Despite recent amendments to the income tax treaty between Canada and the United States (the "Treaty") that were intended to provide relief in respect of hybrid entities with cross-border investments and operations, the Canada Revenue Agency (the "CRA") continues to deny – incorrectly in our view – the benefits of the reduced "branch profits" tax rate in the case of fiscally transparent US limited liability companies ("US LLCs") with non-corporate, treaty-eligible members ("Non-Corporate Members"). In this bulletin, we challenge the CRA's position and put forward an alternative interpretation of the relevant treaty provisions.
Canadian Branch Profits Tax Overview and Its Application to US LLCs
Canada's Income Tax Act (the "Tax Act") imposes a 25% branch profit tax on the after-tax Canadian profits of foreign corporations that are not reinvested in Canada. Under Article X(6) of the Treaty, the branch profits tax rate applicable to US-resident corporations is reduced to 5%, with the first $500,000 of cumulative branch profits being exempt.
Historically, these benefits were not available to US LLCs in light of the CRA's longstanding position that US LLCs were not US residents for purposes of the Treaty. However, Article IV(6) of the Treaty, added by the Fifth Protocol to the Treaty, allows a US LLC with US-resident members to claim benefits under the Treaty with respect to certain amounts "derived" by the US LLC, to the extent that:
- the US LLC is not a resident of Canada; and
- the tax treatment of the LLC's members under applicable US tax law is no different than the treatment that would have been accorded had the members derived the income amounts directly (and not through the US LLC).
CRA's Denial of Treaty Benefits to US LLCs with Non-Corporate Members
Notwithstanding Article IV(6), however, in a series of published statements, the CRA has asserted that the Treaty provides relief from Canadian branch profit tax only for US resident members of an LLC that are corporations. In the CRA's view, branch profits that are deemed to have been derived by Non-Corporate Members (such as individuals or trusts) through a US LLC are taxable at the full 25% branch profits tax rate.
This position is principally based on the CRA's interpretation of Article X(6) of the Treaty, the relevant portion of which read as follows:
"Nothing in this Treaty shall be construed as preventing [Canada] from imposing a tax on the earnings of a company attributable to permanent establishments in [Canada], in addition to the tax which would be chargeable on the earnings of a company which is a resident of [Canada], provided that any additional tax so imposed shall not exceed 5 per cent of the amount of such earnings which have not been subjected to such additional tax in previous taxation years ..." [emphasis added]
The CRA interprets the above provision as a relieving measure that operates to reduce the branch profits tax rate on US-resident corporations from 25% to 5%. However, because Article X(6) only refers to "companies", the CRA takes the view that it does not serve to reduce the branch profits tax rate on income derived by Non-Corporate Members through a US LLC.
A More Appropriate Interpretation of Article X(6)
In our view, the CRA's interpretation of Article X(6) ), is flawed and produces unexpected and inappropriate results from a policy perspective. Even a literal, much less a liberal, interpretation of Article X(6) read in the context of the Treaty as a whole, suggests that US LLCs should be entitled to claim the benefits of Article X(6) in respect of income derived by their Non-Corporate Members.
The CRA's interpretation of Article X(6) fails to take into consideration other relevant provisions of the Treaty. For example, while the CRA may be correct in its view that Article X(6) does not relieve Non-Corporate Members from the imposition of branch profits tax, its analysis fails to take into account that such relief is already afforded by the non-discrimination provisions contained in Article XXV of the Treaty. These non-discrimination provisions prevent Canada, inter alia, from subjecting US-resident taxpayers to taxation that is more burdensome than that imposed on Canadian-resident taxpayers. Since Canada does not impose branch profits tax on Canadian residents, Article XXV should, unless expressly provided for elsewhere in the Treaty, preclude Canada from imposing branch profits tax on any person (including a corporation) who is otherwise entitled to claim Treaty benefits.
Moreover, read in light of Article XXV, it is clear that the purpose of Article X(6) is not, contrary to the CRA's interpretation, to relieve US residents from the imposition of branch profits tax – Article XXV already does that. Rather, the purpose of Article X(6) is to permit Canada to impose branch profits tax, despite Article XXV, but only on corporations and only at a rate of 5%. This interpretation is strongly supported by the introductory language of Article X(6) which reads: "[n]othing in this Treaty [i.e., Article XXV] shall be construed as preventing [Canada] from imposing a tax on the earnings of a company attributable to a permanent establishment in [Canada]...". That introductory language only makes sense if, absent Article X(6), Canada would not be permitted to impose branch profits tax on corporations under the Treaty. Also, this interpretation is consistent with Canada's domestic tax regime, which only imposes branch profits tax on non-resident corporations.
Finally, the CRA's interpretation is inconsistent with the fundamental purpose of Article IV(6) which, as noted above, was to provide Treaty benefits to US LLCs, and is in conflict with the longstanding and widely accepted principle that tax treaties be given a liberal interpretation "with a view to implementing the true intentions of the parties".1 Reading Article X(6) as an exception to the non-discrimination provisions facilitates a greater realization of the policy objectives underlying Article IV(6) and avoids the unintended scenario where Canada is effectively imposing branch profits tax on individuals.
The CRA's construction of the branch profits tax in Article X(6) and the denial of tax benefits to US LLCs with Non-Corporate Members are inconsistent with the policy objective of the Treaty and is not supportable from a technical perspective.
According to our alternative interpretation, Article X(6) serves as an exemption to the non-discrimination provisions contained in Article XXV of the Treaty and merely permits Canada to impose a 5% branch profits tax on corporations. This interpretation is entirely consistent with both the text and the spirit of the Treaty.
We are aware of several instances recently (either at the audit or the objection stage) where the CRA has backed away from its published views on the branch profits tax provisions, and instead opted to apply the interpretation advocated in this article. We recommend that US LLCs with Non-Corporate Members carefully review their past and present filing positions and strategies in relation to Canadian business operations with a qualified Canadian tax advisor and consider what relief, if any, may be available in their circumstances.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2014