Citation: 2010 TCC 186
Date: 20100408
Docket: 2008-2314(IT)G
BETWEEN:
TD SECURITIES (USA) LLC,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Boyle J.
[1]
The issue in this case
is whether a limited liability company established in the United States (an “LLC”) is entitled to enjoy the benefit of the Canada‑United
States Income Tax Convention (the “US Treaty”) in respect of its Canadian‑sourced
income. Since the US Treaty is only applicable to residents of either country
or of both countries, and the appellant is not a resident of Canada, the
question in this case narrows to whether the appellant is a resident of the United States (the “US”) for purposes of the US Treaty. The Fifth
Protocol entered into between Canada and the United States amended the US Treaty to add specific rules that apply
to LLCs and other fiscally transparent entities including partnerships (the “Fifth
Protocol Amendments”). However the Fifth Protocol Amendments were adopted and
came into force after the periods in question.
I. Facts
[2]
The appellant, TD
Securities (USA) LCC (“TD LLC”) is a limited liability company governed by the Limited
Liability Company Act of the State of Delaware.
[3]
The sole member of TD
LLC is TD Holdings II Inc. (“Holdings II”) a Delaware corporation that is not resident in Canada for purposes of the Income
Tax Act (the “Canadian Act”) and is a resident of the US for purposes of the US Treaty. TD LLC’s predecessor entity,
TD Securities USA Inc., was a Delaware corporation. In 2004 TD Securities USA
Inc. was converted into a LLC and renamed TD LLC. This conversion was a tax‑deferred
non‑recognition transaction under the US Internal
Revenue Code (the “US Code”). The reorganization was done to allow a
consolidation of the losses and gains of the subsidiaries of Holdings II for US state income tax purposes.
[4]
An LLC is a company
that is recognized as a distinct legal entity separate from its members under Delaware and United
States law. The parties agree
that a US LLC is similarly recognized as a distinct legal entity separate from
its members under Canadian law. The appellant does not contest that TD LLC
should be treated as a corporation under Canadian law. The Court was not
invited by either party to revisit the characterization issue.
[5]
Holdings II is a wholly‑owned
direct subsidiary of Toronto Dominion Holdings (USA) Inc. (“TD USA”), another Delaware corporation. TD USA is
a wholly‑owned direct subsidiary of The Toronto‑Dominion Bank, a
Canadian chartered bank.
[6]
TD LLC is a registered US broker‑dealer that provides financial services
in the capital markets sector such as foreign exchange trading and interest rate
swaps. It has carried on its business since the mid to late 1970s. It is based
in New York City because that is where its business can
best be transacted and that is where most of its customers are located or headquartered.
Its headquarters are in New
York City. It has over
500 employees.
[7]
TD LLC has a branch
operation in Canada for the purpose of serving its US customers. Given the regulation of the financial
services sector in both countries, its US customers need or prefer to do
business in Canada with a US
company.
[8]
TD LLC’s Canadian
branch profits for 2005 and 2006 were reported by it in its Canadian tax
returns. Non‑residents of Canada that carry on business in Canada are
subject to ordinary Canadian income tax under Part I of the Canadian Act
on the income from their Canadian business activity. The US Treaty provides
that a US resident that carries on business in
Canada is only subject to Canadian income tax if the business is carried on
through a permanent establishment (“PE”) in Canada.
There is no dispute that TD LLC’s Canadian branch satisfies the definition of a
PE.
[9]
Part XIV of the
Canadian Act also provides that a non‑resident carrying on business in
Canada will be liable for an additional tax of 25% of its Canadian net after‑tax
income. This is commonly called “branch tax”. Its serves as the equivalent of
the 25% Canadian non‑resident withholding tax on dividends levied under
Part XIII of the Canadian Act that would have been payable if the non‑resident
had carried its Canadian business through a Canadian subsidiary corporation,
instead of directly through a branch, and had paid a dividend equal to its net
after‑tax income. In this way, the Canadian tax consequences are generally
the same for non‑residents of Canada whether their
Canadian business is carried on through a Canadian subsidiary or a Canadian
branch.
[10]
Part XIV of the
Canadian Act provides that, if a Canadian tax treaty with the country of
residence of a non‑resident carrying on business in Canada through a
branch provides for a lesser withholding tax rate on dividends than 25%, the
25% rate under Part XIV is similarly reduced unless the
treaty itself reduces the rate under Part XIV. The US Treaty expressly
provides
that the rate of Canadian Part XIV tax for Canadian branches of US
residents is reduced to the same 5% rate applicable under the US Treaty to
dividends paid by a wholly‑owned Canadian subsidiary to its US parent. TD LLC claimed the reduced rate of Canadian
branch tax of 5% under the US Treaty in respect of the 2005 and 2006 income of
its Canadian branch.
[11]
The Canada Agency
Revenue (“CRA”) assessed TD LLC to deny it the benefit of the 5% US Treaty rate
of branch tax and assessed Part XIV branch tax at the statutory rate of
25%.
[12]
The US Code taxes
individuals based upon citizenship or residence. It does not use the concept of
residence to levy income tax on corporations. Under the US Code corporations
are divided into domestic and foreign corporations. Domestic corporations,
those established, organized or incorporated in the US, are generally subject
to tax on their worldwide income whereas foreign corporations, those that are
not domestic corporations, are not subject to worldwide tax but are taxed on
their US‑sourced income.
[13]
Under the US Code an
LLC is entitled to elect to be treated as either (i) a corporation subject to US federal income tax like any other US domestic corporation, or (ii) a flow‑through or
disregarded entity whose income will be flowed through to its member or
members. If it elects to be disregarded and it has more than one member, the
LLC will be regarded as a partnership for US federal income tax purposes. Under the US
Code, as under the Canadian Act, the income of a partnership is required to be
allocated amongst its partners and included in income at the partner level. If
an LLC elects to be disregarded and has only one member, its activities will be
treated in the same manner as a sole proprietorship, branch, or division of the
member. If an LLC does not file an election under the so‑called “check‑the‑box”
regulations, it will be deemed to have elected to be a disregarded flow‑through
entity.
[14]
Under the US Code both
a partnership and a disregarded LLC are treated as a pass‑through entity,
that is an entity that is not taxed at the entity level but is taxed at the
level of the owners of the entity.
[15]
TD LLC did not file an
election under the “check‑the‑box” regulations. Accordingly, under
the US Code it is a disregarded entity and it is not itself subject to tax on
its income. Instead, all of its income is required to be included in the income
of its sole member, Holdings II, as if the activities of TD LLC were carried on
directly by Holdings II. The 2005 and 2006 income of TD LLC’s Canadian branch
was included in the income of Holdings II in this manner under the US Code.
[16]
The income of Holdings
II is consolidated with the income of its direct parent, TD USA, under the US
Code provisions for consolidated returns by US
parent corporations. In this way, TD USA pays US tax on all of the income computed under the US Code
for Holdings II. This includes all of the income of TD LLC, just as it did
prior to the reorganization when TD LLC was a corporation wholly‑owned by
Holdings II. Under the provisions of the consolidated group’s tax reimbursement
agreement, the taxes payable by TD USA under the US Code
on the earnings of Holdings II and TD LLC are charged back to, and borne by,
each of Holdings II and TD LLC being the entities that earned the income giving
rise to the tax.
