Canada: Canadian Tax @ Gowlings – January 2006

Last Updated: January 24 2006

Edited by Vince Imerti

  • Update of Current International Tax Issues
  • Canadian Corporate Borrower + Canadian Lender = US Withholding Tax?
  • Characterization of foreign entities for Canadian tax purposes is not as easy as you think!

Update of Current International Tax Issues

Following is a brief update of a number of current Canadian international tax issues which have previously been discussed in CanadianTax@Gowlings Volume 1 - Number 1, dated September 8, 2004 and Volume 2 - Number 1, dated April 1, 2005.

U.S. LLCs

As previously discussed in this publication, the status of U.S. limited liability corporations ("LLCs") under the Canada-U.S. Tax Convention (1980) (the "Treaty") has been uncertain for a number of years. The Canada Revenue Agency ("CRA") has taken the position that LLCs that are treated as corporations for Canadian tax purposes but as flow-through entities for U.S. tax purposes are not entitled to the benefits of the Treaty as they are not liable to taxation in the U.S. and, therefore, are not "resident" in the U.S. for the purposes of the Treaty. Canada and the U.S. have been in negotiations for a new protocol to the Treaty for several years now and this issue has been one of the subjects of these negotiations. While these negotiations have been on-going for some time, it is our understanding that we may see movement in this regard in the very near future.

Cross-Border Share-for-Share Exchanges

Canadian taxpayers and their advisers have made use of so-called "exchangeable share structures" for a number of years in order to synthesize a "rollover" for Canadian shareholders of Canadian corporations to foreign corporate purchasers in circumstances in which the Canadian shareholders are receiving shares of the foreign purchaser. These structures are cumbersome, complicated, and difficult to work with.

In October of 2000 the Department of Finance announced that a legislated regime for such transactions would be introduced into the Income Tax Act (Canada). This was confirmed in the Federal Budgets of 2003 and 2004. However, we are still awaiting the detailed legislative proposals (the Federal Budget of March 2004 indicated that these detailed proposals would be "released for comment in the coming months"). Nevertheless, it is our understanding that the detailed proposals are now ready to be released for comment. Hopefully we will see them soon after the Canadian federal election on the 23rd of this month. However, it is likely safe to say that one should not expect these new rules to be significantly simpler or less cumbersome to work with than the existing exchangeable share structures.

Income Fund Review

Although not, strictly speaking, a matter exclusively of relevance to Canadian international tax planning, one of the most significant developments in Canadian tax law in recent months was the purported end of the Federal Government's review of so-called "income funds". "Income fund" is a generic term used to refer to a number of business structures one of the principal objectives of which is to generate regular cash flow to investors and to shift all or a significant portion of the taxation of such cash flow to the investor level (in other words, to avoid corporate level tax that would arise in a more conventional corporate structure).

On September 8, 2005 the Department of Finance announced that it would be conducting "consultations on tax and other issues related to business income trusts and other flow-through entities" and would be receiving submissions in this regard until December 31, 2005. This announcement went largely unheeded by the Canadian investment and tax communities. Seemingly to get the attention of these communities, on September 19, 2005 the Federal Government announced that it would be suspending the issuance of any advance tax rulings relating to "flow-through entity structures" pending the completion of the previously announced consultation process. Then, on November 23, 2005, more than a month before the end of the originally announced consultation period, but just before the expected fall of the minority Liberal Government, the Minister of Finance announced that he was satisfied that no changes to the tax treatment of income funds was necessary, and the only tax changes needed to address the divergent tax treatment of corporations and income funds was a reduction in the rate of taxation on corporate dividends.

As a result, the taxation of income fund structures in Canada is, apparently, settled and will not be changed. However, notwithstanding the statements of the Minister of Finance, many people feel that we have not heard the end of this saga.

Canadian Corporate Borrower + Canadian Lender = US Withholding Tax?

Since the introduction of the US "check-the-box" regulations ("U.S. Regulations"), Canadian unlimited liability companies ("ULCs") have become an increasingly popular form of entity used by U.S. Corporations to engage in a Canadian business. Currently, both the Province of Nova Scotia and the Province of Alberta have legislation that allows the establishment of ULCs. Under the U.S. Regulations, a U.S. Corporation that owns all of the issued and outstanding shares of a ULC ("U.S. Parent") can elect to have the ULC treated as a disregarded entity for U.S. income tax purposes. This results in certain tax and accounting advantages for the U.S. Parent in the conduct of the ULC's Canadian business.

