CRA favourably applies the anti-hybrid rule where U.S. individuals lend to a ULC through an S Corp.

Two S Corporations (USCo and USCo2), whose shares are owned by the same U.S.-resident individuals in identical proportions, hold the shares of a Nova Scotia ULC (which is a partnership for Code purposes) and, in the case of USCo, also hold an interest-bearing loan of the ULC.

As a shareholder of USCo, each individual includes a pro rata portion of the interest in income under the Code.  Pro rata portions of that same interest also are deductible by USCo and USCo2 in the computation of their income, with such deductions then flowing through to the individuals qua shareholders of both USCo and USCo2.  Accordingly, there is no net inclusion of the interest in each individual’s income.  On the other hand, if the ULC were not fiscally transparent, the individual would be taxable on the full amount of his or her share of the interest, as the applicable portion of the ULC interest deduction would not flow through to the individual via the S Corps.

CRA ruled that the interest enjoys the Treaty-reduced withholding rate of 0% notwithstanding Art. IV,  subpara. 7(b) requiring that the treatment of the interest under the Code be the same as its treatment were the ULC not fiscally transparent.

CRA also ruled that USCo and USCo2 are eligible for the Treaty-reduced rate (of 5%) for substantial corporate shareholders when the usual 2-step (increase PUC, then distribute it) is used to extract cash profits of the ULC, notwithstanding that Canadian source income of an S Corp. may be considered to be derived instead by its individual shareholders pursuant to Art. IV, para. 6 (see also 2 February 2012 T.I. 2012-0434311E5: CRA considers that there is no need to engage para. 6 as the S Corps. are themselves Treaty residents.)

Neal Armstrong and Abe Leitner.  Summary of 2013 Ruling 2012-0467721R3 under Treaties – Art. 4.