Question
The policy underlying Article IV(7)(b) of the Canada-US income tax convention[Footnote 10] is not obvious. The US Joint Committee on Taxation’s explanation to the US Senate’s Foreign Relations Committee states that
“[t]he rules of paragraph 7(b) are aimed largely at curtailing the use of certain legal entity structures that include hybrid fiscally transparent entities, which, when combined with the selective use of debt and equity, may facilitate the allowance of either (1) duplicated interest deductions in the United States and Canada, or (2) a single, internally generated interest deduction. . . . As a general matter, it is a legitimate objective for Canada and the United States, separately or jointly, to attack these or other types of structures that give rise to double deductions (or to single deductions with no income offsets). Commentators have noted, however, that many U.S. companies utilize Canadian ULCs to structure their Canadian investments and businesses, without engaging in such potentially abusive transactions, for a variety of legitimate reasons.”[Footnote 11]
Consider a situation where a fully taxable US C corporation (“USco”) wholly owns a Canadian unlimited liability company (ULC) that carries on business in Canada. ULC is a hybrid entity in that it is treated as a corporation for Canadian tax purposes but is viewed as “fiscally transparent” or “disregarded” under US tax law. As of January 1, 2010, under Article IV(7)(b) of the treaty, payments by ULC to USco in this circumstance will be ineligible for treaty relief to the extent that the payment is treated differently in the hands of the recipient depending on whether or not the payer is a hybrid entity.
Therefore, a dividend paid by ULC to USco seems to fall squarely within the wording of Article IV(7)(b) and would be ineligible for treaty relief because the dividend is treated differently in the hands of the recipient depending on whether or not ULC is fiscally transparent.
Consider a situation where ULC increased its paid-up capital (PUC) by capitalizing its retained earnings and then made a cross-border payment in reduction of that capital. The increase in PUC would create a deemed dividend for Canadian tax purposes, but would have no relevance for US tax purposes, whether or not ULC is fiscally transparent. As a result, because the treatment of the deemed dividend under the taxation laws of the United States would be no different than it would have been if ULC were not disregarded by the United States, the deemed dividend triggered on the increase in PUC should be eligible for treaty relief. A subsequent distribution on the reduction of the newly created capital would not be subject to Canadian domestic withholding tax, so the treaty would not need to be applied.
What is the CRA’s view of such arrangements?
Response
Provided that the deemed dividend resulting from the increase in the PUC of the shares of ULC is disregarded under the taxation laws of the United States, and would be similarly disregarded if ULC were not fiscally transparent, Article IV(7)(b) would not apply.
The application of GAAR would depend on all the facts and circumstances. However, we would not normally expect GAAR to apply if ULC is used by USco to carry on an active branch operation in Canada and USco and ULC enter into the above-noted arrangement so as to continue to qualify for the 5 percent withholding tax on the distribution of ULC’s after-tax earnings to USco.