Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
The Technical Explanation (TE) offers welcome interpretation of the new rules in the Fifth Protocol (the Protocol) to the Canada-United States Income Tax Convention (the Treaty) relating to hybrids and fiscally transparent (flow-through) entities. However, the biggest disappointment is that it offers no relief from the anti-hybrid rules for unlimited liability companies (ULCs) paying dividends and other amounts to their U.S. shareholders.
Application of Anti-Hybrid Rules to ULCs
A ULC is a corporation for Canadian tax purposes but may be treated as a flow-through entity for U.S. tax purposes (i.e., as a branch if owned by a single U.S. shareholder) or a partnership if it has more than one shareholder. The discussion below assumes the ULC is such a "hybrid" entity. ULCs have been used as vehicles to carry on Canadian business or hold Canadian investments in structures that are not aggressive from a U.S. or Canadian tax perspective. For example, ULCs have been used by U.S. residents as the preferred entity through which to carry on a Canadian operating business, instead of operating through an actual Canadian branch of a U.S. resident entity or a Canadian subsidiary corporation that cannot be treated as a branch for U.S. tax purposes. ULCs have also been used as part of more aggressive cross-border tax planning, particularly as part of double-dip financing structures.
The Protocol contains anti-hybrid rules that apply to payments made by ULCs to their U.S. resident shareholders, regardless of whether the payments are deductible expenses, such as interest or royalties, or non-deductible distributions, such as dividends. The effect of the rules is to deny the benefits of Treaty-reduced rates of withholding tax or exemptions from withholding tax that would otherwise apply to the payments, so that the 25% Canadian withholding tax rate applies. From a tax policy perspective, it is perhaps understandable that treaty relief from withholding tax should not be available in a case where the recipient of the payment is not subject to tax on the payment in the recipient's country of residence and the payment is deductible in computing the income of the hybrid entity in the source country. A ULC does not have any special tax status in Canada and is subject to full corporate tax so that a Canadian limited company and a ULC pay exactly the same amount of tax in Canada. Yet where a ULC pays full corporate tax in Canada and then pays a dividend of the after-tax proceeds to its U.S. parent, the withholding rate applicable to such dividend will be 25%, even though the withholding rate would generally be 5% if the payer of the dividend was a Canadian limited company. This result is completely unwarranted from a tax policy perspective. Both U.S. and Canadian tax officials had indicated prior to the release of the TE that, as a policy matter, it might not be appropriate for this rule to apply to non-deductible dividend payments. However, since the wording in the Protocol clearly covers all payments, whether deductible or not, they apparently decided that it was not possible to offer relief by way of the TE. In fact, the TE contains examples that specifically contemplate that dividends and any other non-deductible payments by a ULC to its U.S. parent are caught by the anti-hybrid rules. The officials suggested that they have already started discussing yet another protocol, and hinted that some relief may be offered prior to the effective date of the anti-hybrid rules (January 1, 2010 if the Protocol is ratified in 2008).
The U.S. Joint Committee on Taxation's paper regarding the Protocol, presented for the hearing before the U.S. Senate Committee on Foreign Relations held onJuly 10, 2008, raised issues for the Senate Committee to consider in connection with the proposed ratification of the Protocol. The paper points out that the anti-hybrid rules in the Protocol do not attempt "to classify the use of hybrids as acceptable or unacceptable depending on the factual circumstances" and that "many taxpayers that have not organized their U.S.-Canada cross-border structures to obtain double deductions will have to restructure their legal entities in order to avoid double taxation. " The paper states that the Senate Committee may wish to consider whether a narrower anti-hybrid rule could have been negotiated in order to target abusive structures and cause less disturbance to non-abusive structures. However, it is not the role of the Senate Committee to make changes to the Protocol; the Senate Committee can only ratify it or refuse to ratify it.
Restructuring of Existing ULCs
If the Protocol is ratified and no relief is forthcoming (by way of an additional protocol or otherwise), U.S. residents with ULCs will have to look into possible restructuring alternatives. It will not normally be possible to wind-up a ULC to create a true Canadian branch of a U.S. parent company without adverse Canadian tax consequences because this would result in a deemed disposition of all of the assets of the ULC for Canadian tax purposes for fair market value proceeds. The use of a branch structure may be more feasible for a new Canadian business, but there are sometimes awkward Canadian tax consequences of operating in Canada through a non-resident entity. Depending on U.S. tax considerations, it may be feasible to convert a ULC into a corporation for U.S. tax purposes, and this would have no Canadian tax consequences. However, in some cases, this may trigger unacceptable U.S. tax liabilities based on our understanding that the conversion is considered an outbound transfer of the assets of the ULC from a U.S. taxpayer to a foreign corporation from the U.S. tax perspective.
