On November 24, 2009, the Canada Revenue Agency (“CRA”) provided some guidance on certain issues related to the application of the new hybrid rules in the Fifth Protocol to the Canada-US Tax Treaty (the “Treaty”) to Canadian unlimited liability companies (“Canadian ULCs”) (i.e. Nova Scotia, Alberta and British Columbia ULCs) and US limited liability companies (“US LLCs”). These comments were provided by CRA at the CRA Roundtable at the 61st Annual Conference of the Canadian Tax Foundation.
Two-Step Distributions by ULCs
Treaty benefits will generally be denied under the anti-hybrid rule under Article IV(7)(b) of the Treaty in respect of any dividends paid on or after January 1, 2010 by a Canadian ULC. One possible solution to the denial of such treaty benefits is the implementation of a two-step distribution.
CRA commented on this possible solution in a situation where a US company (“USCo”) owns the shares of a Canadian ULC that carries on business in Canada and Canadian ULC is a disregarded entity for US tax purposes. CRA was asked whether the anti-hybrid rule under Article IV(7)(b) of the Treaty would apply to deny treaty benefits to USCo under the Treaty in respect of a two-step distribution by Canadian ULC.
First, Canadian ULC would increase the amount of its paid-up capital in respect of the particular class of shares which would give rise to a deemed dividend for USCo under Canadian tax laws. Such dividend would be subject to Canadian withholding tax at a rate of 25% unless USCo is entitled to a reduced withholding tax rate under the Treaty. Second, the Canadian ULC would make a payment to USCo on a reduction of the paid-up capital of the particular class of shares. This payment would not be subject to Canadian withholding taxes.
CRA was of the view that USCo should not be denied treaty benefits in these circumstances provided that the deemed dividend resulting from the increase in the paid-up capital of the shares of the Canadian ULC is subject to the same tax treatment under US tax laws as it would be if Canadian ULC were not fiscally transparent for US tax purposes. CRA considers that a deemed dividend is subject to the same tax treatment if it is disregarded under US tax laws and would also be disregarded if Canadian ULC was not fiscally transparent for US tax purposes (i.e., Canadian ULC was treated as a corporation for US tax purposes).
CRA indicated that it would not normally expect the Canadian general anti-avoidance rule (“GAAR”) to apply to this two-step dividend distribution if the Canadian ULC is used by USCo to carry on an active branch operation in Canada and USCo and Canadian ULC enter into this two-step arrangement in order to continue to qualify for the reduced 5% withholding tax rate under the Treaty on the distribution of Canadian ULC’s after-tax earnings to USCo.
Insertion of a Luxembourg SARL
Another possible solution to the denial of treaty benefits on dividends paid by a Canadian ULC is the interposition of a Luxembourg SARL.
CRA considered this possible solution in a situation where a Luxembourg SARL (“Luxco”) is inserted between a US parent company and a Canadian ULC and Luxco is considered to be resident in Luxembourg for Canadian tax purposes and is disregarded for US tax purposes. CRA was asked to confirm whether the 5% withholding tax rate under the Canada-Luxembourg Tax Treaty would apply to dividends paid by Canadian ULC to Luxco.
CRA confirmed that the reduced 5% withholding tax rate under the Treaty will normally apply if Luxco is the “beneficial owner” of the dividends. The CRA also indicated that its views with respect to GAAR as described above in respect of the two-step distribution would also be generally applicable to the insertion of a Luxco.
Interest Payments by ULC to US Grandparent
Depending on the circumstances, treaty benefits may be denied in respect of interest paid by a Canadian ULC on or after January 1, 2010 on related party debt under the anti-hybrid rule in Article IV(7)(b) of the Treaty unless it satisfies, among other things, the “same tax treatment” requirement.
The CRA remarked on whether the payment of interest on a debt of a ULC owed to a US parent and that is rearranged to be owed to the US grandparent would satisfy the “same treatment” requirement in Article IV(7)(b) of the Treaty. In this case, Canadian ULC is treated as a disregarded entity for US tax purposes, US grandparent is regarded as receiving interest from the Canadian branch of its US subsidiary for US tax purposes and the interest is treated as having been paid to the US grandparent by the Canadian ULC for Canadian tax purposes.
CRA expressed the view that Article IV(7)(b) would not apply to deny treaty benefits in respect of the interest paid on the debt to US grandparent in these circumstances if the interest is subject to the same tax treatment under US tax laws in the hands of the US grandparent as it would be if Canadian ULC were not fiscally transparent. CRA indicated that it would interpret “same treatment” as “same tax effect generally”.
CRA cautioned that the GAAR may apply if Canadian ULC is part of a financing arrangement resulting in, among other things, duplicated interest deductions, or internally generated interest deduction in one country without offsetting interest income in the other country. CRA appears to be considered with double dip financing structures.
Dividend and Interest Payments before 2010
CRA considered a situation where a US LLC owns all of the shares of a Canadian ULC. CRA was asked to confirm whether US LLC would be entitled to treaty benefits in respect of any dividend or interest paid by Canadian ULC to US LLC before January 1, 2010. CRA indicated that the anti-hybrid rules in Article IV(7) of the Treaty should not apply to any such payments made by Canadian ULC to US LLC before 2010.
CRA also confirmed that such payments should be eligible for reduced withholding tax rates under the Treaty if paid or credited on or after February 1, 2009 and if such payments are considered to be derived by a resident of the US under Article IV(6) of the Treaty who is a “qualifying person” within the meaning of the limitation on benefits provisions in Article XXIX-A of the Treaty.
LLC with Canadian Branch
CRA was presented with a corporate structure in which a LLC is carrying on business in Canada through a branch and is equally owned by four shareholders; a Bermudian resident corporation, a US “C” resident corporation, a US tax exempt (i.e., pension fund), and a US resident individual. CRA was then asked to comment on the Canadian tax consequences for each shareholder given that Article IV(6) appears to require CRA to look through the LLC to the identity of the shareholder to determine treaty entitlement.
CRA confirmed that notwithstanding that LLC continues to be treated as a corporation for Canadian tax purposes the look-through rule applied and the branch tax rate related to the share of the US corporation would be reduced from 25% to 5% under the Treaty and the share of the US tax exempt would be exempt from such tax under the Treaty. However, the CRA noted that the branch tax would apply at a rate of 25% on both the share of the Bermudian corporation and the share of the US resident individual because there is no provision in the Treaty that would reduce the branch tax rate in these circumstances. Although not entirely clear, it would appear that CRA may have adopted this position on the basis that a US resident individual should not be entitled to a reduction under the Treaty in respect of its share of branch tax because branch tax only applies to non-resident corporations under Canadian tax laws.
Although the CRA has provided some guidance as to the application of the Fifth Protocol to Canadian ULCs and LLCs, the relevant rules are highly complex and fact-specific. As a result, it is recommended that you consult a qualified tax practitioner.