The Canada Revenue Agency (CRA) has recently provided administrative guidance on how it intends to apply the so-called "hybrid entity rules" of the Canada-US Tax Convention (Canada-US Treaty). This guidance is timely as these rules will enter into force on January 1, 2010.
This update focuses on the specific administrative guidance relating to the application of Article IV(7)(b). From a Canadian perspective, there has been considerable concern over the potential application of this article to unlimited liability companies (ULCs) organized under the laws of British Columbia, Alberta or Nova Scotia.
In general, Article IV(7)(b) provides that an amount of income, profit or gain will not be considered to be paid to or derived by a person who is a US resident where the person is considered for Canadian tax purposes to have received the amount from an entity that is resident of Canada, but, by reason of the entity being treated as fiscally transparent for US tax purposes, the treatment of the amount for US tax purposes is not the same as its treatment would be if that entity were not treated as fiscally transparent for US tax purposes. In the context of ULCs, if applied literally, this rule has the potential to significantly and adversely alter the tax efficiency of typical cross-border structures.
Recent Administrative Guidance
Some of the specific transactions considered by CRA in its new administrative guidance are as follows.
Two-step distribution: A ULC may effect a distribution of its profits to its US corporate shareholder (US Shareholder) by a two-step transaction that is economically equivalent to paying an actual dividend. As a first step, the ULC would increase the stated capital of its shares by a particular amount. As a second step, the ULC would decrease the stated capital of its shares by the same amount and distribute such amount to US Shareholder as a return of capital.
On the first step, the ULC would be deemed to have paid, and US Shareholder to have received, a dividend equal to the amount of the increase in the paid-up capital of the shares of the ULC. Canadian withholding tax would apply to the deemed dividend. The second step would be treated as a return of capital, and would not be subject to Canadian withholding tax.
On November 24th, at the CRA Roundtable of the Canadian Tax Foundation's annual conference, the CRA took the position that Article IV(7)(b) would not apply to this two-step transaction — provided that the deemed dividend resulting from the increase in the paid-up capital of the shares of the ULC is disregarded for US tax purposes and would be similarly disregarded if the ULC were not fiscally transparent. The CRA indicated that generally it would not apply the general anti-avoidance rule (GAAR) to such an arrangement, but left open the possibility that specific facts and circumstances could result in the application of the GAAR. The CRA officially issued an advance tax ruling a day later that essentially confirmed its conclusion.
Luxembourg intermediary: A Luxembourg resident société à responsabilité limitée (SARL) is interposed between the ULC and US Shareholder. The SARL elects to be disregarded for US tax purposes. The ULC pays a dividend to the SARL.
At the CRA Roundtable, the CRA indicated that the five per cent withholding tax rate under the Canada-Luxembourg Tax Treaty would normally apply to the dividend paid by the ULC if the SARL is the "beneficial owner" of the dividends.1
One important question the CRA did not address in this context is whether interest paid by the ULC in such a scenario could benefit from the nil withholding tax rate under the Canada-US Treaty on the basis that Article IV(6) would apply to deem the interest payment to be derived by US Shareholder for the purposes of the Canada-US Treaty.
We understand that a policy proposal in the US could potentially frustrate any planning consisting of inserting a SARL, or other foreign entity in a third country that is disregarded for US tax purposes, between a ULC and its US shareholder. The proposal would essentially allow a foreign entity to be treated as disregarded for US tax purposes only if the single owner of the entity were organized under the laws of the foreign country in which the foreign eligible entity is organized. Given that the ULC and its single owner, the interposed third-country entity, would be created in different foreign countries, the ULC would be treated as a corporation for US tax purposes under this proposal. Some planning might be available to avoid this rule as proposed, but much will depend on the actual language of the proposal if it is enacted into law.
Payments to US Grandparent: The ULC has an interest-bearing debt with US Shareholder, and the debt is rearranged so that instead of being payable to US Shareholder, it is payable to the corporate parent of US Shareholder (US Grandparent).
At the CRA Roundtable, the CRA indicated that, assuming the interest is subject to the same treatment in the US in the hands of US Grandparent as it would be if the ULC were not fiscally transparent for US tax purposes, the CRA would agree that Article IV(7)(b) does not apply to such a restructuring. However, the CRA indicated that it would consider applying the GAAR where such restructuring is part of a double-dip or debt pushdown financing arrangement.
