposit-taking financial institution).10 Under the Treaty, these terms have, unless the context otherwise requires or the competent authorities otherwise agree, the meaning which they have under Canada’s domestic tax laws.
In Connection With and Incidental To
The terms “in connection with” and “incidental to” are not defined in the Treaty. The TE states that income is considered to be derived “in connection with” an active trade or business if the income-generating activity in the relevant country is upstream, downstream or parallel to that conducted in the other country. For purposes of illustration, in the U.S. context, the TE states that if the U.S. activity of a Canadian resident company, for example, consists of selling the output of a Canadian manufacturer or of providing inputs to the manufacturing process, or of manufacturing or selling in the U.S. the same sorts of products that were being sold by the Canadian trade or business in Canada, the income generated by that U.S. activity would be treated as earned in connection with the Canadian trade or business.
The TE is silent on whether income is considered to be derived in connection with a trade or business if the income-producing activity in the source country is a line of business that is “complementary” to the trade or business conducted in the residence country by the income recipient. However, the Canadian tax authorities have confirmed that income derived in connection with a U.S. trade or business will include income derived from a complementary business.11 Therefore, the activities need not relate to the same types of products or services, but they should be part of the same overall industry and be related in the sense that the success or failure of one activity will tend to result in success or failure for the other.
In the context of cross-border advances, the TE states that income that is considered to be “incidental” to a trade or business is, for example, income generated from the short term investment of working capital in securities issued by persons in the source country.
Canada has indicated that the guidance provided in the TE is welcome, but it will, nonetheless, be guided by the Canadian jurisprudence in interpreting the terms relevant to the active trade or business test12 in the context of the Income Tax Act.13 As such, Canada may not necessarily reach the same conclusions as the U.S. in applying this test. For Canadian tax purposes, the relevant term is “active business”, which would generally include any business carried on by a U.S. resident other than an investment business14 or a business deemed under the Act not to be an active business.15 The Canadian tax authorities have indicated that in order for income to be derived “in connection with” an active business, there should be a direct connection between the item of income and the business.16 Further, in order for income to be considered to be “incidental to” an active business, there should be a financial relationship of dependence of some substance between the income-generating property and the active business.17 Existing Canadian jurisprudence indicates that property will be considered to be used in the course of carrying on a business only if it is employed and risked in the business, i.e., the holding or use of property must be linked to some definite obligation of the business such that the withdrawal of the property would have a decidedly destabilizing effect on operations.18
Directly or Indirectly
Under the Canadian jurisprudence, income from the investment of funds, surplus to the needs of a business, would normally be considered to be, either from a separate investment business or from property, neither of which would meet the active business test for Canadian tax purposes. Based on these principles alone, the treatment of interest payments made under a cross-border intercompany financing in which a U.S. resident makes an advance to its Canadian subsidiary which is by its terms intended to remain outstanding over several years, might well, therefore, not be considered to be in connection with or incidental to its U.S. active trade or business.
However, the use of the words “directly or indirectly … through one or more … residents of the source state” permits some latitude in application of the active trade or business test if one employs a look through approach to an underlying trade or business which funds the crossborder interest payment. In support of this position, the TE notes that a Canadian resident could claim benefits from the U.S. with respect to an item of income earned by a wholly-owned U.S. holding company interposed between it and an operating subsidiary. In addition, the TE considers income to be earned in connection with or to be incidental to an active trade or business where the resident derives the income directly or indirectly through one or more persons resident in the other country, even where it does not wholly own such persons. The context does not appear to require that the income retain its character in moving through the source state residents so long as it can be established that it originates from a connected active trade or business at some level in the source state group.
To illustrate, US Co will receive interest income from Canco as a long term capital loan. The interest itself will not be considered to be active business income. However, if the interest is funded from dividends paid by Cansub and Cansub 2 to Canco and that income is earned in a business which is connected to US Co’s business, the interest will meet the active trade on business test. Interpretive issues will arise, however, where some of the income which could be regarded as funding the interest is not regarded as connected or incidental to the US business. It is not clear how apportionment will be effected in such circumstances. Nor is it clear whether third country income from a foreign affiliate of Canco which funds the interest payment, if the income also derives from a connected trade or business, will taint the eligibility of Canco interest under the active trade or business test.