[17]
TD USA was unable to claim a full foreign tax credit in its
consolidated US return under the US Code in respect of the Part XIV branch
tax payable on the Canadian income of TD LLC. TD USA was subject to the
limitations on foreign tax credits under the US Code that relate to the
comparable US rate of taxation on foreign‑sourced income. Thus, the
assessments in question increased the combined US and Canadian tax imposed on
the Canadian‑sourced income of TD LLC.
[18]
Three experts on US taxation law testified, one called by the appellant
and two by the respondent. They agreed on how the income of LLCs and
partnerships is subject to tax under the US Code generally, and on how the
income of TD LLC would have been taxed in the US in
its particular circumstances. These are as summarized above.
[19]
The expert called by
the appellant differed in his views from those of the experts called by the
respondent as regards whether, at the relevant time, the US Internal Revenue
Service (“IRS”) would have interpreted the term “resident of a Contracting State” under the US Treaty to include a Canadian flow‑through
entity or other disregarded entity in comparable circumstances. Based upon the
expert evidence presented, the Court is unable to conclude as a matter of fact whether
or not the IRS would have regarded a Canadian flow‑through entity in
those years as a resident of Canada for purposes of the US Treaty entitled to
treaty benefits in respect of any of its US‑sourced income. It appears
from each of the three experts that the IRS and the US never
made such a determination. In addressing this question the experts instead
addressed what they thought the IRS would have done if it was required to make
such a determination based upon US legal and administrative positions in
related areas. The information provided by the experts in their reports and in
their testimonies was helpful, factual evidence as described in greater detail below.
[20]
The expert reports
filed by the respondent included questions and answers phrased in terms of the very
question to be determined by this Court as a matter of Canadian law, i.e., whether
TD LLC was a resident of the US for purposes of the US Treaty. Appellant’s
counsel took initial exceptions to the reports on this basis. Both of the
respondent’s reports were admitted into evidence as expert opinion evidence
because the information contained in their written reasoning working towards
their answer was itself very helpful and informative factual evidence of US law and IRS practice and that information was
admissible expert opinion evidence. The respondent’s expert opinions have been
disregarded in so far as they are opining on what this Court’s answer should be
to the question before it.
[21]
There was no evidence
whether TD LLC and/or Holdings II requested the assistance of the US competent
authority as provided for in the US Treaty to resolve their treaty dispute nor,
if so, what the positions of the US and Canadian competent authorities were,
nor what the outcome was.
II. Positions of the Parties
[22]
It is the respondent’s
position that the meaning of the phrase resident of a Contracting State set out in the US Treaty is clear and unambiguous and
that the evidence is clear that TD LLC was not itself liable to tax in the US. The respondent maintains that the meaning of the
language chosen by two countries to define to whom the US Treaty applies cannot
be interpreted in a manner which will entitle TD LLC to the benefits of the
treaty without either ignoring some of the words used or reading some words
into it. As the respondent argued, treaties should be interpreted liberally and
purposively but, in the end, effect must be given to the words chosen.
[23]
The respondent further
maintains that, even if TD LLC is considered to be liable to tax in the US by
virtue of its income being taxed to Holdings II, that tax is not “by reason of [TD
LLC’s] domicile, residence, place of management, citizenship, place of
incorporation or any other criterion of a similar nature” as required by
Article IV of the US Treaty.
[24]
The respondent also
maintains that, if TD LLC is successful, LLCs will, in the future, be able to
claim treaty relief on the same basis instead of on the basis of the Fifth
Protocol Amendments. The respondent is concerned that this will be an
inappropriate result since the Fifth Protocol Amendments have set out specific
conditions which must be met to claim relief which would be rendered
meaningless if a US LLC could claim relief otherwise than under
paragraphs 6 and 7 of Article IV added by the Fifth Protocol
Amendments.
[25]
The appellant has two
distinct bases which it puts forth to support its claim for treaty relief for the
Canadian-sourced income of TD LLC.
[26]
The appellant’s first
position is that the phrase “liable to tax in” the US is a phrase which is not
defined in the US Treaty and which therefore falls to be defined by this Court
by reference to Canadian law, and is different from the mere determination
whether a person is required to pay tax on its income under the US Code. The
appellant submits that, on this basis, this Court can conclude that TD LLC was
liable to tax in the US and hence was a resident of the US for purposes of Article IV.
[27]
The appellant’s
alternative argument is that, consistent with the commentaries to the relevant
provisions of the Model Tax Convention on Income and on Capital of the Organisation
for Economic Co‑operation and Development (the “OECD and the OECD Model
Treaty”), which commentaries neither Canada nor the US reserved upon nor made
material observations, a liberal interpretation and application of the US Treaty
designed to achieve its purpose must give a meaning to the phrase “resident of
a Contracting State” that includes a US LLC such as TD LLC. In addition to the
OECD commentaries, the appellant relies upon the 1999 OECD report on the
Application of the OECD Model Tax Convention to Partnerships (the “OECD Partnership
Report”).
III. Analysis, Law and Authorities
A. The US Treaty Provisions
[28]
The US Treaty was
entered into by Canada and the US
in 1980 and came into force in 1984. It replaced a previous income tax
convention between the two states.
[29]
Article I of the
US Treaty provides that the Convention “. . . is generally
applicable to persons who are residents of one or both of the Contracting
States.”
[30]
Article II
provides that the Convention “. . . shall apply to taxes on
income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are levied”.
[31]
Article III of the
US Treaty sets out the definitions applicable for purposes of the Convention “. . . unless
the context otherwise requires”.
[32]
Person is defined in Article III
to include “. . . an individual, an estate, a trust, a company and
any other body of persons”. Company is defined to mean “. . . any
body corporate or any entity which is treated as a body corporate for tax
purposes”.
[33]
It is not disputed that
TD LLC is a person as defined. It is not clear if the Court needs to decide if
it is a company but it appears that, for purposes of applying the US Treaty in Canada, TD LLC is a company since Canada treats such an LLC
as a body corporate for purposes of the Canadian Act.
[34]
The US Technical
Explanation to the treaty issued by the US Treasury Department in 1984
expressly confirms that a partnership is a person for this purpose. The
Canadian Minister of Finance indicated by press release that the US Technical Explanation
accurately reflects understandings reached in the course of negotiations with
respect to the interpretation and application of the US Treaty. Little purpose
is advanced by confirming that a partnership is a person if not to confirm that
a partnership’s income can qualify for treaty benefits. It would hardly warrant
express mention in the Technical Explanation otherwise.
[35]
Article III goes
on to provide that “[a]s regards the application of the Convention by a
Contracting State any term not defined therein shall, unless the context
otherwise requires and subject to the provisions of Article XXVI (Mutual
Agreement Procedure), have the meaning which it has under the law of that State
concerning the taxes to which the Convention applies.” Section 3 of the Income
Tax Conventions Interpretation Act is to a similar effect. In other words,
in these proceedings, this Court is to give any term used in the US Treaty and
not defined therein the meaning that term has in Canadian law for purposes of
the Canadian Act unless the context otherwise requires.
[36]
Article IV deals
with residence. It provides that “. . . the term ‘resident’ of a
Contracting State means any person that, under the laws of that State, is
liable to tax therein by reason of that person’s domicile, residence, citizenship,
place of management, place of incorporation or any other criterion of a similar
nature, . . .”.
[37]
The definition carries
on “. . . but in the case of an estate or trust, only to the
extent that income derived by the estate or trust is liable to tax in that
State, either in its hands or in the hands of its beneficiaries.” Under the US
Code, as under the Canadian Act, the income of an estate or trust may flow out
to its beneficiaries for tax purposes in certain circumstances. Thus, the US
Treaty assumes that an estate or trust can satisfy the definition, but places a
specific restriction thereon.
