Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, September 2008
The Canada Revenue Agency (CRA) recently released a non-binding technical interpretation regarding the Canadian tax treatment of conversion of a Delaware limited liability company (LLC) into a limited partnership (LP) under Delaware law.
Delaware law clearly provides that such a conversion does not result in a transfer of property of the convert-ing LLC. Further, Canadian law requires that tax results be determined based on the legal characterization of transactions. Nonetheless, in the technical interpreta-tion, CRA asserted that an LLC should be considered to dispose of its property when it converts into an LP under Delaware law. CRA's position in the technical interpretation is unexpected, and arguably unsound.
Since the mid-1990s, CRA has consistently asserted that U.S. LLCs should be classified as corporations for Canadian tax purposes. Further, CRA has also maintained that neither an LLC nor its members may access any benefits under the Canada-U.S. tax treaty with respect to items of income or gain realized by the LLC, except where the LLC has elected to be taxed as a U.S. corporation. In most cases, LLCs are fiscally transparent for U.S. tax purposes.
CRA's position has had unfortunate and inappropriate consequences in many contexts. As an example, where a U.S. investor happens to have invested in a Canadian private company through a fiscally transparent LLC, dividends received by the LLC are, in CRA's view, subject to statutory, rather than treaty-reduced, withholding rates, and furthermore, the LLC is itself liable to pay Canadian tax on any capital gain realized on a subsequent transfer of the Canadian shares, without the benefit of any treaty exemption. These results are clearly inappropriate from a tax policy perspective, as the U.S. resident members of the LLC are liable to pay U.S. tax on their allocated share of the LLC's income or gain. CRA's view was based on its analysis of the legal nature of an LLC. Strict adherence to legal principle overrode any broader concept of tax policy. This is consistent with the well-established Canadian approach – applicable commercial law characterization generally determines tax consequences.
U.S. investors that obtain Canadian tax advice are made aware of this anomaly, and are careful to structure investments into Canada so that no Canadian shares are directly held by an LLC. However, U.S. investors that do not obtain such up-front advice, and that unwittingly invest in a Canadian private company through an LLC, might reasonably want to re-structure their investment once they are made aware of the harsh Canadian regime. If the Canadian shares have appreciated in value by the time the problem is discovered, however, any transfer of those shares to a more suitable entity will result in a Canadian tax liability on the gain realized on transfer to the more suitable entity.
One re-structuring approach that has been pursued by some U.S. investors faced with this problem is to "convert" the LLC into an LP using the specific codified rules for such conversions in Delaware statutory law. These rules, described below, clearly state that such a conversion does not result in a transfer of property. The rules also state that the converted LP is regarded as the same continuing entity as the predecessor LLC. One would have thought it clear in these circumstances that such a conversion does not result in a disposition of property by the LLC. If that is the case, the U.S. investor could convert the LLC into an LP, and then the members of the LP, which is treated as fiscally transparent for both Canadian and U.S. tax purposes, would be entitled to claim treaty benefits prospectively on a look-through basis. Such re-structuring should not be regarded as abusive, given that the wholesale denial of treaty benefits to LLCs is based on a strict legal analysis rather than any broad principle of tax policy.
At least in the case of LLCs, all of whose members are U.S. treaty-eligible residents, this problem will become a historical artefact upon entry into force of the 5th Protocol to the Canada-U.S. tax treaty, which will almost certainly occur in the near future. The protocol will add a specific relieving rule that ensures that such LLCs are able to claim treaty benefits to the extent their members are themselves eligible for such benefits. Nonetheless, for prior periods, and for LLCs with non-U.S. members, the issue remains live.
In a recently published technical interpretation (Document 2004-0104691E5(E) – Conversion of an LLC to an LP, dated August 14, 2008), CRA was asked whether an LLC that converts into an LP under Delaware law should be considered to have disposed of its property. Unexpectedly, CRA asserted that there is a disposition of property by the LLC in such circumstances.
