19 May 2010 IFA Roundtable, 2010-0366521C6 - Canada-United States Tax Convention

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Interaction between paragraph 78(1)(b) of the Act and Article IV(7)(b) of the Convention where an amount of interest is deemed to be received by a resident of the United States from a Canadian Unlimited Liability Company (ULC) that is fiscally transparent under the taxation laws of the United States

Position: Article IV(7)(b) applies

Reasons: The tax treatment of the amount under the taxation laws of the United States is not the same as it would be if the ULC were not fiscally transparent

International Fiscal Association Annual Conference

May 19, 2010

Application of Article IV(7)(b) to Paragraph 78(1)(b) Amounts

Assume that a Canadian unlimited liability company ("ULC") is wholly-owned by a non-resident corporation ("USCo"). USCo is a resident of the United States for the purposes of the Canada-United States Tax Convention (1980) (the "Treaty"). The ULC is resident in Canada for the purposes of the Income Tax Act (the "Act") and a resident of Canada for the purposes of the Treaty. The ULC is disregarded under the taxation laws of the United States and, therefore, is fiscally transparent for the purposes of Article IV(7)(b) of the Treaty. The ULC is indebted to USCo under the terms of an interest-bearing debt (the "Debt"). Interest on the Debt accrues during the ULC's 2009 taxation year but will not be paid by the end of the ULC's 2011 taxation year. The ULC and USCo file an agreement, described in paragraph 78(1)(b) of the Act, with the effect that the interest on the Debt that accrued in 2009, is deemed, for Canadian tax purposes, to be paid by ULC and received by USCo on January 1, 2012.

For the purpose of this question, assume that, under the taxation laws of the United States, the ULC is considered to be a branch of USCo and, therefore, the interest payable on the Debt is not recognized as an item of income by USCo. Also assume that if the ULC were not fiscally transparent under the taxation laws of the United States, the interest on the Debt would be recognized, as interest, on an accrual basis, in accordance with those laws.

Question

Does Article IV(7)(b) of the Treaty apply to the interest on the Debt that is deemed to have been received by USCo pursuant to paragraph 78(1)(b) of the Act such that it is considered, for the purposes of the Treaty, not to have been paid to or derived by USCo?

CRA Response

Article IV(7)(b) of the Treaty was added by the Fifth Protocol and has effect on
January 1, 2010. It provides:

An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where:

(b) the person is considered under the taxation law of the other Contracting State to have received the amount from an entity that is a resident of that other State, but 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 not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State.

Subsection 78(1) of the Act provides:

Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer to a person with whom the taxpayer was not dealing at arm's length at the time the outlay or expense was incurred and at the end of the second taxation year following the taxation year in which the outlay or expense was incurred, is unpaid at the end of that second taxation year, either

(a) the amount so unpaid shall be included in computing the taxpayer's income for the third taxation year following the taxation year in which the outlay or expense was incurred, or

(b) where the taxpayer and that person have filed an agreement in prescribed form on or before the day on or before which the taxpayer is required by section 150 to file the taxpayer's return of income for the third succeeding taxation year, for the purposes of this Act the following rules apply:

(i) the amount so unpaid shall be deemed to have been paid by the taxpayer and received by that person on the first day of that third taxation year, and section 153, except subsection 153(3), is applicable to the extent that it would apply if that amount were being paid to that person by the taxpayer, and

(ii) that person shall be deemed to have made a loan to the taxpayer on the first day of that third taxation year in an amount equal to the amount so unpaid minus the amount, if any, deducted or withheld therefrom by the taxpayer on account of that person's tax for that third taxation year.

The purpose of subsection 78(1) is to limit the accrual of deductible expenses, such as interest, owing by a taxpayer to a person (creditor) who was not dealing at arm's length with the taxpayer at the time the expense was incurred. Subsection 78(1) provides that if the expense is not paid by the end of the second taxation year following the end of the taxation year in which the expense was incurred, the amount of the expense is added to the taxpayer's income in the third taxation year unless the taxpayer and the creditor agree to be assessed as if the amount were in fact paid on the first day of the third taxation year and were replaced on the same day by a loan of equal amount (less applicable withholding taxes).

Article IV(7)(b) applies to an amount of income, profit or gain received by a resident of a contracting state (residence state) from an entity that is a resident of the other state in the following circumstances: 1) the entity is fiscally transparent under the taxation laws of the residence state; and 2) the treatment of the amount under the taxation laws of the residence state is not the same as it would be if the entity were not fiscally transparent.

It has been argued that the amount deemed to be received by USCo pursuant to paragraph 78(1)(b) of the Act is not subject to Article IV(7)(b) because the deemed receipt in itself is not recognized under the taxation laws of the United States and would not be recognized if the ULC were not fiscally transparent. In our view, the application of Article IV(7)(b) requires an analysis of the treatment of the item of income to which the deemed receipt relates. In the circumstances described above, the portion of the accrued interest on the Debt that is deemed to be received by USCo pursuant to paragraph 78(1)(b) of the Act was not recognized under the taxation laws of the United States; however, such interest would have been recognized under such laws if the ULC were not fiscally transparent. Accordingly, it is our view that Article IV(7)(b) would apply with the result that the interest on the Debt that is deemed to be received by USCo pursuant to paragraph 78(1)(b) would be considered not to be paid to or derived by USCo for the purposes of the Treaty.