[38]
Subparagraph (b)
of the definition of resident of a Contracting State provides that it includes
not‑for‑profit organizations and pension funds that were
constituted in a contracting state and generally exempt from income taxation in
that state by reason of their status. This part of the definition was added to
the US Treaty by the Third Protocol in 1995. The 1995 Technical Explanation to
the Third Protocol issued by the US Treasury Department describes the
addition as a clarification that corresponded to the interpretation previously
adopted by both Canada and the US.
US not‑for‑profit organizations and pension funds would need to be
residents of the US to obtain the general treaty‑reduced
rate of Canadian withholding tax on dividends and interest received on their Canadian
investments. Further, Article XXI of the US Treaty provides certain not‑for‑profit
organizations and pension funds with a complete exemption from Canadian
withholding taxes on certain of their cross‑border investments. The
contracting states were able to interpret and apply the definition of resident
of a contracting state to contextually require the recognition of not‑for‑profit
organizations and pension funds as residents of their home country even though
they do not generally pay income tax in their home country because they are
exempt from tax.
[39]
Similarly, the Third
Protocol in 1995 added a clause which deemed the government of one of the
countries or a political subdivision or local authority thereof, or an agency
or instrumentality of any thereof, to be itself a resident of that state. The
1995 Technical Explanation describes this amendment as confirmatory in nature
and “it is implicit in the current [pre‑1995 Protocol] Convention and in
other US and Canadian treaties, even where not specified”. Treaty residence for
government entities was necessary for them to get the general benefit of
reduced withholding on cross‑border investments and for public sector
pension plans to enjoy the benefit of the Article XXI exemption as fully
as private sector pension funds.
[40]
These latter are both
examples of where specific amendments to the definition of “resident of a
Contracting State” were added to the US Treaty even though both countries
agreed they were not needed, were confirmatory or clarifying in nature, and had
interpreted and applied the pre‑amendment treaty to treat such persons as
residents as defined because the context required or because it was implicit.
[41]
Article XXVI of
the US Treaty deals with the Mutual Agreement Procedure between the Canadian
and US competent authorities. It provides specifically that the competent
authorities may, in trying to resolve any difficulties or doubts regarding the
interpretation or application of the treaty, agree to the elimination of double
taxation with respect to income distributed by an estate or trust in subparagraph (e),
and to the elimination of double taxation with respect to a partnership in subparagraph (f).
It also provides that the competent authorities may consult together for the
elimination of double taxation in cases not provided for in the treaty. Subparagraph (f)
dealing with partnerships was neither revised nor repealed when the Fifth
Protocol Amendments were added.
B. The Fifth Protocol Amendments
[42]
The Fifth Protocol
Amendments were agreed to between Canada and the US
in 2007. The Fifth Protocol Amendments specifically address how the US Treaty
thereafter applies to fiscally transparent entities, such as partnerships and LLCs.
This was accomplished by adding new paragraphs 6 and 7 to Article IV
of the US Treaty as follows:
6. An amount of income, profit or gain shall be considered to be
derived by a person who is 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.
7. 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:
(a)
The person is considered under the taxation
law of the other Contracting State to have derived the amount through an entity
that is not a resident of the first‑mentioned State, but by reason of the
entity not being treated as fiscally transparent under the laws of that State,
the treatment of the amount under the taxation law of that State is not the
same as its treatment would be if that amount had been derived directly by that
person; or
(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.
[43]
The Fifth Protocol
Amendments are not retroactive and therefore do not apply to TD LLC’s 2005 and
2006 Canadian branch profits. That is not to say, however, that they are
irrelevant to the analysis of the issue. The two countries did not agree that
the treaty did not previously apply to LLCs and other fiscally transparent
entities such as partnerships. They have only specified that, subsequent to the
coming into force of the Fifth Protocol Amendments, the treaty will be
applicable to such entities on the basis set out and agreed.
[44]
The US Treasury
Department issued a Technical Explanation in respect of the amendments made to
the treaty by the Fifth Protocol. The Canadian Minister of Finance has
indicated publicly that Canada was given an opportunity to review and comment
on the Technical Explanation to the Fifth Protocol and that “Canada agrees that the Technical Explanation accurately
reflects understandings reached in the course of negotiations with respect to
the interpretation and application of the various provisions in the Protocol.”
[45]
It is clear that
the US did not agree with Canada’s position that, absent the Fifth Protocol
Amendments, the US Treaty did not extend to US LLCs. The Technical Explanation
confirms this by its choice of language in its discussion of new
paragraph 6 of Article IV: “. . . but
for new paragraph 6 Canada would not apply the Convention in taxing
the income.”(Emphasis added) This sentence appears under the heading
“Application of paragraph 6 and related treaty provisions by Canada”. (Emphasis
added)
[46]
A perhaps surprising
and relevant aspect of the Fifth Protocol Amendments is that they are not
drafted in a manner that, applied literally, would resolve the problem faced by
TD LLC or other US LLCs in later years to which the Fifth Protocol Amendments
apply and this is acknowledged in the Technical Explanation. Under the Canadian
Act, TD LLC is the legal entity that is the taxpayer required to prepare and
file a Canadian income tax return in respect of its Canadian branch profits.
The Fifth Protocol Amendments are clearly intended to ensure the LLC’s income
enjoys the benefits of the US Treaty. Yet, the Fifth Protocol Amendments do not
provide that the LLC will be treated as a resident. To that extent TD LLC and
other US LLCs will still not be able to get treaty relief if one seeks to apply
the text of the treaty literally. Paragraph 6 provides that the income of an
LLC or other fiscally transparent entity will be considered the income of its
member, Holdings II in the case of TD LLC. That still does not address how, or
strictly speaking why, the LLC would be able to claim the treaty reduction in
its Canadian income tax return. The Canadian taxpayer will still be the LLC,
not the member. The Fifth Protocol Amendments contemplate relief at the member
level, Holdings II, not at the entity level; yet they do not by these terms
deliver the contemplated relief if applied strictly and literally.
[47]
This is instead dealt
with quite differently by the agreement between the tax administrators of Canada and the US in the Technical
Explanation. The Technical Explanation acknowledges that a literal application
of new paragraph 6 does not resolve the problem. The Technical Explanation
provides:
If new paragraph 6 applies in respect of an
amount of income, profit or gain, such amount is considered as having been
derived by one or more U.S. resident shareholders of USLLC, and Canada shall grant benefits of the
Convention to the payment to USLLC and eliminate or
reduce Canadian tax as provided in the Convention. The effect of the rule is
to suppress Canadian taxation of USLLC to give effect to the benefits available
under the Convention to the U.S. residents in respect of the particular
amount of income, profit or gain.
However, for Canadian tax purposes, USLLC remains
the only “visible” taxpayer in relation to this amount In other words, the
Canadian tax treatment of this taxpayer (USLLC) is modified because of the
entitlement of its U.S. resident shareholders to benefits under the Convention, but this does not alter USLLC’s status under Canadian law. Canada
does not, for example, treat USLLC as though it did not exist, substituting the
shareholders for it in the role of taxpayer under Canada’s system.
Some of the implications of this are as follows.
First, Canada will not require the shareholders of USLLC to file Canadian
tax returns in respect of income that benefits from new paragraph 6.