Disposition Proceeds on Share Transfers
Initial uncertainty as to whether the active trade or business test would apply to capital gains realised by a U.S. resident on the sale of shares of a Canadian corporation seems to have been resolved. The Canada Revenue Agency, in November 2008, indicated that such capital gains could be considered to be derived in connection with US Co’s active trade or business if the Canadian corporation carried on a connected business. In May 2009, the Canadian taxation authorities discussed some form of apportionment where a capital gain could be only partly connected to the US business.19
The Treaty does not provide a “safe harbour” in reference to the substantiality test20 and the TE’s guidance on the substantiality requirement is limited. There is a suggestion that it is not necessary that the trade or business be as large as the income-generating activity, but the trade or business cannot, “in terms of income, assets or other similar measures, represent only a very small percentage of the size of the activity” in the other country. As such, satisfaction of the requirement depends on the particular facts and circumstances relevant to the person claiming treaty benefits as well as on the views of the relevant tax authorities and may create significant uncertainty regarding entitlement to treaty benefits. The Canadian tax authorities have indicated that they intend to use a purposive approach to determine whether the substantiality test is satisfied. If treaty shopping is not involved, i.e., where the U.S. business is longstanding and well established, the Canadian tax authorities can be expected to interpret the substantiality requirement in a flexible manner to avoid forcing taxpayers to request a competent authority determination.
The Canadian tax authorities have considered the substantiality test in the context of the following example which provides helpful guidance.21 A corporation is tax resident in a country within the European Union (EU Corp). Entities related to EU Corp (EU Opcos) carry on business in EU Corp’s country of residence. EU Corp owns all of the shares of several foreign subsidiaries, including a U.S. holding company (US Holdco) which is a U.S. resident for purposes of the Treaty. US Holdco’s activities consist primarily of holding a majority of the voting shares of a U.S. subsidiary (US Co) and all of the shares of a Canadian corporation (Can ULC), and of providing services to US Co and to the US subsidiaries of US Co (US Opcos) which carry on business and are resident for Treaty purposes in the U.S. None of the U.S. entities is a disregarded entity for U.S. tax purposes. The business of the US Opcos is comparable in nature to the business of the EU Opcos. Can ULC is resident in Canada for Treaty purposes and is a disregarded entity for U.S. tax purposes. Can ULC’s activities relate to the holding of shares of US Co, and all or substantially all of Can ULC’s income is derived from dividends paid by US Co (essentially out of dividends received by US Co from the US Opcos).
In this example, as Can ULC’s primary activity related to the holding of the shares of US Co, the Canadian tax authorities concluded, on the specific facts, that the size of US Opcos’ trade or business in the US was substantial relative to the ULC’s activity in Canada and, therefore, that the substantiality requirement was satisfied in respect of payments made by Can ULC to U.S. Holdco.
Latin American companies that substantially own U.S. resident businesses engaged in the active conduct of a trade or business in the U.S., will seek to rely on the active trade or business test. If the test is met, treaty benefits are available on those items of income derived from Canada in connection with or incidental to the U.S. trade or business.
Where the Canadian government is satisfied that the investment has not been structured for treaty shopping reasons, it has suggested that Canada will be flexible in interpreting the active trade or business test. Where an item of income, be it dividends, interest or gains on sale of shares, can be considered to be derived directly or indirectly, from a Canadian business which is connected to a U.S. business, that item of income should be within the ambit of the test.
Derivative Benefits Test
Treaty benefits are also available to a U.S. resident company in respect of Canadian source dividends, interest and royalties if it satisfies the following ownership and a base erosion tests:
- more than 90% of the aggregate votes and value of all of the shares and at least 50% of the votes and value of any disproportionate class of shares (excluding in each case debt substitute shares) of the U.S. resident company must be owned, directly or indirectly, by persons each of whom is a qualifying person or a person who:
- is resident in a country with which Canada has a comprehensive tax treaty and is entitled to full benefits under that treaty—this means that where the treaty has an LOB clause, the person must be a “qualifying person”;
- would be a qualifying person or would qualify under the active trade or business test if that person were a resident of, and carried on business in, the U.S.; and
- would be entitled to a rate of withholding tax on the relevant item of income under the treaty which is no greater than that available under the Treaty; and
- deductible expenses that are paid or payable to non-qualifying persons must equal less than 50% of the U.S. resident company’s gross income (for U.S. tax purposes) for its preceding (or, if newly incorporated, its first) fiscal period must constitute deductible expenses that are paid or payable to non-qualifying persons.
A U.S. resident subsidiary of a Latin American company not listed on a recognized Canadian or U.S. stock exchange will not meet the second test. It also will not meet the third test in respect of interest as the Treaty is currently the only Canadian treaty that provides for zero rate withholding on interest. If the subsidiary receives other items of income, it may or may not meet the third test, depending on whether the relevant tax treaty with Canada is as favourable in the circumstances as the Treaty in respect of such income.
