The Fifth Protocol to the Canada-US Tax Convention, 1980 (Canada-US Treaty) introduced important changes of interest to US multinational enterprises with hybrid entities, such as unlimited liability companies (ULCs) and limited liability companies (LLCs), in their cross-border structures. These changes include the addition of certain rules in Article IV that effectively grant or deny treaty benefits to US residents that derive or receive an amount of Canadian-source income, profit or gain through or from certain hybrid entities ─ by treating the particular amount as having been, or not having been, derived by a person who is a US resident for purposes of the Canada-US Treaty.
Articles IV(6) and (7)(a) work together to codify the principle that an amount of Canadian-source income, profit or gain realized by a non-Canadian fiscally transparent entity will be considered to be derived by a US resident to the extent that US tax law would treat such amount similarly whether the US resident had realized the amount directly or through the non-Canadian fiscally transparent entity. This rule grants treaty benefits to the US resident in respect of such an amount. Importantly, the rule effectively grants treaty benefits to the members of US LLCs provided that such members satisfy the other requirements of the Canada-US Treaty (including that such members must be residents of the US, entitled to treaty benefits under the limitation on benefits provision in Article XXIX A and, in respect of passive property income such as dividends, interest or royalties, constitute the beneficial owner of the particular amount). By its terms, however, Article IV(6) is not so limited and extends treaty benefits to other fiscally transparent entities resident in any jurisdiction other than Canada.
On the other hand, Article IV(7)(b) denies treaty benefits to US residents in limited circumstances. It provides that an amount of Canadian-source income, profit or gain will be considered not to be paid to or derived by a US resident where the US resident is considered under Canadian tax law to have received the amount from a Canadian-resident entity, but by reason of the Canadian-resident entity being treated as fiscally transparent under the laws of the US, the treatment of the amount under US tax law is not the same as its treatment would be if the Canadian-resident entity were not treated as fiscally transparent under US tax law. This rule is broadly worded and can apply where there does not seem to be any abusive tax avoidance. For example, the rule technically applies to an actual (non-deductible) dividend paid by a Canadian-resident ULC to its US-resident parent. This means that Canadian withholding tax should be exigible on such an actual dividend at the rate of 25 per cent, without any treaty relief. Article IV(7)(b) enters into force on January 1, 2010. The approaching entry-into-force date may prompt affected taxpayers to review their corporate structures and consider reorganizations.
By way of background, a ULC is characterized as a corporation for Canadian tax purposes but can elect to be treated as a fiscally transparent entity for US tax purposes. Its hybrid nature makes the ULC suitable for a wide variety of uses by US residents investing in Canada, such as using foreign tax credits arising from Canada efficiently while avoiding Canadian branch tax, consolidating Canadian-source income and losses in a US consolidated group, or implementing certain debt pushdown structures that achieve a double-dip interest deduction in both Canada and the US.
This article examines the Canadian tax implications of certain restructuring options, and one option that does not require a restructuring, potentially available to avoid the detrimental impact of Article IV(7)(b) in the context of a simplified corporate structure comprising a US-resident C corporation that owns a Canadian-resident ULC. The options considered here are grouped into two categories: (1) those that preserve the flow-through status of the group for US tax purposes; and (2) those that do not. Whether preserving such flow-through status is important depends on the facts of each case and the reasons the US resident employed the ULC in the first place. Any of these structures should be reviewed by Canadian and US counsel before implementation.1
Options to Avoid the Application of Article IV(7)(b)
One option potentially available to avoid the application of Article IV(7)(b) to distributions in the nature of dividends does not involve a restructuring but instead involves a two-step cross-border distribution economically equivalent to an actual dividend. As a first step, the Canadian-resident ULC would increase the stated capital of its shares by a particular amount. As a second step, the Canadian-resident ULC would decrease the stated capital of its shares by the same amount and distribute such amount to the US-resident C corporation as a return of capital.2
For Canadian tax purposes, each step of the cross-border distribution should be considered separately according to its legal substance.
On the first step, subsection 84(1)of the Income Tax Act (Canada) would deem the Canadian-resident ULC to have paid, and the US-resident C corporation to have received, a dividend equal to the amount of the increase in the paid-up capital of the shares of the Canadian-resident ULC (namely, the amount of the increase in the stated capital of the shares of the Canadian-resident ULC for purposes of corporate law). Canadian withholding tax would apply to the deemed dividend under subsection 212(2) of the Income Tax Act (Canada). The second step would be treated as a return of capital and would not be subject to Canadian withholding tax.
