Treaty benefits will generally be denied under the new anti-hybrid rule under Article IV(7)(b) of the Canada-US Tax Treaty (the “Treaty”) in respect of any dividends paid on or after January 1, 2010 by Canadian unlimited liability corporations (“Canadian ULCs”). One possible solution to the denial of such treaty benefits is the implementation of a two-step distribution involving an increase in the paid-up capital of the shares of Canadian ULC followed by a reduction in the paid-up capital of such shares (the “Two-Step Distribution”).
Two-Step Distribution by Canadian ULCs to US “C” Corporations, US “S” Corporations and Foreign Partnerships
The Canada Revenue Agency (“CRA”) commented favourably on this possible solution for the first time at the CRA Roundtable at the 61st Annual Conference of the Canadian Tax Foundation (the “2009 CRA Roundtable”). The situation involved a US company (“USCo”) that owns the shares of a Canadian ULC that carries on business in Canada where the Canadian ULC is a disregarded entity for US tax purposes. CRA was asked whether the anti-hybrid rule under Article IV(7)(b) of the Treaty would apply to deny treaty benefits to USCo under the Treaty in respect of the Two-Step Distribution.
CRA was of the view that USCo should not be denied treaty benefits in these circumstances provided that the deemed dividend resulting from the increase in the paid-up capital of the shares of Canadian ULC is subject to the same tax treatment under US tax laws as it would be if Canadian ULC were not fiscally transparent for US tax purposes. CRA considers that a deemed dividend is subject to the same tax treatment if it is disregarded under US tax laws and would also be disregarded if Canadian ULC was not fiscally transparent for US tax purposes (i.e., Canadian ULC was treated as a corporation for US tax purposes).
CRA indicated that it would not normally expect the Canadian general anti-avoidance rule (“GAAR”) to apply to the Two-Step Distribution if a Canadian ULC is used by USCo to carry on an active branch operation in Canada and USCo and Canadian ULC enter into the Two-Step Distribution in order to continue to qualify for the reduced 5% withholding tax rate under the Treaty on the distribution of Canadian ULC’s after-tax earnings to USCo. We note that CRA appears to have adopted a more liberal approach recently on this point in respect of structures where Canadian ULCs are not carrying business in Canada but are holding shares of Canadian and/or foreign corporations.
Since the 2009 CRA Roundtable, CRA has issued various favourable tax rulings on the Two-Step Distribution in situations where shares of Canadian ULCs are held by US “C” Corporations, US “S” Corporations, and foreign partnerships with US resident individuals and US “S” Corporations as partners.
Two-Step Distributions by Canadian ULCs to US limited liability corporations (“US LLCs”)
CRA has consistently taken the position that US LLCs are not entitled to treaty benefits because US LLCs are not liable to tax in the US and therefore are not resident in the US for purposes of the Treaty. New Article IV(6) of the Treaty includes a relieving rule that allows US resident members of US LLCs to access treaty benefits. CRA has not changed its position on US LLCs as a result of the coming into force of this new rule and continues to view US LLCs as the only visible taxpayer for Canadian tax purposes. However, CRA will now look-through US LLCs in accordance with Article IV(6) to determine whether shareholders of US LLCs are entitled to treaty benefits and will “suppress” Canadian taxation of US LLCs to give effect to benefits available to its US resident shareholders.
In February 2010, CRA expressed the view that treaty benefits would be denied for payments of dividends paid by a Canadian ULC to its sole shareholder US LLC on or after January 1, 2010 on the basis that no amount would be considered derived by the shareholder of US LLC for purposes of Article IV(6) of the Treaty because such amount would be disregarded for US tax purposes. This would also mean that the Two-Step Distribution would not be a solution in this case because under the first step there would be no amount derived by the shareholders of US LLC for purposes of Article IV(6).
CRA has consistently taken the position that a US “S” Corporation is entitled to treaty benefits notwithstanding that such entity is not itself subject to taxation in the US. Rather, it is the shareholders of a US “S” Corporation that are subject to taxation. CRA has also adopted a favourable approach with foreign partnerships by looking through such partnership and giving effect to treaty benefits available to partners resident in foreign jurisdictions. Given the similarities between US “S” Corporations and foreign partnerships on the one hand and US LLCs on the other hand, it is difficult to understand why CRA would adopt a different approach for US LLCs where the shareholders of US LLCs are subject to comprehensive taxation on their share of the income of US LLC in their country of residence.
The Tax Court of Canada has recently concluded in the TD Securities (USA) LLC v. The Queen (2010 TCC 186) case that a US LLC was resident in the US for purposes of the Treaty on the basis that the US LLC was liable to tax in the US by virtue of all of its income being fully and comprehensively taxed in the US because of a criterion similar in nature to the enumerated grounds in Article IV(1) of the Treaty – namely, the place of incorporation of its member. The Fifth Protocol (including new Article IV(6)) to the Treaty did not apply to the taxation years under review in this case. Surprisingly, the Crown has decided not to appeal this decision. At the CRA Roundtable at the International Tax Seminar of the International Fiscal Association held in May 2010, the CRA indicated that it expected to be in a position to provide some definitive guidance in the near future regarding the application of the Treaty in light of the findings in TD Securities. At that time, it was not clear whether this decision would impact CRA’s position regarding distributions by Canadian ULCs to US LLCs by way of a Two-Step Distribution.
In July 2010, CRA provided some written guidance on this matter. Notwithstanding the findings in TD Securities, CRA confirmed that it continues to be of the view that a US LLC that is fiscally transparent under the taxation laws of the United States is not a resident of the US for purposes of the Treaty. However, CRA indicated that for Canadian taxes (other than taxes withheld at source), it will accept claims for treaty benefits made by a US LLC where new Article IV(6) is not in effect in respect of a particular taxation year (Article IV(6) of the Treaty became effective for taxes (other than withholding taxes) for taxation years beginning in 2009) provided certain conditions are met. CRA will also accept claims for treaty benefits for taxes withheld at source on amounts paid or credited by a Canadian resident (including a Canadian ULC) to a US LLC prior to February 1, 2009 if certain conditions are met. Treaty benefits should also be available for amounts paid or credited by a Canadian resident (including a Canadian ULC) to a US LLC prior to January 1, 2010 based on certain written responses released by CRA in February 2010 to questions raised at the 2009 CRA Roundtable.
CRA also reiterated its position expressed in February 2010 that where new Article IV(6) is in effect, such article will establish the parameters under which the benefits of the Treaty may be claimed by a fiscally transparent US LLC. US LLCs will only be entitled to claim treaty benefits with respect to an amount of income, profit or gain if such amount is considered to be derived for the purposes of Article IV(6). This confirms that CRA has not changed its position on Two-Step Distributions by Canadian ULCs to US LLCs as a result of the TD Securities decision. Therefore, the Two-Step Distribution will not be a solution for dividends paid on or after January 1, 2010 by Canadian ULCs to US LLCs.