The Canada-United States Income Tax Convention 1980
(the "Treaty") was amended in 2008 to allow U.S. resident
members of a U.S. limited liability company ("LLC") that
is disregarded or treated as a partnership for U.S. tax purposes to
claim the benefit of the Treaty. Prior to this, it was the Canada
Revenue Agency's (the "CRA's") long-standing
administrative position that such LLCs were not entitled to the
benefits of the Treaty. On April 8, 2010, the Tax Court of Canada
held, in TD Securities (USA) LLC v. The Queen,
that an LLC could claim the benefit of the Treaty even before the
Treaty amendments were made. This is relevant both for
pre-amendment tax periods and on an ongoing basis given a recent
CRA technical interpretation suggesting that the Treaty amendments
are not adequate in some circumstances. This flash briefly reviews
the TD Securities decision and possible implications of
the case.
The TD Securities Case
In TD Securities, the taxpayer ("TD LLC") was
a Delaware LLC. In addition to carrying on business in the U.S., TD
LLC operated a branch in Canada through a Canadian permanent
establishment. TD LLC was subject to Canadian corporate income and
branch tax in respect of its Canadian operation. The Canadian
statutory branch tax rate is 25% and the question in this case was
whether TD LLC was entitled to the reduced 5% rate under the
Treaty.
To qualify for benefits under the Treaty, TD LLC needed to be a
resident of the U.S. under the Treaty. This required, in part, that
TD LLC be liable to tax in the U.S. TD LLC was a disregarded entity
for U.S. federal income tax purposes and, as such, it was not
itself subject to tax in the U.S. Rather, its income was included
in the income of its sole member, a U.S. resident
corporation.
The CRA's Position
It has been the CRA's long-standing position that a fiscally
transparent LLC (a LLC that is disregarded or treated as a
partnership for U.S. federal income tax purposes) is not entitled
to Treaty benefits because it is not itself liable to U.S. income
tax, and thus is not a U.S. resident for the purposes of the
Treaty. This contrasts with CRA's position that members of a
partnership may claim Treaty benefits for the partnership's
income because the partnership is not a separate person for these
purposes. The CRA concluded that, unlike a partnership, the LLC was
a person apart from its members, earning its own income, and this
prevented its U.S.-resident members from claiming Treaty benefits
themselves. The 2008 Treaty amendments were intended to overcome
this interpretation.
The TD Securities case dealt with events prior to the
Treaty amendments and, consistent with its position, the CRA argued
that TD LLC was not entitled to benefits under the Treaty and was
therefore subject to Canadian branch tax at a rate of 25%.
The Tax Court's Decision
After considering the treatment of income of a partnership under
tax treaties (including the OECD commentary in this regard) and the
CRA's administrative position that it would provide benefits
under the Treaty to tax exempt entities, partnerships, "S
corporations" and others, the Tax Court stated that it was not
intended that an entity whose income was comprehensively taxed in a
tax treaty country would be denied the benefit of the tax treaty
simply because its income was taxed at the level of the
shareholders, members or partners instead of at the entity level.
Where a U.S. corporation (a so-called "S corporation")
elects it is treated as a transparent entity for U.S. federal
income tax purposes and its income is taxed in the hands of its
shareholders. In allowing S corporations Treaty benefits, the CRA
has distinguished them from LLCs on the basis of fine statutory
differences in the U.S. Internal Revenue Code (the
"US Code").
The Tax Court concluded that TD LLC was liable to tax in the U.S.
because all of its income was comprehensively taxed under the US
Code, albeit not at the LLC entity level. On this basis, the Tax
Court determined that TD LLC was a resident of the U.S. and
entitled to the benefits of the Treaty, namely the reduced rate of
branch tax.
Although the correctness of some of the statements by the Tax Court
can be questioned, the Tax Court came to the correct conclusion
when considered from a policy perspective.
Implications of the TD Securities Case
Subject to a possible appeal, the decision in TD
Securities will provide relief for LLCs for periods prior to
the effective date of the Treaty amendments. However, its scope is
broader than this.
The 2008 Treaty amendments, pursuant to new Article IV(6), provide
releif from the CRA's position that LLCs are not entitled to
benefits under the Treaty. The share of an LLC's income that is
attributable to members who are U.S. residents for Treaty purposes
is entitled to benefits under the Treaty in qualifying
circumstances.
However, in a recent technical interpretation, the CRA stated that
Article IV(6) will not provide relief in all cases. In particular,
the CRA stated that there are issues in the application of Article
IV(6) to income for Canadian tax purposes that is treated
differently or not recognized for U.S. tax purposes. With respect
to income that is treated differently for U.S. tax purposes, the
CRA stated that it is generally willing to consider that Article
IV(6) applies; however, it will not extend this position for
taxation years after 2009 to income that is not recognized for U.S.
tax purposes.
For example, in our Flash entitled "CRA Provides Its Latest
Views on Planning for Canada-U.S. Tax Treaty Changes and Other
Issues", dated November 25, 2009 (available at http://www.dwpv.com/en/17620_24427.aspx
), we described a planning alternative to deal with the
inappropriate application of the new anti-hybrid rules in the
Treaty to the payment of a dividend by an unlimited liability
company ("ULC") to its U.S. resident shareholders. The
anti-hybrid rules can apply to a payment from an entity that is a
corporation for Canadian tax purposes (a ULC) where the entity is
disregarded for U.S. tax purposes and its being disregarded for
U.S. tax purposes affects the U.S. tax treatment of the payment.
The planning alternative involves effectively paying the dividend
by first increasing the paid-up capital of the ULC shares and then
reducing and paying out the paid-up capital. The paid-up capital
increase is treated as a payment of a dividend for Canadian tax
purposes. From a U.S. tax perspective, the increase in paid-up
capital is disregarded and the distribution arises on the return of
capital. Because the U.S. disregards the capital increase in all
cases, this result is not affected by the ULC's transparent
status, and the anti-hybrid rules do not apply. We noted in our
prior Flash that other considerations would apply where the
shareholder is an LLC. In that case, the CRA would take the
position that Article IV(6) does not apply to the deemed dividend
received by the LLC and would deny Treaty benefits. Although the
correctness of the CRA's position is highly questionable (and
the CRA itself has stated that there is substantial uncertainty in
interpreting the scope and intended application of Article IV(6)),
the LLC may now be able to claim benefits under the Treaty on the
basis of the TD Securities decision where all the members
of LLC are U.S. residents that are liable to tax in the U.S. (and
the new limitation on benefits Article in the Treaty is not
applicable to deny Treaty benefits).
Conclusion
Although the Treaty has been amended to accommodate LLCs, the
TD Securities decision could still have important
implications. However, the Tax Court was very careful to limit its
comments to circumstances where all the members of the LLC are
residents of the U.S. and it is unclear what the implications of
the decision will be where any of the members of the LLC are not
U.S. residents. Whether the CRA will appeal the Tax Court's
decision to the Federal Court of Appeal remains to be seen.
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.
