Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, November 2009
The Fifth Protocol to the Canada-U.S. tax treaty (the Treaty) was ratified in December 2008, and for most purposes came into force in 2009. One of the more controversial measures contained in the Protocol is the new "anti-hybrid" rule in Article IV(7) of the Treaty. This unprecedented rule takes effect on January 1, 2010.
The Anti-Hybrid Rule
There are two branches to the anti-hybrid rule.
The first branch deals with "reverse hybrid" entities. These are entities which are fiscally transparent in the source state but not in the state of residence. An example of such an entity is a partnership formed under Canadian law which has elected for U.S. tax purposes to be treated as a foreign corporation. This branch of the rule, found in Article IV(7)(a), applies to an amount paid to or derived by a U.S. person through an entity that is not a U.S. resident, where, by reason of the entity not being treated as fiscally transparent under U.S. law, the treatment of the amount under U.S. law is "not the same" as its treatment would be if that amount had been derived directly by that person. In other words, the rule could potentially apply to an amount derived by a U.S. person through a partnership formed under the laws of Canada where the treatment of the item differs from the hypothetical treatment that would have arisen had the person derived the amount directly rather than through the partnership. If the rule applies, the item of income paid to or derived by the U.S. person is not eligible for Treaty benefits.
The second branch of the rule, and the one arising more commonly in practice in Canada, deals with "hybrid" entities, namely entities that are not fiscally transparent in the source state, but fiscally transparent in the state of residence. An example is a Canadian unlimited liability company (ULC). This branch of the rule, found in Article IV(7)(b), applies to an amount that is paid to or derived by a U.S. person if the person is considered under Canadian law to have received the amount from an entity that is a resident of Canada, where, by reason of the entity being treated as fiscally transparent under U.S. law, the treatment of the amount under U.S. law is "not the same" as its treatment would be if the entity were not treated as fiscally transparent under U.S. law. The rule could potentially apply to an amount paid by a ULC to a U.S. person, but only if the treatment of the item differs from the hypothetical treatment that would have arisen had the ULC not been fiscally transparent for U.S. tax purposes. Where the rule applies, no Treaty benefits are available in respect of the item in question.
It is widely understood that the anti-hybrid rule, and in particular Article IV(7)(b), was drafted in a way that was overbroad and went well beyond the perceived mischief that gave rise to the rule. This has been observed by, among others, the Joint Committee on Taxation of the U.S. Congress, which noted that Article IV(7)(b) was overbroad, especially (though not exclusively) with respect to non-deductible payments such as dividends. Dividends paid by a ULC out of the after-tax earnings of the ULC clearly should not, as a matter of sound tax policy, be subjected to non-treaty rates of dividend withholding tax, and yet this seemed to be the result obtained by mechanically applying the language of Article IV(7)(b).
Meaning of "Same Treatment"
The anti-hybrid rules introduce a notion that is not well understood in Canadian tax law, specifically the concept of comparing the actual U.S. tax treatment of an item in question with its hypothetical U.S. tax treatment under assumed circumstances. This rule begs the obvious question as to what is meant by "treatment", and what criteria are to be applied when comparing actual treatment with hypothetical treatment, and determining whether they are the "same". In the U.S. Treasury Department's Technical Explanation (TE), released in July 2008, it was stated that this determination would be made from a U.S. point of view in accordance with the principles set forth in Code section 894. The TE added that although Canada does not have analogous provisions in its domestic law, "it is anticipated that principles comparable to those described [in section 894] will apply". The Minister of Finance of Canada has stated that Canada agrees with the TE.
On November 25, 2009, the Canada Revenue Agency (the CRA) released a copy of an internal technical interpretation commenting upon the Canadian approach to the question of "same treatment". In short, the CRA stated that three factors will be considered to determine whether the treatment of an amount is the same as its hypothetical treatment: (a) the timing of the recognition or inclusion of the amount; (b) the character of the amount; and (c) the quantum of the amount. Geographic source generally will not be relevant unless it affects the treatment of the amount as an item of income under U.S. tax law. The mere fact that the geographic source of an amount may affect the ability of a U.S. person to claim a foreign tax credit will not be relevant.
In both the technical interpretation noted above and at the "Round Table" session held at the Canadian Tax Foundation Annual Conference on November 24, 2009, the CRA commented on the application of the anti-hybrid rule to some fact patterns. Generally, these comments provide helpful guidance in dealing with the anti-hybrid rule.
Set out below is a description of some of these examples, and the comments made by the CRA.
Example 1: Payment of Dividends by ULC
Suppose the ULC is wholly owned by a U.S. corporation which qualifies for Treaty benefits (USco). Beginning January 1, 2010, any dividend paid by the ULC to USco will be subject to statutory 25% withholding tax. Clearly, this is anomalous from a tax policy perspective.
