Cross-Border Tax Concerns: Canada-U.S.
Sep 21, 2011 QuickCounsel Download PDF
By Norton Rose
The Canada-United States Income Tax Convention (1980) (the "Treaty") underwent important changes with the entry into force of the Fifth Protocol (the "Protocol") in December of 2008. The wide-ranging changes affect many aspects of cross border transactions and commerce, as several of the formerly held conventional wisdoms no longer apply. Some of the main changes applicable to cross-border transactions introduced by the Protocol are described below.
Elimination of Withholding Tax on Interest Payments
The Protocol amended the Treaty to eliminate source-country withholding tax on cross-border payments of interest. Subject to certain exceptions, interest arising in one country and beneficially owned by a resident of the other country that is eligible for benefits under the Treaty will be taxable only in the other country. Certain types of interest, such as "participating" interest arising in Canada and interest arising in the U.S. that is contingent interest of a type that does not qualify as portfolio interest under U.S. law, will not benefit from the exemption. "Participating" interest is, generally, interest that represents a participation in the income or profits of the payor. Such interest specifically includes any interest determined by reference to:
Under the Treaty, certain persons are deemed to be related to the debtor, including a person who participates directly or indirectly in the management or control of the debtor. If interest is not exempt under these rules, withholding tax at the rate generally applicable to dividends (15%) will generally apply if the beneficial owner of the interest is a resident in Canada or the United States, as the case may be, and is eligible for benefits under the Treaty.
Note that effective January 1, 2008 Canada amended its domestic tax rules to eliminate withholding taxes on most types of interest paid by Canadian residents to arm's length persons, so the effect of the Protocol on Canadian withholding tax on arm's length interest payments is limited.
Fiscally Transparent Entities
Limited liability companies ("LLCs") that are disregarded for U.S. tax purposes have not, historically, been considered by the Canadian tax authorities to beeligible for Treaty benefits on the basis that they are not residents of the U.S. for purposes of the Treaty. The changes implemented by the Protocol do not go as far as treating an LLC as a U.S. resident. Instead, pursuant to Article IV(6) of the Treaty, the Protocol has introduced a "look-through" rule. If, under U.S. rules, a resident of the U.S. derives income through a fiscally transparent entity that is not resident in Canada (such as an LLC), and because of the fiscal transparency the U.S. resident has the same tax treatment as if it had derived the income directly, then for purposes of the Treaty the U.S. resident is considered to have derived the income. Treaty benefits are therefore available to the U.S. resident on the income so derived (subject to the limitations on benefits rules, discussed below). To obtain the benefit of this look-through rule, it is not necessary that the fiscally transparent entity be formed under U.S. law. The only restriction is that it is not a resident of Canada. Thus the look-through, and benefits under the Treaty, may be available with respect to a fiscally transparent entity formed under the law of a third country.
As noted above, the longstanding administrative position of the Canada Revenue Agency (the "CRA") has been that an LLC is not considered to be a resident of the U.S. for purposes of the Treaty. However, a decision of the Tax Court of Canada concluded that a U.S. LLC that was a disregarded entity for U.S. income tax purposes was a resident of the U.S. in applying the relevant Treaty provisions in respect of taxation years that ended before the Protocol came into effect (TD Securities (USA) LLC v. The Queen(April 8, 2010)). The breadth of this decision is unclear. The Court does not appear to have concluded that a LLC would be considered to be a resident of the U.S. in applying the Treaty in respect of all of its income, or in all circumstances, such as where income earned by the LLC is not subject to U.S. income tax in the hands of its members.
In response to TD Securities, the CRA has taken the administrative position that, in respect of income, profit or gain arising in circumstances where Article IV(6) has been in effect, the look-through rule establishes the parameters under which Treaty benefits can apply to a fiscally transparent entity. Accordingly, such income, profit or gain of an LLC qualifies for benefits under the Treaty only if it is considered to be derived by a U.S. resident eligible for benefits under the Treaty pursuant to the look-through rule. As a result, there remains some uncertainty regarding the manner in which the Treaty will apply to income earned by certain LLCs to which the look-through rule does not apply, such as in the case of a LLC with members who are not residents of the US.
Even when Article IV(6) would be available, it may be necessary to interpose a "blocker" entity resident in a third jurisdiction in order to reduce the information gathering and reporting obligations that would arise if treaty benefits were to be claimed by a number of U.S. investors in a fiscally transparent entity. For example, in order to establish entitlement to lower Canadian withholding tax rates on interest or dividends, information will generally be required about the investors in the fiscally transparent entity. Private equity funds organized as LLCs are often precluded from disclosing information sufficient to demonstrate the treaty residence of the investors. Even if there is no express prohibition, the information may be difficult to gather, particularly where there are tiered LLCs or partnerships in the structure. Properly structured, the use of a blocker entity in another jurisdiction can maintain tax efficiency without triggering onerous compliance requirements. However, in the Technical Explanation to the Protocol, it is noted that the CRA will treat the LLC as the only "visible" taxpayer, and will provide guidance for how an LLC is to establish entitlement to Treaty benefits. This guidance has not yet been released.
The Protocol introduced an "anti-hybrid" rule intended to limit the benefit of certain cross border tax planning structures. The effect of the rule is to deny Treaty benefits to persons who receive amounts of income, profit or gain from certain hybrid entities, if the tax treatment of such amounts in the jurisdiction of the recipient is not the same as if the hybrid entity had not been used. This rule will apply, for example, to distributions to U.S. residents by unlimited liability companies ("ULCs") formed under certain provincial corporate statutes (i.e., Nova Scotia, Alberta or British Columbia), where the ULC has "checked the box" so as to be a disregarded entity for U.S. tax purposes. An amount of income, profit or gain paid by a ULC (including, for example, interest or dividends) to a U.S. resident will no longer qualify for a reduced rate of withholding tax under the Treaty. Rather, the statutory withholding rate of 25% will apply to such amounts.
The rule will also affect the use of partnerships formed under Canadian law that have U.S. resident partners and that elect to be treated for U.S. tax purposes as a corporation. Currently, payments (e.g., interest) by a resident of Canada to such a partnership are subject to withholding tax at Treaty-reduced rates. The amended Treaty will deny Treaty benefits to such payments, with the result that the statutory rate of 25% will apply.
The anti-hybrid rules will also apply to certain outbound from Canada structures where, for example, a Canadian corporation is the member of an LLC that carries on business in the US.
These rules, which were intended to target certain financing structures which the Canadian government found offensive, will also impact the tax efficiency of inoffensive inbound to Canada acquisition or investment structures.
Limitation on Benefits
The Protocol introduced Canada's first reciprocal limitation on benefits ("LOB") provision by amending Article XXIX-A of the Treaty. The purpose of this provision is to limit or, in some cases, deny benefits under the Treaty to residents of non-contracting states who form entities in the U.S. or Canada in order to obtain more favourable tax treatment under the Treaty (sometimes referred to as "treaty shopping"). Prior to this amendment, Canada had relied on its domestic anti-avoidance rules to combat perceived abuses of treaty shopping. The new LOB provisions can give rise to anomalous results, and can require additional due diligence to determine entitlement to Treaty benefits.
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Additional ACC Resources
ACC Resource Library - Quick Reference
A New Frontier: Successfully Navigating the Pitfalls and Paradigms of Cross-Border Mergers and Acquisitions
ACC Resource Library - ACC Docket
ACC Resource Library - Program Material
ACC Resource Library - Primer
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