The issue becomes what rate of Canadian withholding tax applies on the deemed dividend arising on the first step ─ namely, the domestic rate of 25 per cent or the treaty-reduced rate of five per cent under Article X(2)(a) of the Canada-US Treaty? The answer turns on whether or not Article IV(7)(b) applies to cause the amount to be considered not to be paid to or derived by a US resident.
In respect of the first step, arguably Article IV(7)(b) may not apply on the basis that the "treatment" of the increase in the paid-up capital of the shares of the Canadian-resident ULC under US tax law may be the same whether or not the Canadian-resident ULC is fiscally transparent for US tax purposes. In both cases, the author understands that there is a position that the increase in the paid-up capital of the shares would be ignored for US tax purposes.
We understands that the Rulings Directorate of the Canada Revenue Agency (CRA) has been approached as to whether it would issue an advance income tax ruling on this type of transaction, and that the CRA intends to address it on a priority basis. It is expected that a ruling would be issued, on the basis of assumptions of fact as to the US tax treatment of the two-step cross-border distribution.
Besides this type of planning for distributions in the nature of dividends, a number of restructuring options are available to avoid the application of Article IV(7)(b) to other types of Canadian-source income, profit or gain that preserve the flow-through status of the group for US tax purposes.
The first restructuring option involves the interposition between the US-resident C corporation and the Canadian-resident ULC of a Luxembourg-resident Société à Responsabilité Limitée (SARL) that elects to be fiscally transparent for purposes of US tax law. Consider a dividend paid by the Canadian-resident ULC to the Luxembourg-resident SARL. Article IV(6) might apply (and Article IV(7)(b) might not apply) to the amount of the dividend, and so the US-resident C corporation should be entitled to treaty benefits under the Canada-US Treaty in respect of such amount. More specifically, Article IV(7)(b) might not apply because the US-resident C corporation would not be considered under Canadian tax law to have derived the amount of the dividend through the Canadian-resident ULC. In contrast, Article IV(6) might apply because the US-resident C corporation would be considered under US tax law to have derived the amount of the dividend through the Luxembourg-resident SARL, a fiscally transparent entity that is not a resident of Canada, and by reason of this entity being treated as fiscally transparent under US law, the treatment of the amount under US tax law is the same as its treatment would be if that amount had been derived directly by the US-resident C corporation.
If this result obtains, then the provisions of both the Canada-US Treaty and the Canada-Luxembourg Tax Convention, 1999 (Canada-Luxembourg Treaty) would apply concurrently. In order to comply with both treaties, the Canadian-resident ULC should withhold and remit Canadian withholding tax at the lower of the two treaty-reduced rates applicable to dividends — in this case, the rate is the same under both treaties, namely, five per cent. Naturally, the other requirements of the Canada-US Treaty and the Canada-Luxembourg Treaty must be satisfied before treaty relief would apply. In addition, the potential application of the general anti-avoidance rule (GAAR) in subsection 245(2) of the Income Tax Act (Canada) should be considered.
This planning (in particular, the preservation of the flow-through status of the group for US tax purposes) might be frustrated by a proposal contained in the US federal budget released in May 2009, which is proposed to apply to taxation years ending after 2010. The budget proposed that a foreign hybrid entity may be treated as a disregarded entity for US tax purposes only if the single owner of the foreign hybrid entity is created or organized in, or under the law of, the foreign country in, or under the law of, which the foreign hybrid entity is created or organized. The proposal would generally not apply to a first-tier foreign hybrid entity wholly owned by a US person, except in cases of US tax avoidance.
In our example, the Canadian-resident ULC and its single owner, the Luxembourg-resident SARL, were created in different foreign countries, so the Canadian-resident ULC would be treated as a corporation for US tax purposes under the proposal. This would cause the Canadian-resident ULC to be taxed as a corporation in the US, and not as a fiscally transparent entity. Some simple planning might be available to avoid this rule as proposed, but much will depend on the actual language of the provision as enacted in law.
A second restructuring option involves the US-resident C corporation selling some shares of the Canadian-resident ULC to another related US-resident C corporation. In this way, the Canadian-resident ULC would be treated not as a disregarded entity but as a partnership for purposes of US tax law. As the Internal Revenue Code (US) might recognize the payment of, for example, interest by a partnership to a partner for US tax purposes, the rule in Article IV(7)(b) might not apply to such amounts. This is because the treatment of such interest for purposes of US tax law might be the same whether or not the Canadian-resident ULC were treated as a partnership or as a corporation for purposes of US tax law. On the other hand, the Technical Explanation to the Canada-US Treaty suggests that the same result should not obtain in respect of the payment of dividends by the Canadian-resident ULC to one or both of the US-resident C corporations, because the treatment of the amount for purposes of US tax law differs depending on whether the Canadian-resident ULC is fiscally transparent for purposes of US tax law (that is, if the ULC were treated as a partnership, the amount would be treated as a partnership distribution ─ but if it were treated as a corporation, the amount would be treated as a dividend).
