The Canada Revenue Agency (“CRA”) recently confirmed that it continues to maintain its long-standing position that a US limited liability company (“US LLC”) that is treated as a fiscally transparent entity for US tax purposes is not entitled to treaty benefits under the Canada-US Tax Treaty, as amended by the Fifth Protocol (“Treaty”). However, CRA will look-through US LLCs in accordance with the new relieving rule under Article IV(6) of the Treaty and will suppress the Canadian taxation of US LLCs, which will remain the only visible taxpayers for Canadian tax purposes, to give effect to treaty entitlement of US resident shareholders of US LLCs.
Dividends paid by Canadian Corporations to US LLCs
CRA commented for the first time on treaty entitlement of US resident shareholders of US LLCs under the new look-through rule in Article IV(6) of the Treaty at the 2008 Annual Canadian Tax Foundation Conference. In the particular situation considered by CRA, 100% of the voting shares of a US LLC is owned by US “qualifying persons” for purposes of the Limitation on Benefits provisions in Article XXIX-A of the Treaty, namely, 30% by a US resident individual, 30% by a US resident tax-exempt entity, and the remaining 40% by a US resident corporation (“USCo”). Furthermore, US LLC is treated as a partnership for US tax purposes and owns all of the shares of a corporation resident in Canada (“Canco”).
CRA was asked to confirm the Canadian withholding tax applicable to dividends paid by Canco to US LLC on or after February 1, 2009 (i.e., date of application of look-through rule under Article IV(6) to dividend payments). In responding to this question, CRA assumed that all of the conditions for the application of Article IV(6) of the Treaty would be met including that each of the shareholders of US LLC would be considered under US taxation laws to have derived the amount of dividends through US LLC and that, by reason of US LLC being treated as fiscally transparent for US tax purposes, the treatment of the dividends in the hands of each US LLC shareholder would be the same as it would be if the dividends had been derived directly by each such shareholders under US tax laws. CRA also assumed that the US resident tax-exempt entity is exempt from Canadian taxation on any dividends derived from Canco in accordance with the provisions in Article XXI of the Treaty regarding tax-exempt organizations.
CRA confirmed that Article IV(6) of the Treaty would apply in this situation with the result that dividends paid to US LLC by Canco will be considered to be derived by the US LLC shareholders for purposes of the Treaty. In applying Article IV(6) in conjunction with Articles X (dividends) and XXI (exempt organizations), CRA determined that the Canadian withholding tax rate applicable to a dividend from Canco derived by the US resident shareholders through US LLC would be as follows: (a) 30% of the gross amount of the dividend considered to be derived by the US resident individual would be subject to Canadian withholding tax at a rate of 15% in accordance with Article X(2)(b) of the Treaty; (b) 30% of the gross amount of the dividend considered to be derived by the US resident tax-exempt entity would be exempt from Canadian withholding tax pursuant to Article XXI of the Treaty; and (c) 40% of the gross amount of the dividend considered to be derived by USCo would be subject to Canadian withholding tax at a rate of 5% in accordance with Article X(2)(a) of the Treaty.
In February 2010, CRA expressed the view that the relieving rule in Article IV(6) of the Treaty would not be applicable in circumstances where the dividends are paid by a Canadian resident unlimited liability company (“Canadian ULC”) that is treated as a disregarded entity for US tax purposes1 to its sole shareholder, a US LLC that is treated as a fiscally transparent entity for US tax purposes, because no amount would be considered derived for purposes of Article IV(6). In these circumstances, the dividend would not itself be recognized as an item of income in the hands of the shareholders of US LLC for US tax purposes nor would it have any other US tax consequences. However, the shareholders of US LLC would be required to include their share of the earnings of Canadian ULC on a current basis in computing their US taxable income.
On the one hand, CRA considered the argument to the effect that, where the earnings of Canadian ULC are treated for US tax purposes as being derived by the shareholders of US LLC, a cross-border payment such as a dividend that is paid out of those earnings should also be treated as being derived by the US LLC shareholders. On the other hand, CRA considered that a dividend payment would, for Canadian tax purposes, be distinct from the underlying earnings of US LLC and would not, in itself, be recognized under US tax laws. According to CRA, the better view is that the look-through rule in Article IV(6) does not apply to treat a particular amount of Canadian-source income, profit or gain as being derived by a US resident shareholder of a US LLC for purposes of the Treaty if that amount is “disregarded” for US tax purposes. Therefore, in this situation, US resident shareholders of a US LLC would not be considered to have derived any amount for Treaty purposes and would not be entitled to any treaty benefits in respect of any dividends paid by a disregarded Canadian ULC to a US LLC. As a result, the applicable Canadian withholding tax rate on such dividend would be 25%.
CRA also confirmed in February 2010 that it would adopt a liberal interpretation of the look-through rule in Article IV(6) with respect to an amount of income, profit or gain that is not disregarded under US tax laws but is treated differently under those laws than under Canadian tax laws. For example, CRA is willing to consider that any Canadian source deemed dividend arising on a redemption of shares of a non-disregarded Canadian corporation is derived by the sole US resident shareholder of a US LLC for purposes of the Treaty notwithstanding that the amount paid by the Canadian corporation on redemption may be treated under US tax laws as proceeds of disposition or return of capital. CRA also indicated that it is willing to adopt a similar position in respect of Canadian source cash dividends paid by a non-disregarded Canadian corporation to a US LLC even though under US tax laws such dividends may be treated partly as a dividend and partly as a return of capital.
Canadian branch profit of US LLCs
CRA was asked to comment on the treaty entitlement of shareholders of US LLCs in respect of a Canadian branch at the 2009 Annual Canadian Tax Foundation Conference in the following situation. Four shareholders, namely, a Bermudian resident Corporation, a US resident corporation, a US resident tax-exempt entity and a US resident individual each hold 25% of the shares of a US LLC with a Canadian branch. Since US LLC continues to be the only visible taxpayer and is treated as a corporation for Canadian tax purposes, CRA noted that Canadian Part I tax and Part XIV branch tax must be determined for a corporation. CRA confirmed that it would apply the look-through rule under Article IV(6) in these circumstances to determine if the shareholders are entitled to treaty benefits in respect of the Canadian branch.
CRA concluded that (a) 25% of the Canadian branch profit attributable to the Bermudian corporation would be subject to Canadian branch tax at the full rate of 25%; (b) 25% of the Canadian branch profit derived by the US resident corporation through US LLC would be subject to Canadian branch tax at a reduced rate of 5% under Article X(6) of the Treaty; (c) 25 % of the Canadian branch profit derived by the US resident tax-exempt entity through US LLC would be exempt from Canadian branch tax; and (d) 25% of the Canadian branch profit derived by the US resident individual through US LLC would be subject to the Canadian branch tax at the full rate of 25%. Although not entirely clear, it would appear that the CRA reached its conclusion that a US resident individual is not entitled to the reduced Canadian branch tax rate of 5% under the Treaty on the basis that only a corporation could claim such a reduction under Article X(6) of the Treaty.
It is important that inbound structures with US LLCs be reviewed to determine whether they give rise to full or partial treaty entitlement. Depending on the circumstances, solutions may be implemented to achieve full treaty entitlement.
1 For US tax purposes, a Canadian ULC with one member is treated as a disregarded entity and a Canadian ULC with 2 or more members is treated as partnership unless it has elected to be treated as a corporation.