The derivative benefits test is an all or nothing test. It generally permits a company resident in the U.S. to obtain treaty benefits in respect of interest, dividends or royalties sourced from Canada only if the ultimate owner of the payment would have been entitled to an equivalent rate if it had earned the income directly. Significantly, the test does not grant benefits in respect of either business income or capital gains.
With reference to interest, for example, if a Latin American corporation were to finance the needs of its Canadian subsidiary through its U.S. affiliate, this test would not afford treaty protection to interest paid to the U.S. affiliate. In respect of dividend payments, where the corporate dividend recipient owns at least 10% of the voting shares of the dividend payer, the 5% reduced withholding rate under the Treaty is matched by the Canada-Mexico Treaty, but not by Canada’s tax treaties with other Latin American countries which provide for either a 10% or 15% withholding rate, and may also require that at least 25% of the voting shares of the dividend payer be held by the corporate dividend recipient (see, for example, the Canada-Chile Treaty). In respect of royalty payments, the 10% reduced withholding tax rate provided by the Treaty is matched by Canada’s treaties with many Latin American countries, but some of the treaties do not have any withholding tax exemptions for royalties and only the Treaty provides a withholding tax exemption for royalty payments for the use of, or the right to use, computer software. In these situations, the applicable tax treaty would not provide as favourable a rate of withholding tax as under the Treaty for such items of income and, accordingly, the third test would not be met.
The base erosion test is intended to ensure that the U.S. resident entity is not only owned substantially by qualifying persons but that its taxable income is not eroded significantly by tax deductible payments to nonqualifying persons.
It is also significant that despite the suggestion in the TE that under the ownership test, a person resident in a third country would be a “qualifying person” under the publicly-traded test if the principal class of its shares were primarily and regularly traded on a stock exchange recognized either under the Treaty or under the treaty between the source country granting benefits and the third country, Canada’s tax treaties generally do not use the concept of “recognized stock exchanges”. The result is that a U.S. subsidiary of a Latin American parent corporation not listed on a recognised U.S. or Canadian stock exchange would not qualify for treaty benefits. The Canadian tax authorities have suggested that it may be appropriate to take administrative action to grant treaty benefits in cases where the U.S. subsidiary is not able to satisfy the derivative benefits test solely by reason of the Treaty’s narrowly defined concept of “recognized stock exchange”, i.e., where the principal class of shares of the foreign parent corporation is listed on a stock exchange located in a country with which Canada has entered into a bilateral tax treaty or is included in the list of “designated stock exchanges” under the Canadian taxing legislation. This matter is currently under review to determine whether it poses a significant practical problem for U.S. corporations that may be potential claimants. In the case of U.S. subsidiaries of Latin American corporations, resolution of this issue would not assist where there are higher rates of tax under the relevant tax treaty than under the Treaty as noted above.
Request for Competent Authority Determination
If a U.S. resident person who is not otherwise entitled to benefits under the LOB clause so requests, the Canadian competent authority is required to determine on the basis of all relevant facts and circumstances whether:
- the person’s creation and existence had as a principal purpose the obtaining of benefits under the Treaty that would not otherwise be available; or
- it would be appropriate, having regard to the purpose of the LOB clause, to deny treaty benefits.
The TE states that the determination can be made in respect of all benefits under the Treaty or on an “item by item basis”. If a favourable determination is made, then the competent authority shall grant treaty benefits to the person.22 The TE indicates that a taxpayer will also be able to submit a request for an advance determination of entitlement to treaty benefits. On May 22, 2009, Canada released guidelines for taxpayers requesting such treaty benefits.23 The guidelines suggest that a request should be made to the Canadian competent authority only if the person requesting treaty benefits is not otherwise entitled to benefits and must be accompanied by a full explanation as to why the LOB clause would not otherwise apply. It should be noted that Canada is not requiring certainty as to absence of treaty benefits and will address cases where uncertainty exists. The guidelines were followed in June 2009 with the release of three forms designed as public consultation drafts to serve as declarations by non-residents as to entitlement to treaty benefits.
It should also be noted that while a grant of treaty benefits under Article XXIX A(6) is generally binding on Canada, such a determination will not preclude other action to deny benefits under Article XXIX A (7) of the Treaty, which preserves Canada’s right to challenge entitlement to treaty benefits based on domestic antiabuse principles.
The new LOB clause is an important consideration for Latin American investors in U.S. operations that receive cash flows from Canada. At this point, Latin American companies that indirectly hold Canadian investments through the U.S. or finance their Canadian investments through a U.S. affiliate will likely, in many cases, have to rely on the subjective active trade or business test to access treaty benefits. While it is not expected that these rules will be a significant barrier to Latin American investment through legitimate US business affiliates, careful review of all of the facts and circumstances of existing or planned arrangements is recommended.