5th Protocol to the Canada-US Tax Convention – Hybrid Entities
Assume that 100% of the voting stock of a US limited liability corporation (LLC) is owned by US qualifying persons, namely, 30% by a US-resident individual, 30% by a US-resident tax-exempt entity, and 40% by a US‑resident corporation (USco). Assume also that the LLC is treated as a partnership for US tax purposes and that the LLC owns all of the shares of a corporation resident in Canada (Canco).
Question
What is the Canadian withholding tax applicable to dividends paid by Canco to the LLC on or after February 1, 2009?
Response
In responding to this question, we have assumed that each of the shareholders of the LLC will be considered, under the taxation laws of the US, to have derived the dividends through the LLC and that, by reason of the LLC being treated as fiscally transparent under the taxation laws of the US, the treatment of the dividends is the same as it would be if the dividends had been derived directly by each of the shareholders. We have also assumed that the tax-exempt entity is a trust, company, organization or other arrangement described in either subparagraph XXIX A(2)(h) or (i) of the treaty, the entity deals at arm’s length with Canco, and the entity is exempt from tax on dividends derived from Canada by either paragraph XXI(2) or (3) of the treaty.
Paragraph IV(6) of the treaty provides as follows:
“An amount of income, profit or gain shall be considered to be derived by a person who is a resident of a Contracting State where:
(a) the person is considered under the taxation law of that State to have derived the amount through an entity (other than an entity that is a resident of the other Contracting State); and
(b) by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is the same as its treatment would be if that amount had been derived directly by that person.”
In the circumstances described above, paragraph IV(6) would apply such that, for the purposes of the treaty, the dividends paid to the LLC by Canco will be considered to be derived by the shareholders of the LLC.
With respect to determining the appropriate withholding rate on the dividends derived by the US-resident individual and USco, paragraph X(1) and (2) of the treaty are relevant. These paragraphs provide as follows:
“1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.
2. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of such dividends, the tax so charged shall not exceed:
(a) 5 percent of the gross amount of the dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends (for this purpose, a company that is a resident of a Contracting State shall be considered to own the voting stock owned by an entity that is considered fiscally transparent under the laws of that State and that is not a resident of the Contracting State of which the company paying the dividends is a resident, in proportion to the company’s ownership interest in that entity); and
(b) 15 percent of the gross amount of the dividends in all other cases.
This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.”
Applying paragraph IV(6) in conjunction with articles X and XXI of the treaty:
- 40% of the gross amount of the dividends paid by Canco to the LLC (the amount considered to have been derived by USco) will be subject to a 5% Canadian withholding tax.
- 30% of the gross amount of the dividends paid by Canco to the LLC (the amount considered to have been derived by the individual) will be subject to a 15% Canadian withholding tax.
- 30% of the gross amount of the dividends paid by Canco to the LLC (the amount considered to have been derived by the tax-exempt entity) will be exempt from Canadian withholding tax.