The following solution was accepted by the CRA at the Round Table: Instead of paying a dividend, the ULC undertakes a two-step transaction. First, the ULC increases its paid-up capital without distributing any cash or other property. This increase in paid-up capital gives rise to a deemed dividend for Canadian tax purposes, but no tax consequence for U.S. tax purposes. Because the U.S. treatment (no consequence) is the same as the hypothetical treatment of that transaction that would have arisen had the ULC not been fiscally transparent, the anti-hybrid rule does not apply. Accordingly, the CRA confirmed that Treaty withholding rates (5%) would apply. Immediately after the foregoing step, but in a clearly separate step, the ULC makes a distribution to USco in the form of a return of the paid-up capital that was just created in the first step. A distribution structured legally as a return of paid-up capital is not subject to Canadian withholding tax, and therefore there is no need to have recourse to the Treaty. This two-step procedure effectively accomplishes a distribution without giving rise to a problem under the anti-hybrid rules.
The CRA commented that while the application of the general anti-avoidance rule (GAAR) depends on all the facts and circumstances, it would "not normally" apply GAAR to this type of planning where the ULC is used by USco to carry on an active branch operation in Canada and the arrangement is used by the ULC to qualify for the reduced Treaty rate of withholding tax on the distribution of the ULC's after-tax earnings to USco. While this is a welcome statement, it obviously leaves some room for the CRA to selectively seek to apply GAAR if it believes the circumstances so warrant. It is critically important to ensure that all necessary corporate law formalities are complied with, including any restrictions on the circumstances in which paid-up capital may be increased under the applicable corporate law. It should also be noted that this planning will not work in a situation where the shares of the ULC are held by a fiscally transparent limited liability company (LLC). In that case, alternative approaches should be considered.
Example 2: Luxembourg Intermediary
The CRA also confirmed that the inter-position of a Luxembourg resident company between USco and the ULC normally will result in any dividends paid to Luxco being eligible for the 5% treaty rate of withholding tax under the Luxembourg-Canada Tax Treaty, provided of course the dividend is "beneficially owned" by Luxco. The CRA indicated that its comments on the application of GAAR in Example 1 would also apply to this example.
Example 3: Payment of Interest to "Grandparent"
In this example, "Grandparent" is a U.S. resident company, entitled to Treaty benefits, which wholly owns USco, which in turn wholly owns the ULC. The ULC pays interest on a debt owing directly to Grandparent. The CRA confirmed that the treatment of the interest is considered to be the same as the hypothetical treatment that would have arisen had the ULC not been fiscally transparent (even in the case where Grandparent and USco elect to file a consolidated group tax return for U.S. tax purposes), and that Treaty benefits are therefore available. However, the CRA cautioned that it may apply GAAR to this type of arrangement where the arrangement results in the creation of a "double deduction" or "double dip" or an internally generated interest deduction in one country without offsetting interest income in the other country.
Example 4: ULC with Two Shareholders
This example, which is contained in the technical interpretation, could be extremely helpful in many circumstances. The example sets out a situation in which USco owns 90% of the shares of the ULC. The other 10% is owned by USsub, a U.S. corporation wholly owned by USco. The ULC pays interest to USco on debt owing to USco. It is clear that the anti-hybrid rule would have applied had USco been the sole owner of the ULC.
This is because the actual treatment of the interest under U.S. tax law (it is disregarded) differs from the hypothetical treatment that would have arisen had the ULC not been fiscally transparent.
However, in this example, the introduction of a second shareholder transforms the ULC from being a disregarded entity for U.S. tax purposes into being a partnership for U.S. tax purposes. This makes a critical difference. The CRA confirmed that the treatment of the interest in the hands of USco is the same as the hypothetical treatment that would have arisen had the ULC not been fiscally transparent. Therefore, the anti-hybrid rule does not apply, and Treaty benefits are available.
This suggests it might be possible to defeat the antihybrid rule through the use of ULCs with multiple owners rather than single owners. One critical caveat, however, is that the CRA clearly pointed out in the technical interpretation that it reserves the right to challenge planning of this nature under GAAR. Based on comments made by senior officials of the CRA at the Round Table (including the comment on the potential application of GAAR to the type of arrangement described in Example 3), it is likely that the CRA will be more prone to challenge such planning where the effect is to create a "double deduction" or "double dip". Conversely, if there is no "double dip", it appears the CRA is less likely to take the position that the planning undermines the object, spirit and purpose of the antihybrid rules, and therefore can be challenged under GAAR.
The above is but a brief summary of some of the recent guidance provided by the CRA on the anti-hybrid rule. As the anti-hybrid rule takes effect on January 1, 2010, it is expected that considerably more authority will develop over time.
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.