CRA's support for this position, as articulated in the technical interpretation, departs significantly from the accepted Canadian approach. In particular, CRA reached its conclusion despite the fact that the relevant statutory provisions plainly state that a converted LLC is not considered to have transferred any of its property solely by virtue of the conversion. Unlike the traditional approach to Canadian tax analysis, CRA refused to accept the Delaware commercial law characterization of a conversion, and posited a new test based on whether or not the converted entity is the same "type of entity" as the converting entity.
In the remainder of this article, I review the technical interpretation in detail, and comment on its implications.
Technical Interpretation – Relevant Facts
The facts on which the technical interpretation was requested were as follows:
The entity in question (Entity) was a Delaware LLC governed by the Limited Liability Company Act (Delaware) (LLCA). Entity was converted into a Delaware LP governed by the Delaware Revised Uniform Partnership Act (DRUPA) and the Limited Partnership Act (Delaware) (LPA). At the time of conversion, Entity's property included "taxable Canadian property" (TCP) for purposes of the Income Tax Act (Canada) (the Act) (such as shares of a private Canadian company).
CRA was asked whether Entity would be considered to have disposed of its TCP solely by virtue of the conversion. If there were such a disposition, this would have resulted in Entity being required to apply for a section 116 certificate and file a Canadian tax return. If the disposition resulted in realization of gain (which is unclear), presumably an immediate tax liability would have resulted.
Delaware Statutory Provisions
Both the LLCA and the LPA have specific provisions that contemplate conversions of, among other things, an LLC into an LP.
CRA cited the relevant provisions of both of these statutes.
Section 17-217 of the LPA provides in part:
(f) When any conversion shall have become effective under this section, for all purposes of the laws of the State of Delaware, all of the rights, privileges and powers of the other entity that has converted, and all property, real, personal and mixed, and all debts due to such other entity, as well as all other things and causes of action belonging to such other entity, shall remain vested in the domestic limited partnership to which such other entity has converted and shall be the property of such domestic limited partnership ... The rights, privileges, powers and interests in property of the other entity, shall not be deemed, as a consequence of the conversion, to have been transferred to the domestic limited partnership to which such other entity has converted for any purpose of the laws of the State of Delaware.
(g) ... When an other entity has been converted to a limited partnership pursuant to this section, for all purposes of the laws of the State of Delaware, the limited partnership shall be deemed to be the same entity as the converting other entity and the conversion shall constitute a continuation of the existence of the converting other entity in the form of a domestic limited partnership.
Section 18-216 of the LLCA similarly provides, among other things, that "interests in property of the [LLC], as well as the debts, liabilities and duties of such [LLC], shall not be deemed, as a consequence of the conversion, to have been transferred".
These statutory provisions unambiguously provide that no transfer of property occurs under prevailing Delaware law solely by virtue of a conversion of an LLC into an LP. Further, the converted entity is regarded as a continuation of the converting entity.
In the technical interpretation, CRA cited these provisions, but refused to accept that a converting LLC does not dispose of its property solely by virtue of a conversion.
CRA approached the problem by considering the appropriate entity classification of LLCs and LPs. CRA observed that it has regarded LLCs as non-fiscally transparent entities (corporations) and LPs as fiscally transparent (partnerships).
CRA asserted that in making these determinations, it follows a "two-step" approach, described as follows:
1) Determine the characteristics of the foreign business association under foreign commercial law and the agreements (such as articles of incorporation) and contracts between the parties that govern it. The most important attributes are the nature of the relationship between the various parties and the rights and obligations of the parties under the applicable laws and agreements; and
2) Compare these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories.
CRA then asserted that in the case of a Delaware LP, the property held by the LP "is considered to be held in common by its owners, with each owner holding an undivided interest in the underlying partnership property". This curious statement foreshadows CRA's conclusion. In fact, it is misleading, if not incorrect to assert that a partnership's property is "held in common by its owners". The Act clearly contemplates the concept of a partnership itself owning property. Indeed, the hypothetical taxpayer rules in section 96 pre-suppose that a partnership – not its members – is the owner of partnership property. Similarly, the applicable Delaware statutes also provide that the property of a partnership does not constitute property of the partners. Nonetheless, CRA asserted that an LLC – being a corporation – is the owner of its property in its own right, whereas in the case of a partnership, the owners of the property are the partners themselves. It is unclear how this assertion can be reconciled with the governing Delaware law, which provides otherwise.
