Cross-Border Tax: Canada-US Tax Treaty Update: Canada Revenue Agency Views on Solutions for Interest and Other Payments from Canadian Unlimited Liability Companies

1 mars 2010

( Disponible en anglais seulement )

Paragraph 7(b) of Article IV of the Canada-United States Tax Convention (1980) (the “Canada-US Treaty”) includes an anti-hybrid entity rule that may deny treaty benefits on interest and other payments from a Nova Scotia, British Columbia or Alberta unlimited liability company (a “Canadian ULC”) to its US resident shareholders on or after January 1, 2010.  A Canadian ULC is considered a hybrid entity because it is treated differently for Canadian and US tax purposes – that is to say, it is treated as a corporation from a Canadian tax perspective and either as a disregarded entity or a partnership from a US tax perspective. 

This anti-hybrid rule will generally apply to deny treaty benefits to a US resident shareholder of a Canadian ULC on interest or other payments from Canadian ULC if the amounts so received are not subject to the same tax treatment in the hands of the US resident shareholder under US tax laws as they would be if Canadian ULC were not fiscally transparent for US tax purposes. 

One possible solution to the denial of treaty benefits on interest payments is to rearrange the debt. Another possible solution is to have a Canadian ULC with more than one shareholder that is treated as a partnership for US tax purposes.

Rearrangement of Debt

Canada Revenue Agency (“CRA”) confirmed that a USCo that is the sole shareholder of a Canadian ULC would be denied treaty benefits in respect of any interest paid to it by Canadian ULC because such interest payments would not be subject to the same tax treatment under US tax laws as they would be if Canadian ULC were not disregarded. In the former case, the interest payment would be disregarded and not included in computing USCo’s taxable income while in the latter case the interest payments would be included in computing USco’s taxable income. 

CRA recently commented on the possible solution of rearranging the debt to qualify for treaty benefits.  In the particular situation reviewed by CRA, USCo owns all of the shares of USCoSub which in turn owns all of the shares of Canadian ULC. The debt is rearranged such that instead of being payable by Canadian ULC to its direct parent (i.e USCoSub) it is payable by Canadian ULC to its grandparent (i.e. USCo).  CRA is of the view that there should generally not be a denial of treaty benefits on interest paid by Canadian ULC to USCo in this case under the anti-hybrid rule because such interest payments would be required to be included in computing USCo’s taxable income and would be subject to the same tax treatment under US tax laws as these payments would be if Canadian ULC were not disregarded.

CRA cautioned that it is not possible to make any categorical statements regarding the application of the general anti-avoidance rule (“GAAR”) to the restructuring of cross-border interest payments.  CRA indicated that the GAAR may apply if the Canadian ULC is part of a financing arrangement that results in, among other things, duplicated interest deductions or an internally generated interest deduction in one country without offsetting interest income in the other country.

Canadian ULC with More Than One Shareholder

CRA recently expressed its views on the possible solution of having a Canadian ULC with more than one shareholder that is treated as a partnership for US tax purposes rather than having a Canadian ULC with one member that is treated as a disregarded entity for US tax purposes. In the situation commented on by CRA, USCo owns 90% of all of the shares of Canadian ULC and USCoSub, a wholly-owned subsidiary of USCo, owns 10% of the shares of Canadian ULC.  USCo also made an interest bearing loan to Canadian ULC.  CRA confirmed that generally treaty benefits should not be denied on interest payments by Canadian ULC to USCo in this case under the anti-hybrid rule because the interest payments would be required to be included in computing USCo’s taxable income and would be subject to the same tax treatment under US tax laws as such payments would be if Canadian ULC were not treated as a partnership.

The possible solutions discussed herein could also apply to other types of payments by a Canadian ULC to its US resident shareholders such as, for example, royalty fees. However, we note that the possible solutions discussed in this article do not apply to the payment of dividends by a Canadian ULC to its US resident shareholders.  Planning options with respect to the payment of dividends by a Canadian ULC will be discussed in a future Tax Notes publication.

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