At yesterday's Canada Revenue Agency ("CRA") round
table, held as part of the Canadian Tax Foundation's annual
conference in Toronto, the CRA provided its views with respect to a
number of topics including, among other things, branch tax
implications when investing in Canada through a U.S. limited
liability company (including where a U.S. resident individual is a
member), Canadian permanent establishment implications where an
employee of a U.S. resident provides services in Canada, the tax
consequences to the issuer of exchangeable debentures and the
valuation of "skinny" voting shares in the estate freeze
context. The CRA also provided its view in respect of a number of
planning alternatives to deal with upcoming changes to the
treatment of unlimited liability companies ("ULCs") under
the Canada–U.S. Tax Treaty (the "Treaty"),
which are discussed below. The CRA's comments regarding Treaty
issues are very timely as many U.S. residents have been considering
or undertaking planning to reorganize their ULC subsidiaries prior
to the Treaty changes affecting ULCs becoming effective on January
The Anti-Hybrid Rules
The Fifth Protocol to the Treaty added "anti-hybrid rules" (in new paragraphs 7(a) and 7(b) to Article IV). These anti-hybrid rules will become effective on 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).
In particular, paragraph 7(b) of the anti-hybrid rules will be relevant 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 purposes. Essentially, payments between a wholly-owned ULC and its U.S. corporate parent will no longer qualify for benefits under the Treaty. Thus, the Canadian withholding tax rate for dividends paid by a ULC to its corporate parent will no longer be reduced to 5%, royalty payments will no longer have Treaty protection, nor will interest payments (which would not be exempt under Canada's domestic tax rules, because the ULC and its parent do not deal with each other at arm's length).
The CRA provided comments on various planning alternatives to deal with the paragraph 7(b) anti-hybrid rule, which is generally recognized as being too broad.
The ULC Issue – Dividends
In the context of a ULC that carries on an active operation in Canada, the CRA indicated that it approves of planning to avoid the denial of Treaty benefits for dividends. The paragraph 7(b) anti-hybrid rule will only deny Treaty benefits where the treatment under U.S. tax law of the amount paid by the ULC would not be the same if the amount had been paid by an entity that was not fiscally transparent for U.S. tax purposes.
The CRA has agreed that where the ULC increases the paid-up or stated capital of its shares under its governing corporate law without any distribution to its shareholders and follows that with a distribution out of paid-up or stated capital, the paragraph 7(b) anti-hybrid rule generally should not apply. The increase in paid-up capital will result in a deemed dividend for Canadian tax purposes, which would be subject to Canadian withholding tax. From a U.S. tax perspective, the increase in paid-up capital would be a non-event. Significantly, this would be the case whether or not ULC were fiscally transparent from a U.S. tax perspective. The CRA accepts that the ULC anti-hybrid rule would not apply in respect of the deemed dividend resulting from the increase in paid-up capital and that the Treaty withholding rate of 5% would be applicable in respect of such deemed dividend. The subsequent reduction and distribution of capital are not subject to Canadian withholding tax. Accordingly, by undertaking this two-step transaction, it may be possible to access Treaty benefits in respect of amounts that would otherwise have been paid as dividends by ULC to its U.S. parent.
While this position is helpful, each situation is unique -- for example, different considerations will be relevant where the shareholder of the ULC is a U.S. limited liability company. Thus, this approach may not be a complete solution in all circumstances.
The ULC Issue – Other Payments
With respect to payments of interest or other amounts by a ULC to its U.S. parent, advisers have suggested that where the amount is paid to other members of the U.S. parent group rather than to the ULC's direct shareholder, it may be possible to conclude that the U.S. tax treatment of the payments is the same as it would have been if the ULC had not been a disregarded entity, so that the anti-hybrid rule in paragraph 7(b) does not apply. There was some uncertainty on this point, however, because there would be at least potentially some difference in the U.S. tax treatment of those amounts. The CRA indicated that it was not proposing to take a strict approach to the "same treatment" requirement, at least where the arrangements do not involve a "double dip" or a payment that otherwise gives rise to asymmetrical treatment (e.g., a deduction in Canada, but no income inclusion in the U.S.). This suggests that in many cases shareholders of ULCs may be able to organize their affairs to ensure that payments of interest, royalties and other amounts (other than dividends) would retain Treaty benefits.
The ULC Issue – Third Country Entities
The CRA was also asked for its views on interposing an entity resident in a third jurisdiction (such as Luxembourg) in order to claim the benefits available under that country's tax treaty with Canada, which will not have an anti-hybrid provision. Advisers have been unsure what approach the CRA would adopt in light of recent court cases that have found in favour of taxpayers engaged in tax planning that relied on a beneficial tax treaty applying. The CRA indicated that it accepted that those cases represent the law in this area, and that where the steps taken were effective to make the third-country entity the beneficial owner of the income for which treaty relief was claimed, it would respect that claim.
The comments by the CRA discussed above are very helpful and appear to reflect an intention to take a practical approach to these issues, nevertheless the circumstances of each particular structure must be examined to determine whether the CRA's comments are applicable given the particular facts.
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.