In the foregoing structure, certain interesting issues may arise as a result of the hybrid treatment of the ULC. For Canadian income tax purposes, the ULC is considered to be a corporation resident in Canada and to have all of the attributes of a Canadian corporation. While shareholders of a ULC will have unlimited liability for the ULC's obligations, such shareholders are treated as separate and distinct from the ULC for Canadian income tax purposes. For U.S. income tax purposes, the ULC is disregarded. The assets of the ULC are considered to be owned by the U.S. Parent and the business of the ULC is considered to be carried on by the U.S. Parent.

One interesting scenario results where the ULC obtains bank financing from a Canadian lender. For Canadian income tax purposes, since both the lender and the borrower (in other words, the ULC) are considered to be residents of Canada for income tax purposes, any interest payable by the ULC would not be subject to any form of source withholding in Canada. For US income tax purposes, however, because the ULC is a disregarded entity, any interest payments made by the ULC are considered to have been made by the U.S. Parent. On its face, absent any exempting provisions under the Internal Revenue Code ("Code") or any relieving provisions under the Canada-US Income Tax Convention (the "Convention"), the payment of interest by the ULC to the Canadian lender would attract US withholding tax.

Relief may be available under the Convention, depending upon the particular facts and circumstances of the business carried on by the ULC. For example, the Convention provides certain sourcing rules that deem interest to arise in a particular Contracting State. Paragraph 6 of Article 11 of the Convention provides that interest shall be deemed to arise in the Contracting State in which the payor of the interest is resident. Since, for the purposes of the Code, the payor of the interest is deemed to be the U.S. Parent, absent any further sourcing rules, the interest payable by the ULC would be deemed to arise in the U.S. (being the Contracting State where the U.S. Parent is resident). However, paragraph 6 goes on to provide that where the person paying the interest, whether it is a resident of a Contracting State or not, has in a State other than that in which it is a resident, a permanent establishment or fixed base in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment or fixed base, then such interest shall be deemed to arise in the State in which the permanent establishment or fixed base is situated and not in the State of which the payor is resident. Therefore, provided the ULC has either a permanent establishment or fixed base in Canada, paragraph 6 of Article 11 of the Convention will deem the interest to arise in Canada and, therefore, no U.S. withholding tax should apply.

If the ULC does not have a permanent establishment or fixed base in Canada, other planning steps may be required. For example, a second shareholder of the ULC could be introduced. The U.S. Parent may incorporate a wholly owned subsidiary to acquire a small interest in the ULC or another entity within the U.S. Parent's related group may acquire a small interest in the ULC. We understand that once the ULC is no longer wholly owned by the U.S. Parent, the ULC will not be treated as a disregarded entity, but rather as a foreign partnership for U.S. income tax purposes. Provided the ULC does not carry on any business in the U.S., the sourcing rules under the Code would ordinarily deem the interest paid by the "foreign partnership" to arise outside of the U.S. and, therefore, not be subject to U.S. withholding tax. Caution should be had in implementing this type of structure given the U.S. business purpose test that must be met in order to justify the minority shareholding of the ULC.

The foregoing is but one example of certain anomalous results which may arise with U.S. owned ULC structures because of the hybrid nature of the ULC. Once such issues are identified, however, careful planning, and in some circumstances, additional tax structuring, is usually sufficient to manage such issues and preserve the tax and accounting benefits which drive the ULC structures.

Characterization of foreign entities for Canadian tax purposes is not as easy as you think!

It is safe to say that in recent years we have seen an explosion in the use of hybrid business organizations in international tax planning. In this context a "hybrid" refers to an organization that receives one form of treatment in one taxing jurisdiction but a different form in another. Examples in a Canadian context are Alberta unlimited liability corporations or Nova Scotia unlimited liability companies, both of which are treated as taxable corporations for Canadian tax purposes but can elect to be treated as flow-through entities for U.S. tax purposes.

While the characterization of foreign entities for Canadian tax purposes is, in many cases, relatively straight forward, in some cases this can be a difficult exercise. In general, one must look to the characteristics and legal relationships as determined by the governing foreign law and compare those against Canadian concepts to determine how a foreign entity will be treated for Canadian tax purposes.

