New rules in the Canada-United States Income Tax Convention (Treaty) will deny treaty benefits for many cross-border payments derived through, or paid by, certain hybrid entities on or after January 1, 2010. Recent guidance from the Canada Revenue Agency (CRA) together with prior guidance from the U.S. Treasury provide important assistance in interpreting these rules. However, each cross-border arrangement that includes a hybrid entity must be carefully reviewed to determine whether the new rules apply. In many cases, the adverse consequences of these rules may be avoided through a timely reorganization, although the optimal reorganization steps will depend on the particular facts and circumstances.
Overview Of Hybrid Entity Rules
The new rules apply to certain income, profit or gains derived through, or paid by, a "hybrid" entity, beginning January 1, 2010. A hybrid entity is an entity (such as certain partnerships, Canadian unlimited liability companies, or U.S. limited liability companies) that is treated as fiscally transparent in one of Canada or the United States, but not in the other country.
The new rules will prevent Treaty benefits from applying to many common investment structures. For example, the new rules may apply to certain hybrid entities that carry on business through a branch in the other country, realize gains on the sale of certain property, or that pay dividends, interest and royalties. Where applicable, the new rules will, among other things, increase to 25% the Canadian withholding tax rate on dividends, interest or royalties paid by a Canadian unlimited liability company to a U.S. resident (that otherwise qualifies for benefits under the Treaty). By comparison, absent the application of the new rules, the Canadian withholding tax rate would be 5% or 15% on dividends (depending on whether the holder owns at least 10% of the voting shares of the company paying the dividends), 0% on interest, and 0% or 10% on royalties (depending on the nature of the royalty payment). These rules could also result in similar payments by a U.S. hybrid partnership to a Canadian resident being subject to 30% U.S. withholding tax, rather than the reduced Treaty rates. While in some cases the higher withholding tax may be offset by foreign tax credits available to the recipient, in many cases it will result in increased tax costs. As a result, cross-border arrangements involving hybrid entities must be carefully considered to determine whether (and which) steps should be taken to ensure that Treaty benefits continue to apply.
Technical Aspects Of The Hybrid Entity Rules In Article IV(7)
Article IV(7)(a) applies to payments to, or amounts derived by, a resident of Canada or the United States (Recipient) through a hybrid entity that is treated as not fiscally transparent by the residence country but that is treated as fiscally transparent by the other country. This type of hybrid entity would include a partnership formed in Canada (or other non-U.S. jurisdiction) with U.S.-resident partners, where the partners have elected to treat the partnership as a corporation for U.S. tax purposes.
Article IV(7)(b) applies to payments to, or amounts derived by, a resident of Canada or the United States from a hybrid entity that is treated as fiscally transparent by the residence country but that is treated as not fiscally transparent by the other country. This type of hybrid entity would include a Canadian unlimited liability company that is treated as fiscally transparent for U.S. tax purposes.
Treaty benefits will be denied under Article IV(7) where the tax treatment of the amount in question under the tax laws of the residence country is not the same as it would be if the amount had been derived directly by the Recipient, in the case of Article IV(7)(a), and, if the hybrid entity were not fiscally transparent under the laws of the residence country, in the case of Article IV(7)(b) (Same Treatment Test).
The U.S. Treasury provided guidance for interpreting and applying the Same Treatment Test in a technical explanation released on July 10, 2008 (the "Technical Explanation"). Also on that date, the Canadian Department of Finance issued a press release indicating that Canada agreed with the technical explanation. (Details of that guidance are set out in our Osler Update of July 11, 2008.) Despite this guidance, many significant questions regarding how the Same Treatment Test would be applied to common scenarios remained unanswered.
Recent CRA Guidance
On November 24, 2009, at the Canadian Tax Foundation annual conference and in a technical interpretation released the next day (Technical Interpretation), the CRA provided important guidance on the technical aspects of Article IV(7) and its applicability in various scenarios. The CRA also provided some guidance on the circumstances in which, in its view, the general anti-avoidance rule (GAAR) could apply to deny Treaty benefits that would otherwise be available.
In the Technical Interpretation, the CRA stated that an amount of Canadian-source income, profits or gains will be considered to receive the same U.S. tax treatment if each of (i) the timing of the recognition/inclusion of the amount, (ii) the character of the amount, and (iii) the quantum of the amount are the same. Although the U.S. Treasury Technical Explanation also referred to the source of the income as being relevant in applying the Same Treatment Test, the CRA took the position that a difference in the geographic source of a payment would not be relevant for purposes of the Same Treatment Test, provided the geographic source did not affect the U.S. tax treatment of the income in question (e.g., the source of the income item does not modify the timing of recognition/inclusion, quantum or character of the amount for U.S. tax purposes). For instance, although the source (as determined for U.S. tax purposes) of a particular income item may affect the computation of the U.S. recipient's foreign tax credit limitation and thereby produce, in a broad sense, a U.S. tax "difference", the CRA took the position that this type of difference was not sufficient to engage Article IV(7)(b), presumably because it had no impact on the timing, quantum or character of the underlying income item itself.
