The Canada Revenue Agency (“CRA”) recently provided its views on the application by Canada of its domestic rules to certain planning which has been proposed to avoid the application of the anti-hybrid rules in the Canada-U.S. Income Tax Convention (the “Treaty). The CRA has also released an internal document which sets out its views on the application of the “same treatment” test under these rules.
The Anti-Hybrid Rules
Briefly, the anti-hybrid rules were added by the Fifth Protocol and are contained in Article IV(7) of the Treaty. Effective January 1, 2010, they will deny treaty benefits in respect of amounts received from or through certain hybrid or reverse hybrid entities in two broadly defined sets of circumstances. In some cases, these rules may strip away the benefits provided by the rule in Article IV(6) of the Treaty which permits a look-through to determine entitlement to treaty benefits for income derived through fiscally transparent entities.1 For a more detailed discussion of these rules and other recent amendments to the Treaty, including the new limitation on benefits provision, please click here.
Specifically, Article IV(7) denies treaty benefits, i.e., an amount of income, profit or gain will be considered not to be paid to or derived by a person who is a resident of a contracting state (the “residence state”) if:
- the person is considered under the tax laws of the source state to have derived the amount through an entity (other than an entity resident in the residence state), but by reason of the entity not being treated as fiscally transparent under the laws of the residence state, the treatment of the amount under the tax laws of the residence state is not the same as its treatment would have been if the amount had been derived directly by that person (the “Source Hybrid Rule”)2
- the person is considered under the tax laws of the source state to have received the amount from an entity that is a resident of the source state, but by reason of the entity being treated as fiscally transparent under the laws of the residence state, the treatment of the amount under the laws of the residence state is not the same as its treatment would have been if the entity were not treated as fiscally transparent in the residence state (the “Recipient Hybrid Rule”).3
While the Source Hybrid Rule is similar in scope and effect to Article 1(6) of the U.S. Model Treaty, the Recipient Hybrid Rule is new to U.S. tax policy. 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 rules is the fact that, as currently formulated, they do not distinguish between deductible payments such as interest and royalties and non-deductible payments such as dividends. The rules also appear to apply inconsistently to deductible interest or royalty payments derived from a hybrid entity depending on how the hybrid is characterised under residence state laws and to whom a payment is considered to be made.
Initially, international tax planners reacted to the anti-hybrid rules by suggesting that U.S. investors with existing Canadian hybrid structures should either convert the offending hybrids back to non-hybrid entities or interpose holding structures in intermediary jurisdictions to preserve the benefits of the hybrid planning. This latter alternative for restructuring existing Canada-U.S. arrangements was considered by the CRA at the Roundtable held at the Canadian Tax Foundation’s Annual Conference on November 24, 2009 (the “2009 CRA Roundtable”). Specifically, the CRA was asked to comment on whether the 5% reduced dividend withholding tax rate under Article X of the Treaty for dividends paid by a ULC to its U.S. parent would be preserved if a Luxembourg société à responsabilité (“Luxco”), resident in Luxembourg for Canadian tax purposes but fiscally transparent for U.S. tax purposes, were interposed between an existing ULC and its U.S. parent. The CRA confirmed that the 5% withholding tax rate would normally apply as long as Luxco would be regarded as the “beneficial owner” of the dividends within the meaning of the Treaty,4 subject to the potential application of GAAR depending on the facts and circumstances.
In light of recent guidance from the CRA5 on November 20, 20096, it would appear that such steps may not be required, at least in certain cases, to protect benefits under the Treaty where a hybrid entity makes distributions or payments from Canada to U.S. recipients or where U.S. vendors dispose of shares in a Canadian business.
In an advance income tax ruling issued on November 20, 2009, 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 benefit 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 paidup capital by the same amount, and distribute cash equal to the amount of the paid-up capital reduction to LP as a return of paid-up 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 Part XIII 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 Recipient Hybrid Rule 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 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. Accordingly, the members of LP would be entitled to the benefits under Article X of the Treaty to which they would have been entitled if the deemed dividend had been paid as a cash dividend and the Recipient Hybrid Rule had not applied to such a payment.