Another restructuring alternative may be to insert a third-country holding company between the U.S. parent and the ULC; for example, the Canada-Luxembourg Tax Treaty does not have an anti-hybrid rule or a limitation on benefits article. Anti-avoidance issues and costs of establishing and maintaining the new holding company would have to be considered. For a U.S. resident shareholder of a ULC that is not, or may have difficulty establishing its status as, a "qualifying person" for purposes of the new limitation on benefits article contained in the Protocol (and discussed later in this bulletin), it may be important to transfer the shares of the ULC to the new holding company before the Protocol comes into force with respect to capital gains. This would be necessary if a gain would be triggered for Canadian tax purposes in connection with a transfer of the shares at fair market value from the U.S. shareholder to the new holding company, and the U.S. shareholder wishes to claim a Treaty exemption on the grounds that the shares do not derive their value principally from Canadian real property or resource property. Accordingly, such a U.S. resident shareholder should consider the restructuring alternatives now and be prepared to insert a new third-country holding company, if that is the chosen alternative, before the end of 2008.
Other Hybrid Structures
Other examples given in the TE of application of the anti-hybrid rules were not surprising. As expected, the said rules will have application to hybrid partnerships; for example, U.S. partnerships (treated for U.S. tax purposes as corporations) used by Canadian residents to carry on business in the U.S. or finance U.S. investments, and Canadian partnerships (treated for U.S. tax purposes as corporations) used by U.S. residents to finance Canadian investments and businesses. All affected hybrid structures will have to be reviewed, and potentially collapsed or restructured beforeJanuary 1, 2010 (assuming the Protocol is ratified in 2008). The comments above concerning the potential need to complete transfers of Canadian shares before the Protocol limitation on benefits article becomes effective should be taken into account in all cases. This will not be relevant if all U.S. resident entities are clearly "qualifying persons" entitled to full Treaty benefits.
Guidance on Relieving Rules for U.S. Limited Liability Companies (LLCs) and Other Fiscally Transparent Entities
The TE offers guidance regarding how the new relieving rules for fiscally transparent entities will be interpreted and administered. U.S. entities that will be treated as fiscally transparent, and therefore looked through to determine entitlement to Treaty benefits, include partnerships, certain common investment trusts, grantor trusts and LLCs (if they are treated for U.S. tax purposes as partnerships or disregarded entities rather than corporations). U.S. "S" corporations will be granted Treaty benefits by Canada as U.S. resident corporations in their own right (a long-standing Canada Revenue Agency (CRA) practice), although the new limitation on benefits article needs to be considered. Canadian entities that will be treated as fiscally transparent are partnerships (except where Canadian law imposes tax on the partnership; for example, a SIFT partnership) and "bare" trusts. Canadian revocable trusts that are not bare trusts are not included in the list of Canadian fiscally transparent entities, even if the settlor of the trust may be attributed income and gains of the trust for Canadian tax purposes.
The TE clarifies that because LLCs are still regarded as corporations for Canadian tax purposes, an LLC (not its members) will still file Canadian income tax returns reporting any relevant Canadian source income and gains. However, since the LLC itself is not entitled to Treaty benefits, the LLC will claim Treaty benefits that are available to its U.S. resident members as a result of the look-through treatment of fiscally transparent entities. Practical details regarding the information that will have to be provided by the LLC to establish the members' Treaty status were not included in the TE. The TE indicates that the CRA will provide guidance in this regard. Given that the Protocol has not extended Treaty benefits to LLCs themselves (but rather to U.S. qualifying members), it will continue to make sense in certain circumstances to consider the use of a "blocker" entity when making investments or carrying on business in Canada.
In the case of an LLC carrying on business in Canada, Canada will look only to the presence and activities in Canada of the LLC for purposes of determining whether the LLC earns income through a permanent establishment and will not look to those of the members acting in their own right.
The TE clarifies that Treaty benefits may be claimed by looking through a fiscally transparent entity in a third country. The example given was that of a U.S. resident owning a French entity that earns Canadian-source dividends. If the French entity is fiscally transparent for U.S. tax purposes, the U.S. resident can claim Treaty benefits with respect to the dividend, even if the French entity is not fiscally transparent for Canadian or French tax purposes. If the Canada-France Tax Treaty is also applicable, then the Canadian withholding tax rate would be the lesser of the Treaty rate and the Canada-France Tax Treaty rate. This result will be particularly useful in the case of related-party interest, as the Treaty is the first Canadian tax treaty to reduce the withholding tax rate (gradually) to nil for U.S. residents that qualify for Treaty benefits. Similar compliance issues as those described above with respect to LLCs would presumably apply to the third-country entity.
The Protocol will add language to the dividend article to allow access to the 5% withholding tax rate where shares are held through a fiscally transparent entity. The 5% rate applies only if the beneficial owner of the shares is a company that owns 10% or more of the voting stock of the dividend payer. Voting stock held indirectly through a fiscally transparent entity will generally be taken into account under the new language. The CRA has taken the position under the existing Treaty that the voting stock of a Canadian corporation must be directly held by a U.S. company in order to meet the requirements for the 5% rate. It is interesting that the TE states that the U.S. considers the new language to be "merely a clarification," suggesting they are not in agreement with the CRA's interpretation of the existing Treaty. A U.S. company that has recently suffered the 15% withholding tax rate on dividends paid by a Canadian corporation to a partnership, and that would have qualified for the 5% rate if indirect share ownership were counted, could consider whether to challenge the CRA's position by applying for a refund of the excess withholding tax.
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.