Other restructuring options are available to avoid the application of Article IV(7)(b), but these structures do not preserve the flow-through nature of the group for US tax purposes. Where the Canadian business is wholly owned and all foreign tax credits arising from Canada may be claimed in the US, however, the elimination of flow-through status might not be particularly detrimental.
The simplest option involves the Canadian-resident ULC converting into a regular corporation under Canadian corporate law that is treated as a corporation for US tax purposes. Alternatively, the Canadian-resident ULC could elect to be treated as a corporation for US tax purposes. This option might trigger adverse US tax consequences to the US-resident C corporation, such as the realization of a gain on the conversion.
Another option involves the Canadian-resident ULC continuing in a US jurisdiction such as the State of Delaware. The continued corporation would be treated as a corporation, and not as a fiscally transparent entity, for US tax purposes. It would retain its residence in Canada at common law in order to, among other things, avoid a deemed disposition of its assets for Canadian tax purposes and the incidence of Canadian departure taxes. Article IV(7)(b) might not apply to dividends paid by the continued corporation to the US-resident C corporation because the continued corporation would not be treated as fiscally transparent under US law.
A number of issues arise in this context. One issue is whether the continued corporation's dual residence must be resolved by the Competent Authorities pursuant to the tie-breaking rule in Article IV(3)(b) ─ and, if so, whether there is a risk that the Competent Authorities could determine that the continued corporation is a resident of the US, defeating the purpose of retaining its residence in Canada at common law. Further, the potential application of the GAAR should be considered.
Yet another option involves the Canadian-resident ULC contributing its property to a Canadian partnership in consideration for a partnership interest on a tax-deferred basis. The Canadian partnership would elect to be treated as a Canadian corporation for US tax purposes. Arguably, Article IV(7)(b) might then not apply to dividends paid by the Canadian-resident ULC to the US-resident C corporation because the treatment of the amount for US tax purposes should be the same whether or not the Canadian-resident ULC is disregarded under US tax law. As the US-resident parent is a C corporation, it might claim a foreign tax credit in the US to mitigate the leakage arising as a result of the Canadian income tax payable by the Canadian-resident ULC on its Canadian-source taxable income realized as a result of its allocation of the partnership's profits. This structure also requires carefully considered analysis, including detailed consideration of the potential application of the GAAR.
One simple option that has been suggested on behalf of taxpayers with more limited means involves the US-resident C corporation incorporating a new Canadian-resident corporation. The Canadian-resident ULC would make contributions of contributed surplus (or, alternatively, simply gift the amounts) to the Canadian-resident corporation, which would in turn on-pay such amounts to the US-resident C corporation as dividends. Again, this proposal raises a number of issues, including whether the Canadian-resident corporation has a source of income or otherwise must include the contributions in computing its income under paragraph 12(1)(x) of the Income Tax Act (Canada), and whether a deemed dividend to the US-resident C corporation might arise under the combined operation of paragraph 214(3)(a) and subsection 56(2) of the Income Tax Act (Canada) on the transfer of amounts from the Canadian-resident ULC to the new Canadian-resident corporation. These issues might be resolved by further planning using cross-shareholding and dividend-sprinkling techniques. Further, the potential application of the GAAR should be considered.
These are only some of the options being discussed in the marketplace.
The CRA is well aware that many taxpayers are similarly situated and must confront the potential application of Article IV(7)(b) before its entry into force on January 1, 2010.
In May 2009, at an International Fiscal Association (Canadian Branch) seminar, the CRA addressed some of these issues. The CRA is now finalizing a discussion draft providing further guidance on the application of Article IV(7)(b), and intends to circulate it to the Department of Finance (Canada) for comments before public release. The CRA expects that such guidance will be published sometime later this year. It should assist taxpayers in planning an appropriate reorganization, if necessary. Further, taxpayers should watch for the release of any advance income tax rulings issued by the CRA Rulings Directorate on the application of Article IV(7)(b) in the next few months.
Many taxpayers propose to wait for administrative guidance as to the application of Article IV(7)(b), which may assist in determining which of the potential restructuring options to implement. Unlike some other aspects of business, there does not appear to be any "first-mover" advantage in implementing any of these structures before the rest of the herd.
1 The comments herein in respect of US law are based solely on the authors' understanding and have not been independently reviewed by US counsel; therefore, they should not be interpreted as expressions of opinion concerning such US law.
2 A similar tax result might obtain through the payment of stock dividends, with such modifications as the circumstances require.
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.