At the 2009 CRA Roundtable, 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 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 Recipient Hybrid Rule would not apply. The CRA also commented that while the application of GAAR would depend on facts and circumstances of a particular situation, it would not normally expect 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.
CRA Guidance on Same Treatment
In its recent published guidance on same treatment for purposes of Articles IV(6) and IV(7) of the Treaty, the CRA reiterated that, in accordance with the principles expressed in the U.S. Treasury Department’s Technical Explanation of the Fifth Protocol which Canada has endorsed, it would consider that an amount of Canadian-source income, profit or gain receives the same treatment under U.S. tax laws if (i) the timing of the recognition/inclusion of the amount, (ii) the character of the amount, and (iii) the quantum of the amount are the same under the fiscal transparency/no fiscal transparency comparisons required by these provisions.
Accordingly, with respect to an item of income received from a Canadian resident that is fiscally transparent for U.S. tax purposes, the CRA would consider the item of income to be subject to the same treatment in the hands of the recipient for the purposes of the Recipient Hybrid Rule if the quantum and character of the item of income and the timing of its inclusion in the income of the recipient is the same as it would be if the entity were not fiscally transparent.
Geographic Source of a Payment
The CRA has noted that the geographic source of an amount is only relevant to the extent that it affects the treatment of the amount, as an item of income, under U.S. tax laws. For example, if the geographic source of an amount received by a U.S. parent from a Canadian ULC that is fiscally transparent for U.S. tax purposes would be considered to be different if the ULC were not fiscally transparent, but the difference were only relevant to the computation of the U.S. parent’s foreign tax credits, then the CRA has indicated that it would not consider the difference, in itself, to be sufficient to apply the Recipient Hybrid Rule.
Character of Income, Profit or Gain
With respect to the character of income criterion, the CRA has stated that the character of an amount of income, profit or gain would be the same for U.S. tax purposes if the actual income item of the U.S. resident is treated as having the same character of interest, dividend, royalty, gain or business income and that characterization is preserved in the treatment of the item in the hypothetical comparison situation.
In order to apply the Recipient Hybrid Rule, an amount will first be determined, under the tax laws of the source state, to have been received by a resident of the residence state. In that regard, the CRA has noted the payment of an item of income, such as interest, may be taxed to a U.S. resident on an accrual rather than a receipt basis. As such, the payment itself may not result in the realization of income by the U.S. resident for U.S. tax purposes, regardless of whether the Canadian resident payer is fiscally transparent. For the purposes of applying the Recipient Hybrid Rule, in such cases, the CRA could view the payment as having been previously recognized and included in the income of the U.S. resident for U.S. tax purposes, but only if the Canadian resident payer is not treated as fiscally transparent for U.S. tax purposes.
Timing of Income, Profit or Gain
In the CRA’s view, the timing of the recognition of an amount of Canadian-source income, profit or gain of a U.S. resident would be considered to be the same for U.S. tax purposes if the income item is included in income or is considered to be received by the U.S. resident in a particular taxable year and, under the hypothetical comparison, the inclusion or receipt of the income item for U.S. tax purposes would occur in the same taxable year.
In the case of an item of income derived through an entity that is treated as a partnership for U.S. tax purposes, the income will still be taken into account on a current basis where it is included in a member’s income in a taxable year ending after the taxable year of the partnership, but only where the timing difference occurs solely as a result of the member having a different taxable year than the partnership.
Inclusion in income by reason of the application of U.S. anti-deferral rules governing controlled foreign corporations or passive foreign investment corporations will not, however, be taken into account in analysing whether same treatment exists.
Quantum of Income, Profit or Gain
In determining whether the quantum of Canadian-source income, profit or gain meets the same treatment test, the CRA has noted that the item of income would be expected to be reported in U.S. dollars for U.S. tax purposes, while the actual payment may be denominated in Canadian dollars. In the case of income derived or received by a partnership or an entity treated as a partnership for U.S. tax purposes that has a taxable year which differs from that of its members, the quantum of the income will not be disqualified solely by reason of a difference in the Canadian dollar and U.S. dollar amounts due to the application of prevailing market foreign exchange rates to such amounts.