In its Technical Interpretation released on November 25th, the CRA clarified its general position with respect to the application of the same treatment test under Article IV(7)(b). In general terms, the CRA will look at the timing, character and quantum of an amount to determine whether it meets the "same treatment" test, but will not consider its geographical source to be relevant unless this affects its treatment as an item of income for US tax purposes.
In its Technical Interpretation, the CRA went further in blessing payments to a US grandparent where US Grandparent and US Shareholder file a consolidated tax return. This is an important clarification, because in a case where the ULC is a disregarded entity and its deductible payment is treated as a payment by the Canadian branch of US Shareholder, the net effect under the US consolidated return regulations would be to disregard the payment from a US tax perspective. By contrast, if the ULC were treated as a corporation for US tax purposes, payments from it would not be subject to the intercompany transaction rules, and thus there would be a net inclusion for US Grandparent without a corresponding expense in the consolidated group. The CRA effectively concluded that the "same treatment" test under Article IV(7)(b) is limited to a separate entity analysis, and that taxability of a payment in the US is not a relevant consideration in determining whether the payment receives the "same treatment."
A ULC with more than one shareholder: US Shareholder 1 and US Shareholder 2 own shares of a ULC. The ULC has an interest-bearing debt with US Shareholder 1. The ULC is treated as a partnership rather than as a disregarded entity for US tax purposes.
In its Technical Interpretation, the CRA concluded that Article IV(7)(b) would not apply to the payment of interest by the ULC to US Shareholder 1 on the basis that US Shareholder 1 will be considered to earn interest income from the debt with the ULC regardless of the ULC's status as a fiscally transparent entity for US tax purposes. In determining whether Article IV(7)(b) applies to the interest payment, the CRA's focus is on the tax treatment of the interest as an item of income, without reference to the allocation of expenses from the partnership. In other words, Article IV(7)(b) does not apply to such an arrangement even though the net tax effect for US Shareholder 1 will depend on the ULC's status. If the ULC is a fiscally transparent partnership for US tax purposes, US Shareholder 1 would be able to offset its interest income by its share of the ULC's interest expense, whereas if the ULC were regarded, US Shareholder 1 would not be able to offset any of its gross income inclusion with an allocation of interest expense.
In its Technical Interpretation, the CRA also reiterated its traditional position that Article IV(7)(b) would apply to the base case where the ULC pays interest to US Shareholder as its sole shareholder.
Royalty paid to a Third Party: A Third Party that is a US resident and a "qualifying person" under the Canada-US Treaty grants to a ULC the right to use a patented manufacturing process in exchange for a licensing fee.
In its Technical Interpretation, the CRA confirmed that Article IV(7)(b) would not apply to the payment of the licence fee by the ULC to the Third Party. The CRA has essentially clarified that it considers potential differences in the foreign tax credit implications for the Third Party to be irrelevant for the "same treatment" test under Article IV(7)(b).
Back-to-back dividends: A ULC owns a Canadian subsidiary (Cansub). Cansub pays a dividend to the ULC, which in turn immediately pays a dividend of an identical amount to US Shareholder. From a US tax perspective, US Shareholder is considered to have received a dividend from Cansub.
In its Technical Interpretation, the CRA takes the debatable view that Article IV(7)(b) will apply to the dividend paid by the ULC to US Shareholder. The CRA argues that the dividend paid by Cansub to the ULC is a distinct amount for which US Shareholder is not liable to pay Canadian tax, and that therefore the treatment of this amount is not relevant for the same treatment test under Article IV(7)(b).
The CRA's administrative guidance should provide clarity in most circumstances and will greatly diminish the adverse impact of Article IV(7)(b). In this respect, Article IV(7)(b) now presents itself much more as a trap for the unwary than as a significant obstacle to the use of a ULC in a cross-border arrangement.
As Article IV(7)(b) takes effect on January 1, 2010, we expect that further guidance will develop over time through other advance tax rulings and technical interpretations. Taxpayers should review their cross-border arrangements to determine what, if any, restructuring should be implemented to address this new rule.
1 The most recent CRA view on the meaning of "beneficial owner" in light of the Federal Court of Appeal decision in Prévost Car is set out in CRA document no. 2009-032145.
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.