New CRA positions on hybrid entity provisions of the Canada-US treaty
International Tax Alert, February 17, 2010
Article IV(6): Members of disregarded US LLCs earning disregarded income will not obtain treaty benefits
Readers are likely aware that one of the main purposes of the Fifth Protocol to the Canada-US income tax treaty was to provide treaty benefits to US owners of limited liability companies (LLCs) earning Canadian source income in circumstances where the LLC is disregarded for US tax purposes. As discussed in a previous Alert, the Canada Revenue Agency (CRA) has made inconsistent statements in a technical interpretation and at the Canadian Tax Foundation (CTF) annual conference concerning whether income that is recognized for Canadian tax purposes but not for US tax purposes can be considered to have been “derived” by the owners of a US LLC or other fiscally transparent entity.
The CRA has now released a revised answer to the question posed at the CTF conference. The answer provides a restrictive view as to the circumstances in which a LLC can claim treaty benefits in respect of Canadian-source income and may cause US taxpayers to reconsider structuring inbound investments to Canada using disregarded LLCs.
The CRA response indicates that article IV(6) of the treaty will not apply to provide relief to the owners of a LLC where the LLC is considered to have earned income such as a dividend or interest from another entity that is also disregarded for US tax purposes, such as a Canadian unlimited liability company (ULC). This is the case because the income does not exist for US tax purposes (i.e., it is disregarded).
The CRA response to the question at the CTF conference in November, which concerned dividends paid in 2009 by a ULC to a LLC, implied that treaty benefits would be available to the members of the LLC as a result of article IV(6). Recognizing the confusion created by this change in position, the revised answer to this question indicates that the denial of treaty benefits will only apply to income arising after 2009.
However, despite some uncertainty, the CRA response states that it “is willing to consider” that article IV(6) will apply if the transaction is not disregarded for US tax purposes but is treated differently than it is treated for Canadian tax purposes. For example, if a regarded Canadian subsidiary were to pay a dividend to a LLC that is treated as a dividend for Canadian tax purposes but as a return of capital for US tax purposes, article IV(6) would apply to provide treaty benefits to the owners of the LLC in respect of the dividend. Similarly, if a redemption of shares were to result in a deemed dividend for Canadian tax purposes, article IV(6) should still apply even if the redemption proceeds were treated as proceeds of disposition or a return of capital for US tax purposes.
The CRA’s new position has broad implications:
- First, while many payments made by a ULC to its US shareholders will be denied treaty benefits in any case as of January 1, 2010 due to article IV(7)(b), certain transactions are not caught by that provision. In particular, the CRA has “blessed” certain transactions designed to avoid article IV(7)(b) where dividends are paid by a ULC. The transactions involve the capitalization of the retained earnings of the ULC to trigger a deemed dividend for Canadian tax purposes under section 84 of the Income Tax Act (the Act), followed by a return of paid-up capital. Article IV(7)(b) does not apply since the capitalization of the retained earnings of the ULC is a “nothing” for US tax purposes, whether or not the ULC is disregarded. A return of capital is not subject to Canadian withholding tax. However, if the shareholder of the ULC is a LLC, we understand that article IV(6) will not apply for the same reason (i.e., the capitalization of retained earnings is disregarded for US tax purposes) and the dividend will thus be subject to a 25% withholding tax.
- Second, while this new position does not affect transactions that are also recognized for US tax purposes (even if the transactions are treated differently for US tax purposes), one should beware of situations where income is deemed to arise for Canadian tax purposes but the event has no US tax consequences.
Article IV(7)(b): The GAAR and transactions to avoid article IV(7)(b) on distributions from ULCs
As discussed above, the CRA is prepared to provide rulings which state that article IV(7)(b) will not apply to distributions made by a ULC to its owner or owners which take place in two steps: the capitalization of the retained earnings of the ULC and the subsequent return of the paid-up capital created on the capitalization. The CRA has been unclear as to the circumstances in which they will rule that the General Anti-avoidance Rule (GAAR) will not apply to such transactions. Based on comments made by the CRA at the CTF conference and in prior discussions, it was fairly clear that the CRA would not seek to apply the GAAR if the ULC was an operating company or a holding company owning interests in a partnership that was also treated as a partnership for US tax purposes. Although no announcement has been made in this respect, the CRA is now prepared to entertain ruling requests involving situations where the ULC is a holding company owning Canadian or foreign subsidiaries or interests in a Canadian reverse hybrid partnership. We understand that the fact that the earnings of the Canadian or foreign businesses are deferred for US tax purposes should not be “fatal”. However, it is strongly recommended that a ruling be sought in such cases.
Avoiding article IV(7)(b) on deductible interest payments
As noted in our previous Alert, the CRA has also provided comfort that article IV(7)(b) will not apply to certain transactions involving deductible payments. These include the conversion of a wholly-owned ULC to a partnership for US tax purposes and the transfer of a loan receivable from the ULC’s parent to its grandparent. However, we understand that the CRA will seek to apply the GAAR to these transactions if the deduction is part of a financing transaction involving the deferral of income for US tax purposes. If the ULC is an operating company, the income of which is not deferred for US tax purposes, we understand that the CRA is willing to rule that the GAAR will not apply.
S corporations and qualifying S corporation subsidiaries
The CRA has previously stated that US S corporations are entitled to benefits under the treaty. This view is memorialized in the Technical Explanation to the treaty and we understand that it will not be reconsidered. Note that a ULC owned by an S corporation could utilize the deemed dividend transaction to avoid article IV(7)(b) in respect of distributions because there is no need to resort to article IV(6) to deem the owners of the S corporation to have derived the income.
However, we understand that the CRA has recently been asked to confirm their previous view that a qualifying S corporation subsidiary will also be entitled to treaty benefits, and this position is now under review.
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