The CRA guidance also confirms the view that it is the item of income which must be identified and to which the same treatment analysis must be applied. The determination of whether the quantum of an item of income meets the same treatment test is to be made on a gross basis, without reference to losses, deductions or credits available under the Internal Revenue Code in computing either the recipient’s U.S. tax liability or the consolidated taxable income of a corporate group that includes the recipient.
What Works and What Does Not
In addition to providing general guidance, the CRA has also provided its views on the application of the same treatment test in Articles IV(6) and (7) to several different hypothetical investment structures.7 While the application of the rules will necessarily depend on the particular facts, the CRA’s commentary provides valuable insight into how the anti-hybrid rules may be applied.
The application of the rules may differ depending on whether the fiscally transparent entity is disregarded or treated as a partnership for U.S. tax purposes in cases where interest payments are made between Canada and the U.S. For example, assume USCo parent has made an interest-bearing loan to ULC, its wholly-owned subsidiary 8 Since ULC is fiscally transparent under U.S. tax laws, interest paid by ULC to USCo under the loan would not be recognized for U.S. tax purposes. Accordingly, the treatment of the interest to USCo would not be the same as it would have been had the ULC not been fiscally transparent (i.e., income inclusion on an accrual basis) and, therefore, the CRA would apply the Recipient Hybrid Rule would apply to deny treaty benefits to USCo in respect of the interest income.
In contrast, assume instead that ULC is 90% owned by USCo and 10% owned by USCo’s wholly-owned subsidiary USSub which, like USCo, is a U.S. resident and qualifies for treaty benefits under the limitation on benefits provision in the Treaty.9 USCo again makes an interest-bearing loan to ULC. The ULC is treated as a fiscally transparent partnership for U.S. tax purposes. However, for U.S. tax purposes, USCo is considered to earn interest income payable to it on its loan to ULC. USCo and USSub are also considered to have incurred their proportionate share of the interest expense payable by ULC on the loan from USCo. If ULC were not treated as fiscally transparent for U.S. tax purposes, USCo would realize interest income, but USCo and USSub would not be considered to have incurred any interest expense payable by ULC on the loan from USCo for U.S. tax purposes. The Recipient Hybrid Rule would not apply to the interest payments made by ULC to USCo since the U.S. tax treatment of the interest income to USCo would be the same whether or not ULC were treated as fiscally transparent for U.S. tax purposes. As it is the item of income which is relevant for purpose of determining whether the anti-hybrid rules apply, differences in the treatment of the interest expense under U.S. tax laws would not be relevant.
Assume now that USCo owns all of the shares of USSub which in turn owns all of the shares of ULC. USCo makes an interest-bearing loan to ULC. Both USCo and USSub are resident in the United States and qualifying persons for purposes of the Treaty. ULC is a disregarded entity for U.S. tax purposes. USCo is considered to have loaned money to USSub for U.S. tax purposes and would include interest income from the loan in its income on an accrual basis. Had ULC not been fiscally transparent, USCo would have included exactly the same amount of interest in its income. USCo and USSub file on a consolidated basis for U.S. tax purposes with the result that the interest income and interest expense would offset each other. Had ULC not been fiscally transparent this offset would not occur. Again, only the U.S. tax treatment of the interest income is relevant for purposes of the Recipient Hybrid Rule. Neither the fact that the payor is different for U.S. tax purposes, nor the fact that the treatment of the interest expense is different would be taken into account in the analysis. The anti-hybrid rules would not apply.11
Disposition of Shares of a Fiscally Transparent Entity