Instead, USLLC itself will file a Canadian tax return in which it will claim
the benefit of the paragraph and supply any documentation required to support
the claim. (The Canada Revenue Agency will supply additional practical
guidance in this regard, including instructions for seeking to establish entitlement
to Convention benefits in advance of payment.). Second, as is explained in
greater detail below, if the income in question is business profits, it will be
necessary to determine whether the income was earned through a permanent
establishment in Canada. This
determination will be based on the presence and activities in Canada of USLLC
itself, not of its shareholders acting in their own right.
[Emphasis added.]
[48]
Like the earlier US
Treaty amendments dealing with not‑for‑profit organizations and
government entities, this is another example of the Canadian and US tax
administrators interpreting and applying the chosen language of the treaty to
deal with residence in a workable manner to achieve a result consistent with
its purpose and context.
[49]
What is even more
telling with the Technical Explanation to the Fifth Protocol Amendments is
that, as the two countries are turning their minds to the wording of new
provisions being drafted contemporaneously with the administrative provisions,
they are content relying upon a sensible approach to the application and
interpretation of the words and not the strict meaning or result of the words
chosen for the treaty.
C. The Interpretation of Treaties
[50]
The Vienna
Convention on the Law of Treaties
provides that a treaty is to be interpreted in good faith in accordance with
the ordinary meaning to be given to the terms of the treaty in their context
and in light of its object and purpose. It also authorizes regard to subsequent
practice in the application of the treaty in certain circumstances and for certain
purposes, as well as the use of other supplementary means of interpretation
when the interpretation of the treaty otherwise leads to a result which is
manifestly absurd or unreasonable.
[51]
It is fair to say that
in this case there is a tension between the ordinary meaning of the terms used
in the treaty and its object and purpose. This is a case where it prima
facie appears that a strict application of the terms used to define
resident of a Contracting State leads to an unreasonable result and thus, regard to
supplementary means of interpretation is an appropriate part of the required
analysis. The prima facie unreasonableness is demonstrated by, amongst
other things, the fact that a strict application of the text would conflict
with how both countries have interpreted and applied the treaty to government
entities, not‑for‑profit organizations, pension funds and, as
described below, partnerships which are themselves also fiscally transparent
flow‑through entities.
[52]
In The Queen v.
Crown Forest Industries Limited et al., 95 DTC 5389, the Supreme
Court of Canada had occasion to consider the appropriate interpretation to be
given to the phrase “resident of a Contracting State” in Article IV of the
US Treaty and, in particular, what it meant to be “liable to tax” in the US by
reason of the enumerated criteria.
[53]
The Court began from
the premise that: “In interpreting a treaty, the paramount goal is to find the
meaning of the words in question. This process involves looking to the language
used and the intentions of the parties.” The Court went on to quote approvingly
from Addy J. in Gladden Estate v. The Queen, 85 DTC 5188,
wherein he wrote at p. 5191:
Contrary to an ordinary taxing statute a tax treaty or convention
must be given a liberal interpretation with a view to implementing the true
intentions of the parties. A literal or legalistic interpretation must be
avoided when the basic object of the treaty might be defeated or frustrated
insofar as the particular item under consideration is concerned.
[54]
Both the Vienna
Convention and the Supreme Court of Canada in Crown Forest confirm that
“literalism has no role to play in the interpretation of treaties”: Coblentz
v. The Queen, 96 DTC 6531 (FCA).
[55]
In Crown Forest
the Supreme Court of Canada also held that, in ascertaining the purposes of a
treaty article, a court may refer to extrinsic materials which form part of the
legal context, including model conventions and official commentaries thereon,
without the need to first find an ambiguity before turning to such materials.
[56]
The Preamble to the US
Treaty sets out its purposes of reducing or eliminating double taxation of
income earned by a resident of one country from sources in the other country, and
of preventing tax avoidance or evasion. In Crown Forest the Supreme
Court of Canada held that the purposes of the US Treaty also included the
promotion of international trade between the two countries and the mitigation
of administrative complexities arising from having to comply with two
uncoordinated taxation systems.
[57]
In Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54,
2005 DTC 5523, the Supreme Court of Canada emphasized that “[t]he
provisions of the Income Tax Act must be interpreted in order to achieve
consistency, predictability and fairness so that taxpayers may manage their
affairs intelligently.” This Court sees no reason why the objectives of
consistency, predictability and fairness should be any less in the case of the
interpretation and application of international tax conventions forming part of
applicable Canadian income tax law.
[58]
On the substantive
issue of the meaning of the phrases resident of a contracting state and liable
to tax by reason of the enumerated criteria, the Supreme Court of Canada in Crown
Forest clearly concluded that the definition sought to describe those who
are subject to as comprehensive a tax liability as is imposed by a state, which
in the US as in Canada is taxation on worldwide income. The Court was not faced
in Crown Forest with circumstances where one person’s worldwide income
was subject to tax in the hands of another related entity resident in the same
jurisdiction by virtue of specific US domestic taxing
rules. It is nonetheless a strong confirmation that the intended purpose and
scope of Articles I and IV of the US Treaty were that the treaty apply to
those bearing full tax liability in either of the contracting states based upon
the nature and extent of their connections with that country.
[59]
In The Queen v. Prévost
Car Inc., 2009 FCA 57, 2009 DTC 5053, the Federal Court
of Appeal wrote:
10 The worldwide recognition of the provisions of the Model
Convention and their incorporation into a majority of bilateral conventions
have made the Commentaries on the provisions of the OECD Model a widely‑accepted
guide to the interpretation and application of the provisions of existing
bilateral conventions (see Crown Forest Industries Ltd. v. Canada,
[1995] 2 S.C.R. 802; Klaus Vogel, “Klaus Vogel on Double Taxation
Conventions” 3rd ed. (The Hague: Kluwer Law International, 1997) at 43. In
the case at bar, Article 10(2) of the Tax Treaty is mirrored on Article 10(2)
of the Model Convention.
11 The same may be said with respect to later commentaries,
when they represent a fair interpretation of the words of the Model Convention
and do not conflict with Commentaries in existence at the time a specific
treaty was entered and when, of course, neither treaty partner has registered
an objection to the new Commentaries. For example, in the introduction to the
Income and Capital Model Convention and Commentary (2003), the OECD invites its
members to interpret their bilateral treaties in accordance with the
Commentaries “as modified from time to time” (par. 3) and “in the spirit of the
revised Commentaries” (par. 33). The Introduction goes on, at par. 35, to note
that changes to the Commentaries are not relevant “where the provisions… are
different in substance from the amended Articles” and, at par. 36, that “many
amendments are intended to simply clarify, not change, the meaning of the Articles
or the Commentaries”.
D. OECD Model Treaty
[60]
Articles 1 and 4
of the OECD Model Treaty correspond to Articles I and IV of the US Treaty.
[61]
The language used in Article I
of the US Treaty and Article 1 of the OECD Model Treaty differ in that the
US Treaty provides that the treaty is “generally applicable” to residents of a contracting
state whereas the OECD Model Treaty uses the word “applicable”. The use of the
phrase “generally applicable” in the US Treaty suggests that the US Treaty may
also be applicable to others in particular circumstances. Indeed, this is
confirmed in the original Technical Explanation to the US Treaty.
[62]
The OECD Commentary on Article 1
has more than three pages of commentary on the application of the OECD Model
Treaty to partnerships. The commentary on partnerships is instructive in
interpreting the phrase “liable to tax” in a contracting state because neither
the OECD Model Treaty nor, in the years in question, the US Treaty expressly
provided how they applied to partnerships and partners. Of specific interest
are paragraphs 4, 5 and 6.3 of the OECD Commentary on Article 1 which
read as follows:
4. A first difficulty is the extent to which a partnership
is entitled as such to the benefits of the provisions of the Convention. Under
Article 1, only persons who are residents of the Contracting States are
entitled to the benefits of the tax Convention entered into by these States.