Examples Of Situations Where Article IV(7)(a) Or (b) Will Not Apply
The CRA indicated that Article IV(7)(a) and (b) would not apply to deny Treaty benefits in the following situations, subject to the potential application of GAAR in a particular circumstance:
- Increase and Reduction of Paid-up Capital (PUC) by a Hybrid ULC – A Canadian unlimited liability company that is fiscally transparent for U.S. tax purposes and regarded as a corporation for Canadian tax purposes (Hybrid ULC) has a U.S. resident shareholder. Rather than paying a dividend to which Article IV(7)(b) would apply, Hybrid ULC (i) increases its PUC, resulting in a deemed dividend for Canadian tax purposes, and (ii) later pays a distribution to its shareholder as a return of capital. The PUC increase creates a deemed dividend from a Canadian tax perspective, but is ignored from a U.S. tax perspective (regardless of the treatment of Hybrid ULC for U.S. tax purposes). The CRA stated that Article IV(7)(b) would not apply to deny the reduced rate of withholding tax applicable to the deemed dividend under the Treaty since the deemed dividend satisfies the Same Treatment Test. No Canadian withholding tax applies on the subsequent return of capital distribution under Canadian domestic tax law. The CRA also indicated that GAAR should not apply to this arrangement in "plain vanilla" situations.
- Luxembourg Intermediary – A Luxembourg société à responsabilité limitée (SARL) is inserted between a U.S. shareholder and its Hybrid ULC subsidiary. The SARL is considered to be a resident of Luxembourg for Canadian tax purposes, but is disregarded for U.S. tax purposes. Although Article IV(7)(b) would otherwise have denied benefits under the Treaty, the CRA indicated that the Canada-Luxembourg tax treaty should apply to provide reduced withholding tax rates provided that the SARL is the "beneficial owner" of any dividends paid by Hybrid ULC. (See our Osler Update of March 2, 2009 for further information on the meaning of "beneficial ownership" for tax treaty purposes.)
- Interest Payments by Hybrid ULC to U.S. Grandparent – All of the shares of a Hybrid ULC are owned by a U.S. subsidiary (USSub) of a U.S. corporation (USco). Hybrid ULC has a debt owing to USco. USco and USSub file a consolidated tax return for U.S. federal income tax purposes. In that consolidated tax return, interest included in the income of USco is offset by the interest expense deduction of USSub since, for U.S. tax purposes, USco would be considered to have made a loan to USSub. If Hybrid ULC were not fiscally transparent for U.S. tax purposes, there would have been no offsetting interest expense deduction available to the USco consolidated group. The CRA nevertheless indicated that the Same Treatment Test would be satisfied in this circumstance because only the item of income, being the interest, and not the corresponding expense item, is relevant for purposes of the analysis in Article IV(7)(b). Since USco would be considered to have received interest income whether or not Hybrid ULC is fiscally transparent for U.S. tax purposes, the Same Treatment Test is satisfied and Article IV(7)(b) does not apply.
- Hybrid ULC with More than One Shareholder – USco and USSub each own shares of a Hybrid ULC. Hybrid ULC has a debt owing to USco. Hybrid ULC is treated as a partnership, rather than a disregarded entity, for U.S. tax purposes since it has more than one shareholder. For U.S. tax purposes interest paid by Hybrid ULC is considered to be paid to USco, which is the same treatment that would apply if Hybrid ULC were regarded as a corporation (despite the fact that where Hybrid ULC is treated as a partnership, USco would be entitled to reduce its interest income by its share of Hybrid ULC's interest expense). The CRA indicated that Article IV(7)(b) would not apply to interest payments made by Hybrid ULC to USco, since the Same Treatment Test would be satisfied.
- Sale of Shares of Hybrid ULC– USco sells shares of Hybrid ULC to an arm's length purchaser. For Canadian tax purposes USco realizes a capital gain on the sale of shares. For U.S. tax purposes USco is considered to have sold the assets of Hybrid ULC. If Hybrid ULC had been regarded as a corporation for U.S. tax purposes USco would have been considered to have sold the shares of Hybrid ULC, rather than its assets, which could result in a difference in the character and quantum of the income or gains derived by USco. However, the CRA indicated that Article IV(7)(b) would not apply on the basis that the sale proceeds were received from an arm's length purchaser, rather than from the Hybrid ULC. As a result, USco would be eligible for an exemption for Canadian capital gains tax under the Treaty. The CRA noted, however, that if Hybrid ULC redeemed, acquired or cancelled its shares from USco Article IV(7)(b) could apply to both deemed dividends or gains arising on the disposition of the shares (since USco would be considered to have received such amounts from Hybrid ULC). The CRA also noted that Article IV(7)(b) could apply to any deemed dividend that could arise under Canadian domestic law on the transfer of shares of Hybrid ULC by USco to another Canadian ULC wholly-owned by USco.