As an aid in this process, the Canada Revenue Agency ("CRA") has published a list of foreign entities that it considers to be corporations. While many of these foreign entities have characteristics of a partnership and are treated as such in the governing jurisdiction, CRA treats them as corporations for Canadian tax purposes. As the CRA's list does not cover all foreign entities, one must consider the factors that are taken into account when determining the characterization of a foreign entity.

The term "partnership" is not defined in the Income Tax Act (Canada) ("Canadian Tax Act"). Accordingly, in deciding whether a particular foreign entity should be treated as a partnership for Canadian tax purposes, a review of its meaning under Canadian (in this case provincial) law is required as a partnership is a legal concept derived from the common law and the relevant provincial partnership statutes.

The seminal court decision in respect of the subsistence of a partnership under Canadian law is the decision of the Supreme Court of Canada in Continental Bank of Canada v. R. In that case, the Court stated that three essential elements of a partnership must be present in order to have a valid partnership. The three elements are: (1) there must be a business, (2) the business must be carried on in common by two or more persons, and (3) the business must be carried on with a view to profit. The CRA's views on the existence of a partnership are generally consistent with the views of the Court as expressed in Continental Bank. The CRA has also provided the following guidance:

  • if the right to a share of profits of a party represents the payment of an obligation as opposed to a partnership right to so share, any presumption of partnership relating to the share of profits is rebutted;
  • if several persons form an association for the purpose of carrying out particular business transactions without accepting total liability for the association's debt (in other words, if each associated person is liable only for their respective portions of the debts), the existence of such an arrangement is viewed as in indication that a partnership does not exist.

On the other hand, the Canadian Tax Act defines "corporation" to include an "incorporated company", which is not further defined in the Canadian Tax Act. Subsection 35(1) of the Interpretation Act (Canada) provides that a corporation does not include a partnership that is considered to be a separate legal entity under the provincial law, but does not extend this exclusion to a partnership governed by foreign law that has a separate legal personality.

The CRA has stated that a corporation is an entity created by law having a legal personality and existence separate and distinct from the personality and existence of those who caused its creation or those who own it. Furthermore, the CRA has stated that as long as an entity has such a separate identity and existence, it will consider such entity to be a corporation even though under some circumstances or for some purposes the law may ignore some facet of its separate existence or identity.

This statement suggests that the CRA uses a bright-line test based on the characteristic of a separate legal personality in determining whether an entity is a corporation. A review of CRA's published positions reveals that where the separate legal personality is explicitly stated in the legislation governing the non-resident entity, in most cases, such an entity will be considered a corporation for purposes of the Act. For example, the CRA has concluded that a Tennessee limited liability corporation ("LLC"), a Kentucky LLC and a New York LLC would be corporations based on the fact that the governing laws declare the LLC to be a separate legal entity. In the case of a Michigan LLC, the CRA has noted the fact that the entity can own property in its own right, and can sue and be sued, are characteristics amounting to a separate legal personality.

However, in some CRA technical interpretations in respect of the appropriate characterization of a non-resident entity, the CRA has considered other attributes of the foreign entity in addition to the separate legal personality test. For example, in determining whether an entity governed by the Delaware Revised Uniform Partnership Act ("DRUPA") is a partnership for Canadian income tax purposes, the CRA has stated that the existence of a separate legal entity clause contained in foreign partnership legislation would not, by itself, preclude an arrangement from being considered as a partnership for Canadian income tax purposes. In coming to this conclusion, the CRA indicated that the attributes of an entity created under foreign partnership legislation should be compared to those of a Canadian partnership and a Canadian corporation when determining the classification of the foreign entity for Canadian tax purposes.

Some of the other factors that the CRA has considered include:

  • limited liability of the members
  • number of members
  • perpetual or limited life of the entity
  • member's share of entity's profits
  • transferability of ownership interest
  • ownership by members of entity's property.

For example, in determining whether a SRL formed under the Barbados Societies with Restricted Liability Act is treated as a corporation for Canadian tax purposes, the CRA identified a list of key attributes of the foreign entity. Despite the fact that an SRL has attributes that are more similar to a partnership, the CRA concluded that as a whole, the SRL more closely resembles a corporation under Canadian common law.

Accordingly, it is evident that the determination of whether a foreign entity would be considered as a corporation for Canadian income tax purposes will not rest solely on the fact that it is a separate legal entity. In addition to that important attribute, all other attributes of the foreign entity in question must be considered and compared with those of a Canadian partnership and a corporation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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