It is interesting to note that in 2004, CRA considered the same question (Document 2003-0049231E5). In that case, CRA declined to express a conclusion, stating instead that the facts and the details of the partnership agreement would have to be reviewed to determine whether the assets of the partnership are in fact assets of the partners themselves. The implication was that if applicable law and the partnership agreement provided that partnership assets were not assets of the partners themselves, the LLC would not dispose of its property when it converts. In the more recent technical interpretation, there is no apparent attempt to reconcile CRA's new analysis with the approach taken in 2004.
Following the unsupported assertion that the LP's property is property of the partners, CRA concluded that:
"the conversion, viewed from a Canadian tax perspective, results in a fundamental change in the nature and character of the entity being converted: a corporate entity the income of which is subject to tax in its own hands is converted into a non-corporate entity (a partnership) the income of which is subject to tax in the hands of its partners. ... As a DLLC and a DLP are not the same type of entities for Canadian tax purposes, the property of Entity will be considered to be transferred by Entity to the DLP on the conversion." [emphasis added and terminology adjusted]
This is a startling and novel approach to Canadian tax analysis. Canadian tax analysis to date has invariably been based on applicable commercial law – if, under applicable commercial law, property has been transferred, there is a disposition; otherwise there is no disposition unless a specific rule in the Act otherwise provides.
As an example, on a U.S. absorptive merger, it has long been accepted that the corporation which does not survive the merger is considered to have disposed of its property to the survivor. The reason for this is that the applicable commercial law provides that there is a transfer of property to the survivor.
Another similar example arises where two Canadian corporations amalgamate in a so-called "non-qualifying" amalgamation. (A non-qualifying amalgamation for this purpose is an amalgamation that does not qualify for statutory rollover relief under section 87 of the Act. As an example, if a shareholder of a predecessor (other than another predecessor) does not receive shares of the amalgamated company, the amalgamation will be non-qualifying.) In such a case, no statutory rollover is available with respect to the property of the amalgamating corporations. However, under applicable Canadian corporate law, there is no transfer of property; the amalgamated company is regarded as continuation of its predecessors. No transfer of property occurs. On this basis, CRA has correctly concluded that there is no disposition of property for tax purposes on such an amalgamation (see "Revenue Canada Roundtable", in Report of Proceedings on the Forty-Fourth Tax Conference, 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993), 54:1-75, question 26, at 54:17-18). The guiding principle is that tax consequences flow from legal characterization.
This guiding principle seems to have been discarded by CRA in the recent technical interpretation. CRA asserted that the LLC's property was disposed of because an LLC and an LP are different "types of entity". There is in fact no existing principle of Canadian tax law under which property is considered to have been disposed of solely because an entity is converted from one "type of entity" into a different "type of entity". The assertion of such a principle represents a new and unfounded approach.
Incidentally, CRA also asserted that the owners of membership interests in the converting LLC should be regarded as having disposed of such interests in exchange for interests in the LP. Except in the case of Canadian real estate based vehicles, this observation is of limited relevance, since the membership interests will normally not be TCP.
CRA made no comment on the proceeds of the alleged disposition of property by the LLC. While the Act would impute fair market value proceeds if the LLC's property were considered to have been disposed of to a non-arm's length person or as a gift inter vivos, it is conceptually difficult to argue that the LLC and LP do not deal at arm's length (or that the LLC made a gift to the LP) when in fact they never co-exist. Given CRA's novel approach, it is difficult to be certain how CRA might approach the question of proceeds of disposition.
The recent technical interpretation discussed in this article was issued in August 2008, though it appears to have been requested in 2004. Given this apparently considerable time frame, it is disappointing that CRA has approached the disposition question in a manner that departs so significantly from accepted principles. CRA has posited a new test for determining whether there is a disposition of property – that test being whether the original and subsequent owners of the property are the same "type of entity". No authority is cited for this new test.
It remains to be seen whether a court would accept this new theory. For the moment, however, the safest approach for an LLC holding TCP would probably be to defer any potentially taxable event or receipt of Canadian source income until after entry into force of the protocol.
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.