- Royalty Paid to a Third Party – A Hybrid ULC is wholly-owned by USco. Hybrid ULC is granted a right to use a patented manufacturing process by a third party that is resident in the United States and eligible for benefits under the Treaty ("IP Holder"). Hybrid ULC pays license fees to IP Holder. For U.S. tax purposes, IP Holder would be considered to have received the license fees from USco, rather than Hybrid ULC. The CRA confirmed that the Same Treatment Test would be met in this situation since the quantum, character and timing of the payment received by IP Holder is the same whether or not Hybrid ULC is fiscally transparent for U.S. tax purposes. The only difference is the identity of the payor for U.S. tax purposes, which is not sufficient to cause the Same Treatment Test to not be met. As a result, IP Holder would be entitled to the reduced rate of withholding tax on royalties under the Treaty.
Examples Of Situations Where Article IV(7)(a) Or (b) Will Apply
In contrast to the examples summarized above, the CRA indicated that Article IV(7)(a) or (b) would apply to deny Treaty benefits in the following situations:
- Hybrid Partnership with Canadian Source Income – A U.S. corporation (USco) and its wholly-owned U.S. subsidiary (USSub) are members of a Canadian partnership that is fiscally transparent for Canadian tax purposes, and regarded as a corporation for U.S. tax purposes (Hybrid Partnership). Hybrid Partnership holds shares and debt of a Canadian corporation (Canco), and owns a patent that is licensed to Canco. Hybrid Partnership also directly carries on business activities in Canada but does not have a permanent establishment in Canada.
- Income Earned by Hybrid Partnership: For U.S. tax purposes dividends, interest and royalties paid by Canco to Hybrid Partnership, or income earned by Hybrid Partnership from its Canadian business activities, would be treated as income of a Canadian corporation (i.e., Hybrid Partnership), which is different than what the treatment would be if Hybrid Partnership had been treated as fiscally transparent for U.S. tax purposes. The CRA considers Article IV(7)(a) to apply on the basis that the Same Treatment Test would not be satisfied. As a result, the dividends, interest and royalty payments would be subject to Canadian withholding tax at a rate of 25% and business income earned by Hybrid Partnership would be taxable in Canada, since the "permanent establishment" exemption in the Treaty would not apply.
- Gain on Sale of Shares of Canco: For U.S. tax purposes, a gain realized on the sale of the shares of Canco would be considered to have been realized by Hybrid Partnership, rather than by USco and USSub. In contrast, if Hybrid Partnership were fiscally transparent for U.S. tax purposes, each of USco and USSub would have been required to include its allocable share of the gain in income. As a result, the CRA considers the Same Treatment Test to not be satisfied in this scenario and would apply Article IV(7)(a). The result is that USCo and USSub would not be entitled to a Treaty exemption in respect of any taxable capital gain realized on the disposition of the Canco shares.
- The CRA is of the view that the result in both these cases would not change if USCo and USSub were required to include the income or gains earned by Hybrid Partnership in income on an accrual basis under the U.S. anti-deferral rules (i.e., the U.S. "subpart F" or "passive foreign investment company" rules).
- ULC with One Shareholder – USco owns all of the outstanding shares of a Hybrid ULC. USco makes an interest bearing loan to Hybrid ULC. For U.S. tax purposes, interest paid by Hybrid ULC to USco is disregarded. If Hybrid ULC had instead been regarded as a corporation for U.S. tax purposes, USco would have been required to include the interest in its income on a current basis. As a result, the Same Treatment Test is not met. Accordingly, Article IV(7)(b) will apply to deny USco the benefit of the Treaty and Canadian withholding tax at a rate of 25% will apply to the interest payments made by Hybrid ULC to USCo.
- Back to Back Dividends – USco holds shares of Hybrid ULC which holds shares of a Canadian corporation (Canco). On the same day, Hybrid ULC pays a dividend to USco in an amount equal to the dividend it receives from Canco. From a U.S. tax perspective, USco is considered to have received a dividend from Canco. If Hybrid ULC had been regarded as a corporation for U.S. tax purposes, USco would have been considered to have received a dividend from Hybrid ULC, rather than Canco. Although a dividend from Canco would be similar to a dividend from Hybrid ULC, the CRA notes that the U.S. tax treatment is different. As the Same Treatment Test is not satisfied, Article IV(7)(b) applies to the dividend paid by Hybrid ULC to USco.
Cross-Border Arrangements Need To Be Reviewed
Given the impending effectiveness of the Treaty changes discussed above, cross-border arrangements should be reviewed to determine whether restructuring transactions should be implemented. There are a number of Canadian and U.S tax considerations to be taken into account in making such a determination. The Osler cross-border tax team is uniquely qualified in such matters and would be pleased to help with your deliberations. If you require any assistance, or have any other questions relating to the Treaty, please contact any member of our National Tax Department.
U.S. Tax (IRS Circular 230): Any U.S. tax or other legal advice in this update is not intended and is not written to be used, and it cannot be used, by any person to avoid penalties under U.S. federal, state or local tax law, or promote, market or recommend to any person any transaction or matter addressed herein.
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.