While paragraph 2 of the Commentary on Article 3 explains why a partnership
constitutes a person, a partnership does not necessarily qualify as a resident
of a Contracting State under
Article 4.
5. Where a partnership is treated as a company or taxed in
the same way, it is a resident of the Contracting State that taxes the partnership on the
grounds mentioned in paragraph 1 of Article 4 and, therefore, it is entitled to
the benefits of the Convention. Where, however, a partnership is treated as
fiscally transparent in a State, the partnership is not “liable to tax” in that
State within the meaning of paragraph 1 of Article 4, and so cannot be a
resident thereof for purposes of the Convention. In such a case, the
application of the Convention to the partnership as such would be refused,
unless a special rule covering partnerships were provided for in the Convention.
Where the application of the Convention is so refused, the partners should be
entitled, with respect to their share of the income of the partnership, to the
benefits provided by the Conventions entered into by the States of which they
are residents to the extent that the partnership’s income is allocated to them
for the purposes of taxation in their State of residence (cf. paragraph 8.7
of the Commentary on Article 4).
. . .
6.3 The results described in the preceding paragraph should
obtain even if, as a matter of the domestic law of the State of source, the
partnership would not be regarded as transparent for tax purposes but as a
separate taxable entity to which the income would be attributed, provided that
the partnership is not actually considered as a resident of the State of
source. This conclusion is founded upon the principle that the State of
source should take into account, as part of the factual context in which the
Convention is to be applied, the way in which an item of income, arising in its
jurisdiction, is treated in the jurisdiction of the person claiming the
benefits of the Convention as a resident. For States which could not agree
with this interpretation of the Article, it would be possible to provide for
this result in a special provision which would avoid the resulting potential
double taxation where the income of the partnership is differently allocated by
the two States.
[Emphasis added.]
[63]
The OECD commentaries
to Article 1 with respect to partnerships are expressly said to be the
conclusions of the OECD Partnership Report.
[64]
Two OECD countries expressly
reserved on paragraphs 5 and 6 of the commentary on the basis that express
language in a treaty would be required. A third country made a similar
reservation in respect of all of the commentary to Article 1. Neither
Canada nor the US reserved nor made an observation on this
point.
[65]
The Working Group of
the Committee on Fiscal Affairs which authored the OECD Partnership Report was
formed to study the application of the OECD Model Treaty to partnerships,
trusts and other non‑corporate entities. While the OECD Partnership Report
focuses on partnerships, the report opens with an acknowledgment that many of
the principles discussed therein may also apply with respect to other non‑corporate
entities. The Court was not made aware of any OECD developments regarding other
non‑corporate entities. The Court agrees that many of the same principles
and considerations also apply to a determination of whether the income of an
LLC is entitled to treaty benefits.
[66]
Paragraph 26 of
the OECD Partnership Report provides that many of the difficulties resulting
from some countries treating partnerships as taxable entities and others
treating their income as flowed through to their partners may be solved through
a better coordination in the application and interpretation of the tax
conventions.
[67]
Paragraph 27
provides:
27. Where income is derived from a particular State, the
determination of the tax consequences in that State will first require the
application of the domestic tax laws of that State. It is the provisions of
these laws that will determine who may be subjected to tax on that income in
that State. The provisions of tax conventions, however, may then intervene
to restrict or eliminate the taxing rights originating from domestic law where
a person, usually but not necessarily the taxpayer identified under domestic
law, is eligible for the benefits of the tax convention in relation to that
income.
[Emphasis added.]
[68]
Paragraph 34
provides:
34. . . . If the State in which a partnership
has been organised treats that partnership as fiscally transparent, then the
partnership is not “liable to tax” in that State within the meaning of Article
4, and so cannot be a resident for purposes of the Convention. Although
inconvenient at times (e.g. paragraph 89 below), there appears to be little
scope for a contrary argument under the current wording of Article 4.
[69]
Paragraph 47 provides:
47. Where the partnership as such does not qualify as a
resident under the principles developed in the preceding section, the
Committee agrees that the partners should be entitled to the benefits provided
by the Conventions entered into by the countries of which they are residents to
the extent that they are liable to tax on their share of the partnership income
in those countries. The following introductory examples illustrate the
results which the Committee believes are appropriate in some commonly recurring
situations. It is important to note that the solutions developed in this report
do not exclude the possibility that Member countries may in their bilateral
relations develop different solutions to the problems of double taxation which
may arise in connection with partnerships.
[Emphasis added.]
[70]
The OECD Partnership Report
goes on to then provide detailed examples in which it sets out the appropriate
results for a number of commonly recurring situations. Example 4 deals with a
situation where the country in which the income is sourced treats a partnership
as a taxable entity and the other treats it as a fiscally transparent entity. While
this is not the case for Canada as source country with respect to partnerships,
it is the case for Canada as the source country with respect to US LLCs, and is
to that extent instructive. Paragraphs 60 to 62 of the report provide:
60. Under [source] State S domestic law, the taxpayer will be
partnership P. State S could then argue that since partnership P is not
entitled to the benefits of the treaty, it can tax the income derived by P regardless
of the provisions of the S‑P Convention. This, however, would mean
that the income on which A and B are liable to tax in State P would be
subjected to tax in State S regardless of the Convention, a result that seems
in direct conflict with the object and purpose of the Convention.
61. The Committee compared that approach, under which State S
applies the provisions of the Convention by reference to the treatment of the
partnership under its domestic law, with another approach, under which State S
considers the entitlement to treaty benefits of A and B, both residents of
State P, under the principles put forward above. Under the latter approach, State
S would determine that the provisions of the Convention should be applied to
prevent it from taxing the royalties since, under these principles, the income
must be considered to be paid to A and B, two residents of State P, who should
also be considered to be the beneficial owners of such income as these are the
persons liable to tax on such income in State P. The Committee concluded that
this approach was the correct one as it is more likely to ensure that the
benefits of the Convention accrue to the persons who are liable to tax on the
income.
62. The Committee did not consider this approach to be
inconsistent with the provisions of paragraph 2 of Article 3,
under which terms not defined in the Convention have, unless the context
provides otherwise, the meaning which they have under the domestic law of the
Contracting State that applies the Convention. In the example, the tax
treatment of the partnership in State P is part of the facts on the basis of
which the terms of the Convention are to be applied. Thus, by referring to that
tax treatment, State S does not adopt a particular interpretation of the terms
of the Convention put forward by State P; it merely takes into account of facts
required for the application of these terms. The Committee concluded that,
in any event, if an interpretation based on domestic law would lead to cases
where the income taxed in the hands of residents of one State would not get the
benefits of the Convention, a result that would be contrary to the object and
purpose of the Convention, the context of the Convention would require a
different interpretation.
[Emphasis added.]
[71]
Article 4 of the
OECD Model Treaty does not differ in any material respect from Article IV
of the US Treaty with respect to the meaning of the term “resident of a Contracting State”.
[72]
The OECD Commentary to Article 4
makes it clear in paragraphs 8 and 8.5 that the concept of persons liable
to tax by reason of the enumerated criteria is trying to capture those who are
subject to comprehensive taxation, being a full liability to tax on all income
wherever earned. This is consistent with the comments of the Supreme Court of
Canada in Crown Forest.
