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
1, 2010.
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.
Conclusion
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.