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November 24, 2009: At the Canada Revenue Agency (CRA) Roundtable at the Canadian Tax Foundation conference, CRA clarified its views on certain issues arising from the Fifth Protocol to the Canada-U.S. Income Tax Convention (the “Treaty”). The CRA comments are very timely as a number of US residents have been contemplating how best to reorganize their Unlimited Liability Company (ULC) subsidiaries prior to the Treaty changes which come into effect January 1, 2010.
Below is a summary of CRA’s views with respect to a number of planning alternatives that deal with the upcoming Treaty changes as they relate to ULC’s.
The Fifth Protocol to the Treaty includes “anti-hybrid” rules that deny treaty benefits to hybrid entities – entities that are “fiscally transparent” for tax purposes in one country but not in the other (e.g. reverse hybrids and ULCs). A denial of treaty benefits could result in a 25% (previously 5% under the Treaty) withholding tax on payments such as interest or dividends between a ULC and its corporate US parent.
Planning to avoid the denial of Treaty benefits for dividends
CRA has stated that the following plan for maintaining treaty benefits for dividend distributions is acceptable. In a situation where a U.S. company (USCo) owns a Canadian ULC that carries on business in Canada, the following was raised with CRA:
(Q) What happens if the ULC increases its paid-up capital and then later distributes that capital to its shareholders?
(R) For Canadian tax purposes, the increase is deemed to be a dividend. Assuming that the ULC carries on an active branch operation in Canada, Article IV(7)(b) (the “anti-hybrid rules”) of the Treaty should not apply and the distribution of the ULC’s after-tax earnings (via a deemed dividend) to USCo would qualify for the reduced 5% withholding tax rate under the Treaty. Further, the subsequent return of paid up capital to shareholders would not be subject to Canadian withholding tax. For U.S. tax purposes, the increase in paid-up capital is a non-taxable event, regardless of whether the Canadian company is an ULC or a regular
Planning to avoid the anti-hybrid rules by interposing a Luxembourg entity
In a situation where a U.S corporation owns a Canadian ULC through an entity resident in Luxembourg, a jurisdiction with which Canada has a treaty, the following was raised:
(Q) Where a Luxembourg company (Luxco) is disregarded for U.S. purposes, will a 5% withholding tax rate be applied to dividends paid by the Canadian ULC?
(R) The 5% withholding rate will normally apply if Luxco is the “beneficial owner” of the dividends. This response seems to indicate that the CRA is accepting and following recent jurisprudence on this matter.
Interest and Royalty
Planning to avoid the denial of Treaty benefits for other payments such as interest and royalties
In a situation where a ULC owes interest to its U.S. corporate parent and the debt is rearranged to be payable to the U.S. corporate grandparent instead of the parent, the following was raised:
(Q) Would the payment of interest by the ULC to its U.S. grandparent satisfy the “same treatment” requirement in Article IV(7)(b) of the Treaty?
(R) If the amount deducted by the ULC is included in income by the U.S. grandparent, Article IV(7)(b) should not apply. The requirement is not that the amount received be treated identically, but rather that it have the same tax effect generally. The CRA notes however, that GAAR could apply to plans where the ULC is part of a financing arrangement that results in duplicated interest deductions or an internally generated interest deduction in one country without offsetting interest income in the other country.
Similar application of this commentary can be applied to royalties paid by a ULC to a third party (“IP Holder”) that is resident in the United States and eligible for Treaty benefits. CRA confirmed that in a situation where a ULC pays license fees to the IP Holder, the IP Holder would be entitled to the reduced rate of withholding tax on royalties under the Treaty as the “same treatment” test would be met.
Payments Before 2010
Confirmation that treaty benefits are available on payments made by a ULC to a US resident corporation during 2009
In a situation where a Limited Liability Company (LLC) owns an ULC, the following was raised:
(Q) Would treaty benefits be available with respect to dividend or interest payments by an ULC to a LLC before January
(R) CRA confirmed that an amount paid or credited to a U.S. LLC by a Canadian ULC, prior to January 1, 2010 and after January 31, 2009, should be eligible for treaty-reduced rates.
Situations where the "Anti-Hybrid" Rules Still Apply
CRA has indicated that Article IV(7)(b) will still apply to deny Treaty benefits in the following situations:
Interest Payments made by ULC to US Parent In a situation where US Corporate Parent (USCo) makes an interest bearing loan to ULC, CRA comments that Article IV(7)(b) will apply to deny Treaty benefits and a withholding tax of 25% will apply to the interest payments made by ULC to USCo. Since the interest paid by ULC to USCo is disregarded from a US tax perspective, the “same treatment” test is not met.
The clarifications that the CRA have provided alleviate some of the concerns raised with respect to planning alternatives for ULCs. While some ULC structures may still be entitled to Treaty benefits, each cross-border arrangement that includes a ULC or hybrid entity should still be carefully reviewed to determine whether the CRA’s comments are applicable given the particular facts and circumstances and whether restructuring of the ULC is still required.
If you have any questions related to this Tax Alert or your particular situation, please contact your local MNP tax advisor.
Related Topics:Canada Revenue Agency; U.S. Tax; United States; Personal Tax
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