[73]
Paragraph 8.7 of
the OECD Commentary to Article 4 provides:
8.7 Where a State disregards a partnership for tax purposes
and treats it as fiscally transparent, taxing the partners on their share of
the partnership income, the partnership itself is not liable to tax and may
not, therefore, be considered to be a resident of that State. In such a case, since
the income of the partnership “flows through” to the partners under the
domestic law of that State, the partners are the persons who are liable to tax
on that income and are thus the appropriate persons to claim the benefits of
the conventions concluded by the States of which they are residents. This
latter result will be achieved even if, under the domestic law of the State of
source, the income is attributed to a partnership which is treated as a
separate taxable entity. For States which could not agree with this
interpretation of the Article, it would be possible to provide for this result
in a special provision which would avoid the resulting potential double
taxation where the income of the partnership is differently allocated by the
two States.
[Emphasis added.]
[74]
Some countries did
reserve on paragraph 8.7 but neither Canada
nor the US reserved or made a relevant observation.
[75]
From these OECD
materials it seems clear that the OECD wants to be able to maintain that a
partnership that is treated as a flow‑through in its country of
establishment will not be considered liable to tax therein for purposes of the
OECD Model Treaty. However, the OECD makes it equally clear that, the OECD
Model Treaty is intended to, and should be interpreted and applied in a manner
that nonetheless extends the benefits of the Convention to the income of such a
partnership notwithstanding that it is not, strictly speaking, a resident of
its home country. In the case of partnerships this is to be done at the partner
level notwithstanding that the partnership is not liable to tax in its home
country and its partners are not considered to have earned the income in the
source country.
[76]
While these two
conclusions — that a partnership is not liable to tax in
its home country if it is treated as fiscally transparent and that its income
from a source country that does not regard it as fiscally transparent should
nonetheless get the benefit of the tax convention — are developed in the context of fiscally
transparent entities that are partnerships, this Court sees no reason that the
conclusions should be any different in the case of a fiscally transparent US
LLC.
[77]
Clearly these conclusions
and the reasoning in the OECD Model Treaty and commentaries reflect the
intention of the OECD member countries, including Canada and the US, with respect to treaties based upon the OECD Model Treaty,
such as the US Treaty. Further, given the absence of reservations or
observations thereon by Canada and the US, the Court accepts that these
reflect the intentions of Canada and the US
with respect to the US Treaty specifically and how its objects and purposes are
to be achieved.
E. Canadian Interpretation and Administration
[78]
In Crown Forest
the Supreme Court of Canada quoted with approval from the decision of the
Supreme Court of the United
States in Sumitomo Shoji
America, Inc. v. Avagliano et al., 457 U.S. 176 (1982), that “[a]lthough
not conclusive, the meaning attributed to treaty provisions by the Government
agencies charged with their negotiation and enforcement is entitled to great
weight.”
[79]
In CRA Income Tax – Technical
News No. 35 dated February 26, 2007, the CRA outlines its “long‑standing
position” on liability to tax for treaty purposes. In it the CRA wrote:
It remains CRA’s position that, to be considered “liable to tax” for
the purposes of the residence article of Canada's tax treaties, a person must generally
be subject to the most comprehensive form of taxation as exists in the relevant
country. This, however, does not necessarily mean that a person must pay tax to
a particular jurisdiction. There may be situations where a person’s worldwide
income is subject to a contracting state's full taxing jurisdiction but that
state's domestic law does not levy tax on a person's taxable income or taxes it
at low rates. In these cases, the CRA will generally accept that the person is
a resident of the other Contracting State unless the arrangement is abusive. . .
[80]
It is not disputed that
the CRA has a long‑standing practice of characterizing the income earned
by a foreign partnership made up of foreign partners consistent with the OECD
Partnership Report. That is, even though the partnership is a fiscally
transparent entity, the partners of the partnership will be entitled to treaty
benefits. With respect to the US Treaty, the CRA has acknowledged this is based
upon its understanding of the intent of Canada
and the US.
[81]
The CRA has also
confirmed that it will treat a so‑called “S Corporation” as a resident of
the US for purposes of the US Treaty. A US corporation that elects under subchapter S of the US
Code is treated as a flow‑through entity whose income is taxed under the
US Code in the hands of its shareholders. This was again confirmed by the CRA
in a 2008 Technical Interpretation
without mention of new paragraphs 6 and 7 of the Article IV added by
the Fifth Protocol Amendments.
[82]
However, in the case of
LLCs, the CRA appears to have departed from the above consistency. In a 1993
Technical Interpretation
the CRA first addresses the need to determine whether a particular US state’s
LLCs should be considered corporations or partnerships based upon their particular
characteristics.
The CRA went on to say that, if an LLC is treated as a partnership for purposes
of the US Code such that the partners rather than the company are liable to tax
on the company’s income, the LLC will not be considered a resident of the US
for purposes of the US Treaty. It does not expressly deal with whether or why
members of the LLC will or will not enjoy treaty benefits on the same basis as
partners of a partnership. In its later May 20, 1997 interpretation the CRA
identifies its concern as being that, if a US LLC enjoys US Treaty benefits, a
Canadian resident could carry on its Canadian business in Canada through a US
LLC and avoid both Canadian and US taxes on the income of its Canadian
business.
[83]
In Income Tax –
Technical News No. 16 dated March 8, 1999 the CRA confirmed its
positions that S Corporations will be treated as treaty residents and that LLCs
will not. It noted the inconsistency and regretted, but did not reverse, its S
Corporation position. It did not acknowledge, address or attempt to reconcile
its treatment of LLCs with its treatment of partnerships nor did it address
specifically the members of an LLC.
[84]
From the above it can
be seen that Canadian tax authorities have, with the sole exception of their
approach to LLCs, been consistent in their interpretation and application of
the US Treaty provisions applicable to a determination of treaty residence.
They extended treaty benefits to US not‑for‑profit organizations
and pension funds notwithstanding that these entities did not generally pay tax
under the US Code. They similarly extended treaty benefits to government
entities notwithstanding that they were not liable to tax under the US Code.
They extended treaty benefits to S Corporations notwithstanding that their income
is flowed through to their shareholders under the US Code. They extended treaty
benefits to the income of foreign partnerships notwithstanding that their
income is flowed through to partners, such treaty benefits to be determined and
enjoyed at the partner level.
[85]
The sole anomaly is the
CRA’s position with respect to US LLCs which, even after the lengthy trial
herein, remains largely unexplained and entirely irreconcilable with the
Canadian government’s approach to foreign partnerships.
[86]
The treatment of
partnerships and of LLCs should be analagous for purposes of the interpretation
and application of the US Treaty. A non‑Canadian partnership is deemed to
be a person with respect to payments made to it for Part XIII non‑resident
withholding tax purposes: see paragraph 212(13.1)(b) of the
Canadian Act. A US LLC such as TD LLC is treated as a corporation and thus a
separate person for purposes of the Canadian Act. In each case the partnership
and the LLC are the taxpayers for purposes of the Canadian Act. In neither case
are the partners or members the taxpayers. In the years in question the US
Treaty did not have an express rule for partnerships or for LLCs or other
fiscally transparent entities. The CRA applies a look‑through approach in
applying Canadian tax treaties to partnerships, even though the taxpayer for
Part XIII Canadian non‑resident withholding tax purposes is the
partnership, not the partners.