To illustrate to application of the Recipient Hybrid Rule to a disposition of shares of a fiscally transparent entity, assume USCo owns all of the shares of ULC. USCo is a U.S. resident and a qualifying person for purposes of the limitation on benefits provisions of the Treaty. ULC is again a disregarded entity for U.S. tax purposes. Although the treatment to USCo of its proceeds of disposition of the ULC shares would not meet the same treatment test for purposes of Article IV(7)(b), that provision would not apply to deny USCo treaty protection in respect of its gain as the proceeds of disposition would be received from an arm’s length purchaser and not from the ULC. However, if the ULC were to redeem, cancel, purchase for cancellation or otherwise acquire its own shares from USCo, Article IV(7)(b) could apply to dividends or capital gains of USCo arising on the disposition of the ULC shares. A sale by USCo of the shares of ULC to a second wholly-owned ULC in circumstances in which section 212.1 of the Income Tax Act (Canada) would apply to deem a dividend to have been received by USCo, could also result in the application of Article IV(7)(b) to the dividend.12
Royalties paid by a hybrid entity from Canada to a U.S. recipient would appear also to benefit from a similar analysis to that for interest. While no specific examples address royalty payments paid by ULCs which are partnerships for U.S. tax purposes, one example13 provides guidance which is helpful. Assume USCo owns all of the shares of ULC. A third party entity, IPCo, grants ULC a license in return for a fee. ULC’s payments to IPCo would be subject to Part XIII Canadian non-resident withholding tax. For U.S. tax purposes, IPCo would be regarded as receiving the fee from USCo. There would be no difference in the quantum, timing or character of the royalty paid. However, under U.S. law the source of the payment (USCo or ULC) would be different depending on whether ULC were or were not fiscally transparent. In this circumstance, Article IV(7)(b) would not apply to the royalty.
Dividends and Back- to-Back Dividends
By contrast, the CRA guidance provides no good news for U.S. shareholders receiving dividends from hybrid ULCs. The guidance confirms that there is no exemption from the application of Article IV(7)(b) of the Treaty for either a dividend paid by a hybrid ULC out of taxed earnings from a business conducted in Canada or a dividend paid by a hybrid ULC which is funded by a dividend from a non-hybrid subsidiary and paid on the same day and in the same amount as the dividend from the subsidiary.14
What conclusions can we draw from the CRA’s recent guidance? Those who have closely followed comments from both Canadian and U.S. government officials cannot help but recall the following observations made by the U.S. Joint Committee on Taxation in their July 2008 report in regard to the anti-hybrid rules:
Neither the proposed protocol nor the Technical Explanation, however, attempts to classify the use of hybrids as acceptable or unacceptable depending upon the factual circumstances. Subparagraph 7(b) also applies with respect to both nondeductible dividend payments and, at least in the case of disregarded entities (as discussed below), deductible dividend payments…The Committee may wish to inquire whether a rule might have been negotiated in lieu of subparagraph 7(b) that would have more narrowly targeted abusive cross-border structures while at the same time causing less disturbance to nonabusive structures.15
Considering the stated purpose of these provisions – to curtail the use of hybrid fiscally transparent entity structures to facilitate “(1) duplicated interest deductions in the United States and Canada, or (2) a single, internally generated interest deduction in one country without offsetting interest income in the other country”,16 one might well ask, how did we arrive at 30% (U.S.) or 25% (Canada) rates of withholding tax for dividend distributions with no treaty mitigation, contrasted with treaty reduced rates for interest and royalty payments between Canada and the U.S. (if properly structured). Canada has, it appears, taken the first step toward a unilateral resolution of the issue confronting ULCs and their U.S. shareholders. The CRA ruling opens the door to dividend planning to avoid the application of the Recipient Hybrid Rule, although taxpayers should be cautioned that the ruling is facts and circumstances based and should not be assumed to apply in all cases. It does, however, leave open the possibility of planning involving the use of other provisions of the Canadian taxing legislation to create dividends or deemed dividends for Canadian tax purposes in cases where, for U.S. tax purposes, these transactions would not be recognised regardless of whether or not a Canadian entity is fiscally transparent.17
All this said, the CRA guidance, while helpful in clarifying some of the open issues which have surrounded the application of the anti-hybrid rules, does not provide definitive solutions. Taxpayers who are well advised may avoid the pitfalls and in many cases will be able to continue their existing structures undisturbed. However, less fortunate investors on both sides of the borders may unwittingly get caught by the traps which now abound!