The Canada Revenue Agency has released guidelines for distributions from ULCs to United States persons, notably dividends and in some cases interest, which would otherwise be subject to 25% withholding tax starting January 1, 2010. This jump in withholding rates from current levels is a consequence of anti-hybrid provisions introduced in the last round of amendments to the Canada-U.S. tax Treaty. The guidelines will provide welcome relief for many common cases but taxpayers are cautioned that they do not equate to a narrowing of the anti-hybrid rules themselves. To avoid negative results, taxpayers must implement appropriate steps before any affected payments are made after 2009; a do-nothing approach will result in higher withholding tax. In addition, CRA reserves the right to challenge situations it considers abusive.
Hybrid Treatment Rules for LLCs and ULCs
The Fifth Protocol to the Canada U.S. tax Treaty (Canada-United States Tax Convention (1980)) introduced a number of important changes affecting "hybrid entities", which are treated as fiscally transparent under the tax laws of one state, but regarded as separate entities under the tax laws of the other state. Certain of these provisions are relieving, notably those involving payments through fiscally transparent U.S. limited liability companies (LLCs) to qualifying U.S. residents. Prior to these relieving rules, which came into force in 2009, payments to U.S. LLCs did not qualify for Treaty relief, based on a long-standing CRA interpretation that LLCs were not "residents" of the U.S. for purposes of the Treaty. Notwithstanding the relief that is now available in the context of LLCs, certain issues still remain in situations where not all members of the LLC are residents of the U.S. or where certain specific Treaty provisions are relied upon.
Less favourably, the Treaty was also amended to add so-called anti-hybrid rules, which will come into force on January 1, 2010, resulting in potentially adverse consequences for U.S. residents investing in Canada through, and receiving payments from, ULCs that are treated as fiscally transparent for U.S. tax purposes. The intended object of the rules appears to have been to counter certain planning, notably "double-dip" financing techniques, which the tax authorities consider to give rise to undue tax benefits. However, the anti-hybrid rules were drafted very broadly and will deny Treaty benefits in any case, including innocuous situations, where a U.S. resident receives amounts from a ULC and under U.S. tax law, the treatment of the amount is not the same as its treatment would be if the ULC were not fiscally transparent for U.S. tax purposes. In this context, CRA generally interprets "same" to mean the payment has the same quantum, character and timing to the recipient whether made by a fiscally transparent ULC or a regarded entity. For example, in the case of a U.S. resident with a wholly-owned ULC subsidiary that is disregarded for U.S. tax purposes, payments from the ULC, including interest, royalties and dividends will not satisfy the same treatment requirement (as compared to such payments from an "ordinary" Canadian subsidiary that is regarded for U.S. tax purposes) and will no longer be entitled to a reduced rate of withholding under the Treaty, generally between 0% and 15%. Instead, beginning in 2010, such payments will become subject to the applicable Canadian domestic withholding tax rate of 25%.
There was speculation that the Canadian and U.S. governments would further amend the Treaty before the 2010 effective date of the anti-hybrid rules, to narrow their scope; however, no such legislative relief will be forthcoming in time. Instead, CRA released guidelines this week identifying certain techniques that CRA generally considers will avoid the anti-hybrid rules, with the caveat that CRA reserves the right to challenge planning that it considers to be abusive, citing double-dip financings as an example.
Guidelines for ULC Distributions
CRA has identified the following techniques as generally effective to avoid the anti-hybrid rules, except in circumstances of abusive planning.
Use of Third-Country Intermediary
Since the anti-hybrid rules are unique to the Treaty, one method to avoid the anti-hybrid rules is to interpose an entity formed in a third country between the U.S. resident(s) and the ULC. The intermediary would normally be formed in a country with which Canada has a tax treaty (in order to access treaty withholding rates), be fiscally transparent for U.S. and third country purposes and treated as a resident of the third country for Canadian tax purposes. Luxembourg Sŕrls and Dutch Co-ops are two examples of possible intermediaries that are already frequently used in structuring fund investments into Canada. It is important that the third country entity be treated as the "beneficial" owner of the ULC shares and debt and be tax resident in its jurisdiction of formation, which will require the establishment of adequate substance and the maintenance of central management and control in the third country. Provided these conditions are met, this planning should work for various types of payments, including interest and dividends, on an ongoing basis.
Prior to January 1, 2010, a dividend from a ULC to a U.S. resident shareholder will be subject to 5% withholding where the shareholder is a company that owns 10% or more of the voting shares of the ULC. In other cases, the Treaty rate is 15%. To maintain these preferential rates and avoid 25% withholding tax on dividend payments after January 1, 2010, the ULC may undertake two-step planning instead of simply declaring and paying a conventional dividend:
- first, adopt the appropriate corporate resolution to increase "paid-up capital" (PUC) by capitalizing retained earnings, which will trigger a deemed dividend for Canadian tax purposes; and then
- reverse the PUC increase by adopting the appropriate corporate resolution to reduce capital, and pay out the reduction as a return of capital, which is not subject to withholding tax under Canadian tax law.
According to the CRA guidelines, provided that the deemed dividend is a non-event for U.S. tax purposes and, therefore, would not violate the same treatment rule, the deemed dividend should be eligible for Treaty withholding rates (5%/15%). The advantage of the two-step approach is that it avoids the cost and complexity of creating and maintaining an intermediary entity; however, the two-step process must be undertaken each time a dividend would otherwise be paid.
Where a ULC is indebted to its immediate parent, consideration may be given to restructuring the debt to move it up the U.S. corporate chain (creating a so-called "grandparent loan") so that interest payments are made to an upper-tier shareholder. Alternatively, consideration may be given to restructuring a single member ULC to add a shareholder (e.g. a wholly-owned subsidiary of the original shareholder) with the intention that the ULC be treated as a partnership for U.S. tax purposes and not a disregarded entity. In the case of interest planning in particular, CRA cautions that the "same treatment" rule must be respected, i.e., the payment should be considered to be interest in the hands of the recipient and included in income currently for U.S. tax purposes.
Provided the recipient of the interest payment qualifies as a U.S. resident for Treaty purposes (a status available to most C corporations) and the interest is not participating interest, the applicable Treaty withholding tax rate will be 0% as of January 1, 2010. This represents a reduction compared to the current Treaty rate of 4% on related party interest, and so there may be an advantage to deferring interest payments to 2010 where possible, provided the anti-hybrid restructuring can first be implemented.
CRA remains concerned about tax planning that it considers abusive and has explicitly reserved the right challenge such cases. Aggressive fi nancing techniques involving interest payments that are deductible on one side of the border but disappear on the other side (i.e., result in no corresponding income inclusion) or that generate multiple deductions remain subject to challenge either under the anti-hybrid rules themselves (especially having regard to the same treatment requirement) or under GAAR. Non-deductible payments, such as dividends, are usually of less concern to CRA because they are less likely to involve abusive tax planning.
The anti-hybrid rules come into force on January 1, 2010, so there is still a window before the end of the year to make payments of dividends, interest or royalties from ULCs at 2009 Treaty withholding rates. As noted above, the Treaty withholding rate on related party non-participating interest is dropping on January 1, 2010, to 0% from the current 4%, so there may be an advantage to deferring interest payments until the new year provided that the grandparent loan or other technical planning can be undertaken to avoid the anti-hybrid rule and assuming GAAR would not otherwise apply in the circumstances.
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.