[87]
This Court concludes,
from the overwhelming consistency of the Canadian government’s approach to fiscally
transparent entities and to other entities that are not liable to tax under a
treaty partner’s domestic legislation, that it was not intended that an entity
whose income was fully and comprehensively taxed in the other contracting state
would be denied the benefit of a treaty simply because its income was taxed by
the other country at the level of its shareholders, members or partners.
[88]
Further, implicit in
the CRA’s position with respect to partnerships and S Corporations is that the
basis of taxation of an owner (partner or shareholder) is a similar criterion to
the enumerated criteria for purposes of Article IV of the US Treaty. Similarly,
paragraph 6.2 of the Income Tax Conventions Interpretation Act also
makes it clear that, in considering whether a partnership is a resident of
another state for purposes of a tax treaty, the residence of the partners is
relevant. This is also implicit in the CRA’s administrative positions described
above as well as in the OECD Commentary and Partnership Report.
F. US Interpretation and Administration
[89]
The interpretation and
administration of the provisions of a treaty by a treaty partner can also be
instructive and provide evidence of the intentions, objects and purposes of the
treaty. All of the US material before the Court confirms that the approach of
the US authorities to the interpretation and application of
tax treaties to fiscally transparent entities is consistent with the OECD look‑through
approach.
[90]
The Chief Counsel of
the US Treasury issued a Technical Assistance dated March 15, 2000 on
the subject of Certification of Limited Liability Companies. It addressed the
issues of whether and how the IRS should respond when requested to certify to a
treaty partner country’s tax authorities that a single‑owner LLC is a
resident of the US that is entitled to treaty benefits under
the US tax convention. The Chief Counsel’s conclusion is:
Because a single‑owner LLC that is disregarded as an entity
separate from its owner is not a “person”, nor is it “liable to tax”, the [IRS]
may not certify that the LLC is a resident of the United
States. However, the [IRS] may certify that the single‑owner
of the LLC is a resident of the United States, which should suffice to
establish that income derived by the LLC in the treaty country is being derived
by a resident of the United States and is entitled to treaty benefits.
[91]
The US competent authority has also determined under the mutual
agreement procedures with several of its other treaty partners that the income
of LLCs will be extended treaty benefits at the member level on a look‑through
basis.
The United Kingdom revenue authority had also confirmed this approach
to US LLCs in its Double Taxation Relief Manual prior to being “formalised” by amendments
to the US‑UK Treaty.
[92]
The Associate
International Tax Counsel of the US Department of the Treasury addressed the
1994 Annual Conference of the Canadian Tax Foundation as part of a panel on
Canada‑US Cross‑Border Issues. According to the published summary,
in discussing the Third Protocol Amendments to Article IV of the US Treaty
dealing with government entities, not‑for‑profit organizations and
pension funds, the US attached no significance to the failure of the Protocol
to deal specifically with the treatment of partnerships and confirmed that the
existence of a partnership will not preclude the availability of treaty
benefits. “The US authorities generally apply a look‑through
approach to analysing partnerships in the treaty context: treaty benefits are
granted to the extent that the partners themselves qualify for such benefits.”
It is noted that the Canadian Assistant Deputy Minister of Finance responsible
for the Tax Policy Branch —
the very group responsible for the negotiation of Canada’s tax treaties
including the US Treaty and the Protocols thereto — was on the same panel and did not express
a different view. Indeed, the rapporteurs note by way of footnote that the CRA
has expressed the same view in the technical interpretations going back to 1983.
[93]
Treasury Regulations
under section 894 of the US Code provide that the US will only extend
treaty benefits to passive income derived by a treaty resident of another
country through a fiscally transparent entity if the income is taxed by the
other country on the same basis as to timing, character and source as had the
treaty resident earned the income directly.
Treasury Decision 8722 which announced the Temporary Regulations makes it
clear that it is well established that, in interpreting and applying US tax
treaties, fiscally transparent entities are ignored and a look‑through
approach is intended, with the result that the entity’s owners are treated as
the persons who derive the income. Treasury Decision 8889 of 2000 which
announced the Final Regulations confirms that the US
regards the principles behind Treasury Regulations 894 as fully consistent
with its treaties. These comments in these last two documents are not limited
to passive income.
[94]
The United States
Model Income Tax Convention of 2006 (the “US Model Treaty”) provides
expressly in Article 1 that income derived through an entity that is
fiscally transparent under the laws of either contracting states shall be
considered to be derived by a resident of a state to the extent that the item
is treated for purposes of the taxation law of such contracting state as the
income of a resident. The Technical Explanation to the US Model Treaty confirms
expressly that this would apply in the case of an LLC. While the US Model
Treaty is simply that, a model treaty, the Technical Explanation to it provides
that the intention of the rule is to “eliminate” certain “technical problems”
that “arguably” would have prevented persons investing through a fiscally
transparent entity from claiming treaty benefits. The predecessor US Model Treaty
of 1996 was to a similar effect.
[95]
It is clear from the
above that the US has throughout intended that the entitlement to treaty
benefits of income earned by a fiscally transparent entity such as a
partnership or LLC be determined at the member level using a look‑through
approach and that the US has consistently interpreted Article IV of the US
Treaty to permit or require that approach.
IV. Conclusion
[96]
The US Code
comprehensively taxes the worldwide income of TD LLC as fully as if it had been
earned by any other entity including a US
domestic corporation. The only problem arises because it is not TD LLC that is
taxed on the income. The US Code provides that the income of TD LLC is fully
and comprehensively taxed to its member, Holdings II. This income is
consolidated in the TD USA tax return and tax thereon is charged back by TD USA to TD LLC.
[97]
In such a case, it
seems clear that the income of TD LLC should enjoy the benefits of the US
Treaty. The evidence is overwhelming that the object and purpose of the US
Treaty read in the context of all of the evidence and authorities would not be
achieved and would be frustrated if the Canadian‑sourced income of TD LLC
that is fully taxed in the US under the US Code does not enjoy the benefits of the
US Treaty including Article X(6). The appeal must therefore be allowed and
the assessments be sent back to the Minister for reconsideration and
reassessment on the basis that the Canadian branch profits of TD LLC enjoy the
favourable reduced Part XIV branch tax rate reduction provided for in
Article X(6) of the US Treaty.
[98]
Canada gets to choose
who to tax under the Canadian Act, a US LLC or its members, a partnership or
its partners. However, when deciding how to apply its international convention
with its treaty partner, Canada must consider as part of the context that
the US also gets to choose at which level to impose its
domestic tax under the US Code on that income, partnership or partner, LLC or
member. This was clearly intended by the treaty countries in order to give
effect to the US Treaty’s object and purpose. It makes little sense to think
that treaty entitlement should be affected by a US LLC’s exercise of its right
under the US Code to elect to have its income taxed in its hands or flowed through
and taxed in the hands of its US resident members.
[99]
The proper method of interpreting
the US Treaty to determine if it applies to income earned by to US partnerships
that are fiscally transparent and by US LLCs including TD LLC prior to the Fifth
Protocol Amendments, is to follow the interpretive approach taken by the OECD countries,
the OECD Model Treaty and the related commentaries and report. That is, to read
the text of the opening sentence of Article IV in the context of the treaty
as a whole, in the context of the object and purpose of the treaty, and in the
context of how our treaty partner chooses to fully and comprehensively impose tax
under its domestic tax legislation, the US Code, on the income of TD LLC and
other fiscally transparent entities. This is consistent with the approach taken
by Canada and the US with respect to the interpretation of the
US Treaty in its application to government entities and not‑for‑profit
organizations prior to the addition of specific amendments confirming the treaty’s
application to such entities. It is also consistent with both countries’
approach to determine the treaty entitlements of non‑corporate entities
such as partnerships and S Corporations prior to the Fifth Protocol Amendments.
