When the Canada-US tax treaty was amended by the Fifth Protocol (effective 2010), new Article IV(7)(b) was added to eliminate treaty benefits for certain hybrid entity arrangements which generated deductions in Canada but no corresponding income pick-up in the US. The actual wording of the new rule inappropriately extended to simple Canadian unlimited liability company (ULC) structures, which did not achieve this mischief. For example, Article IV(7)(b) applied to deny the treaty withholding tax rate on interest and dividends paid by a Canadian ULC to its a US parent company, notwithstanding that the ULC was disregarded for US tax purposes and therefore all of the ULC’s income was (immediately) taxed in the US. The Canada Revenue Agency (CRA) has since issued favorable rulings which allow such US parent companies to restructure and thereby avoid the technical application of Article IV(7)(b). Ruling 2013-0491331R3 (recently released) is the latest of such rulings:
- The US parent formed a limited partnership with one of its shareholders, and thereafter transferred to the partnership its interest-bearing noted owed by the ULC.
- This simple step meant that the actual wording of Article IV(7)(b) would not be engaged, and interest paid by the ULC to the partnership would be exempt from withholding tax under Article XI(1) of the treaty.
- The CRA further confirmed that Canada’s general anti-avoidance rule would not apply because all of the ULC’s income would continue to be subject to tax in the US. In other words, no abuse arose because the restructured arrangement did not result in the mischief to which Article IV(7)(b) was directed.