The Fifth Protocol to the Canada-United States Income Tax
Convention (the "Treaty") came into force on
December 15, 2008. It contained a number of significant amendments
to the Treaty, including the addition of new "anti-hybrid
rules" (in new paragraphs 7(a) and 7(b) to Article IV). The
anti-hybrid rules will become effective January 1, 2010 and will
deny benefits under the Treaty in respect of amounts received or
derived by Canadian and U.S. residents through certain hybrid
entities (generally entities that are "fiscally
transparent" for tax purposes in one country but not in the
other). Many investments made through unlimited liability companies
(ULCs), limited liability company (LLCs) and partnerships will be
affected if they are not restructured. To ensure there is
sufficient time to properly consider alternative structures and
implement any necessary reorganizations, taxpayers potentially
affected by the anti-hybrid rules should be considering their
planning options now. In addition, in some cases, a reduced asset
value in the current economic downturn may facilitate the ability
to reorganize current investment structures without tax cost.
The Anti-Hybrid Rules
The anti-hybrid rules affect certain amounts paid by or derived
through a "hybrid" entity. A "hybrid" entity is
an entity that is fiscally transparent for tax purposes
(disregarded or treated as a partnership) in either Canada or the
U.S. but is not fiscally transparent (it is itself a taxpayer) in
the other state. Where applicable, the anti-hybrid rules deny
Treaty benefits to investors in the hybrid entity. Below are two
examples of structures that will be affected by the anti-hybrid
rules. There are many other structures that will be adversely
affected by the anti-hybrid rules, both outbound and inbound, even
if there was no particular tax advantage from the use of the hybrid
LLC Example The first branch of the
anti-hybrid rules (paragraph 7(a) of Article IV) is relevant where
a person resident in Canada or the U.S. receives an amount through
a hybrid entity that is not resident in, and is not fiscally
transparent in, the country in which the person is resident. This
will generally be the case where a Canadian resident receives U.S.
source income through an LLC that is disregarded or treated as a
partnership for U.S. income tax purposes (but which would not be
treated as fiscally transparent in Canada).
In this example, since LLC is disregarded for U.S. income tax
purposes, Canco is subject to tax in the U.S. in respect of its
income from the U.S. business carried on by LLC. In addition, Canco
is subject to U.S. branch tax. By virtue of the Treaty, as
currently in effect until December 31, 2009, Canco would not be
subject to U.S. taxation in respect of its income from the U.S.
Business if such business is not conducted through a permanent
establishment (PE) in the United States (assuming the limitation of
benefits article in the Treaty is not applicable). Moreover, even
if the U.S. Business is conducted through a PE, the U.S. branch tax
rate would be reduced to 5% under the Treaty (and the first
US$500,000 of income would be exempt from branch profits tax).
Effective January 1, 2010, the anti-hybrid rules will apply to deny
the benefits of the Treaty to Canco in respect of its U.S. business
income derived through LLC which would cause the income to become
taxable in the U.S. even if the U.S. Business is not conducted
through a PE. Canco may also become subject to U.S. branch tax at
the statutory rate of 30%, though the latter conclusion is
The second branch of the anti-hybrid rules (paragraph 7(b) of
Article IV) is relevant where a person resident in Canada or the
U.S. receives an amount from a hybrid entity that is resident in
the other country and is fiscally transparent in the country in
which the person is resident. This will generally be the case where
a U.S. resident has received Canadian source income from a ULC that
is disregarded or treated as a partnership for U.S. income tax
In this example, under the terms of the Treaty as currently in
effect until December 31, 2009, the Canadian withholding tax rate
would be reduced under the general provisions of the Treaty to 5%
for dividends paid by ULC to USco and to 4% in 2009 (and nil
thereafter) for interest paid by ULC to USco (assuming a new
limitation of benefits article in the Treaty is not applicable).
However, effective January 1, 2010, the anti-hybrid rules will
apply to deny the benefits of the Treaty to USco for interest and
dividends paid by ULC to USco and, accordingly, such amounts will
be subject to withholding tax at the Canadian statutory rate of
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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