The result also harmonizes with section 219.2 which does not require that
a treaty’s reduced withholding tax rate apply to the particular taxpayer. The
result does not jeopardize the Canadian approach to partnerships under all
Canadian tax treaties but for the US and France treaties where we now have express language. Such an
approach is also entirely consistent with the approach Canada and the US have
taken in respect of the application of the US Treaty in later years under the Fifth
Protocol Amendments, the terms of which textually do not provide that
partnerships, LLCs and other fiscally transparent entities are deemed to be residents
for purposes of Article IV; the treaty partners instead chose to rely upon
the Technical Explanation to impose the obligation on the tax administrators of
each country to ensure that treaty benefits would nonetheless be enjoyed on the
income earned in or from the other country by a partnership, LLC or other
fiscally transparent entity.
[100]
Such an approach dictates
the simple conclusion that the relevant articles of the US Treaty be
interpreted in such a manner that the Article X(6) branch profits tax rate
reduction applies to the Canadian branch profits of TD LLC. That is sufficient
to dispose of this appeal and is a tempting place to conclude. However, there are
certain further conclusions which can and must be drawn from this as a matter
of logic and reason as well as law.
[101]
The OECD Commentaries
on this issue are clear from a substantive point of view but appear to be
walking a fine semantic line. On more than one occasion they state in a
principled fashion that the fiscally transparent entity is not liable to tax.
However, each time they go on to conclude in a pragmatic fashion that,
interpreted and applied correctly having regard to the treaty’s intended object
and purpose, treaty benefits should apply to the income of the entity based on
the member’s entitlement. The commentaries then go on to say that the relief
can nonetheless be delivered at the entity level. The OECD Commentary may have
a good reason for not wanting to conclude one way or the other on whether the
treaty so applies because the entity is resident for treaty purposes or because
the income is that of the member for treaty purposes. Given the vastly
different legal and tax régimes represented by the OECD, this Court cannot
guess what the motivating reasons for this diplomatic ambiguity are and no
representative of Canada testified at this trial. However, this Court finds it
easier to discern how Canada and the US
can be presumed to have the US Treaty so apply given that they subsequently
addressed the issue in the Fifth Protocol Amendments and the Technical
Explanation thereto. While Canada and the US try to walk both lines — in the treaty text not treating the entity
as a resident because it is not liable to tax yet acknowledging their intention
of applying the text as if the LLC was a resident —, having forced this matter to court, Canada
can perhaps no longer leave it ambiguous. Since this Court has to decide
whether TD LLC is a resident of the United States and
liable to tax therein by reason of one of the enumerated or similar grounds, it
concludes that it is. The Court concludes that implicit in the clear intention
of the OECD countries, including Canada and the US,
that treaty benefits be enjoyed by TD LLC in the present circumstances, and
given the context of the Canadian and US tax régimes and the text of the US
Treaty :
(i)
TD LLC must be
considered to be a resident of the US for purposes of
the US Treaty otherwise the treaty could not apply;
(ii)
TD LLC must be
considered to be liable to tax in the US by virtue of all of its income being
fully and comprehensively taxed under the US Code albeit at the member level;
and
(iii) the income of TD LLC must
be considered to be subject to full and comprehensive taxation under the US
Code by reason of a criterion similar in nature to the enumerated grounds in
Article IV, namely the place of incorporation of its member which is the
very reason that TD LLC’s income is subject to full taxation in the US.
V.
The Respondent’s Concerns of Potential Abuse
[102] The respondent argued that, if this appeal is allowed,
there would be potential abuse and ambiguity of application of the US Treaty to
US LLCs on a going forward basis subsequent to the Fifth Protocol Amendments.
The expressed concern is that, if this appeal is allowed, US LLCs and
partnerships that are fiscally transparent will be able to choose in the future
between having the US Treaty apply in accordance with the reasons herein or,
alternatively, in reliance upon new paragraph 6 of Article IV.
Potential abuse and frustration of the purpose of the Fifth Protocol Amendments
would result since the application of the reasons in this case would not
incorporate the requirements of paragraph 7 of Article IV added by the
Fifth Protocol Amendments.
[103]
The respondent’s expressed
concerns are not persuasive. The revised US Treaty, including the Fifth
Protocol Amendments thereto, will be both part of the text and context to be
considered when applying the US Treaty in any such future case. It cannot
reasonably be expected that the amended and revised US Treaty would necessarily
be interpreted and applied in a manner similar to how it was interpreted in the
context of its provisions prior to the specific amendments dealing with
partnerships, LLCs and other fiscally transparent entities.
[104]
The Court recognizes a certain
irony in the fact that its decision in this case has been, on a prospective
basis, statutorily overridden prior to it having been decided. Further, this
decision cannot be said to stand for the simple proposition that every US LLC
is a resident of the US for the purposes of the US Treaty. On the facts of
this case, as put before this Court, and the applicable law and authorities
advanced and argued by the parties, the requirements of new paragraphs 6
and 7 of Article IV would be satisfied by TD LLC and Holdings II if the
Fifth Protocol Amendments were applicable to the years in question. For that
reason the decision in this case does not constitute a materially different
gate to access the US Treaty by US LLCs, much less a potential flood gate.
[105]
In this case, the respondent did
not even suggest that there was any potential avoidance of Canadian taxes or abuse
of the Canadian tax régime resulting from the decision by the TD Bank group to
use a US LLC to operate a Canadian branch. There were clearly understandable
and unchallenged business purposes, including non‑abusive state tax
planning purposes, to operate its US broker‑dealer business as a US LLC and for that
business to establish a Canadian branch. If, in another case, prior to or
following the Fifth Protocol Amendments, the respondent takes the position that
the use of a US LLC in that case contributes to inappropriate or abusive tax
avoidance, that will form part of the context to be considered by a court in
its interpretation and application of the US Treaty in that case. The
respondent does not even suggest in this case that TD LLC has been used in an
abusive manner to access US Treaty benefits, nor to achieve any other tax
abuse. Had potentially abusive tax avoidance or potential treaty abuse formed
part of the context the Court had to consider in this case, the outcome may
have been different. This is best left for a court to deal with in the future
should it arise.
[106]
Further, not only did this Court not
have to address the express limitation provisions in new paragraphs 6 and
7 of the Article IV of the US Treaty, it was not asked to consider the
potential application of any other limitation of benefits provisions or
principles applicable to the treaty, nor to consider the possible application
of the section 245 general anti-avoidance rule to the facts of this case.
Had any of these been put forward as even potentially applicable, which the
respondent properly did not, the context of this case would have further
changed.
[107]
The decision in this case stands
for no more than the proposition that, properly interpreted and applied in
context in a manner to achieve its intended object and purpose, the US Treaty’s
favourable tax rate reductions apply for years prior to the Fifth Protocol
Amendments to the Canadian‑sourced income of a US LLC if all of that
income is fully and comprehensively taxed by the US to the members of the LLC
resident in the US on the same basis as had the income been earned directly by
those members.
VI. Disposition
[108]
The appeal is allowed
and the assessments are sent back to the Minister of National Revenue for
reconsideration and reassessment in accordance with these reasons.
[109]
The appellant is
entitled to costs, including the reasonable costs incurred for its expert
report and the testimony of its expert.
Signed at Toronto, Ontario, this 8th day of April 2010.
"Patrick Boyle"
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