17 May 2023 IFA Roundtable - Official Response
Presented by: Yves Moreno, Director, International Division, Income Tax Rulings Directorate, Canada Revenue Agency
Unless otherwise stated, all statutory references in this document are to the Income Tax Act, R.S.C. 1985, c. 1 (5th Suppl.) (the “Act”), as amended to the date hereof
Question 1: Section 247 & Recent Changes Regarding Stock-Based Compensation
CRA has traditionally not allowed inbound charges for stock option expenses incurred by related parties to be deducted by a Canadian taxpayer when the cost of such stock options is included in the cost of services provided by the related non-resident person. There are revised rules in Canada allowing, in certain situations, deductions of non-qualified stock option expenses. In this context, will CRA now expect that Canadian taxpayers will include stock option expenses in the cost base for services charged to related non-residents, where the employees providing the services to the related non-residents received employer-deductible stock options? If "Yes", will CRA provide reciprocity on inbound stock-based compensation charges if the circumstances are similar?
In paragraph 44 of TPM-15, the CRA explains that:
If a charge includes non-deductible items [e.g., pursuant to paragraph 7(3)(b)], but the amount is an arm's length amount, the Income Tax Act does not prevent the taxpayer from paying the amount [i.e., no adjustment under 247(2)]; however, it will prevent its deduction for tax purposes [e.g., pursuant to paragraph 7(3)(b)].
The new rules in paragraph 110(1)(e) allow an employer that is a qualifying person to claim a deduction equal to the value of the benefit that is deemed by subsection 7(1) to have been received by an employee in respect of non-qualified securities, provided certain conditions are met.
Some have implied that the introduction of paragraph 110(1)(e) to provide a deduction in computing taxable income in situations in which an employee no longer benefits from a deduction in respect of stock-based compensation as something which suggests a change to CRA’s approach regarding the application of paragraph 7(3)(b) is appropriate.
Paragraph 110(1)(e) contemplates its application in cross-border situations. In particular, subparagraph 110(1)(e)(v) as recently amended limits the deduction where the benefit associated with the stock-based compensation is received by an em ployee who is a non-resident of Canada.
The deduction for the employer will apply only if:
(v) in the case of an individual who is not resident in Canada throughout the year, the benefit deemed by subsection 7(1) to have been received by the individual was included in computing the taxable income earned in Canada of the individual for the year. A Canadian taxpayer receiving consideration for providing goods or services to related non-residents (“Outbound Charges”) is expected to comply with the arm’s length standard. Conversely, a Canadian taxpayer might pay consideration to related non-residents (“Inbound Charges”). The CRA distinguishes two types of Inbound Charge. The first type of Inbound Charge involves payments by a Canadian resident or non-resident person that is liable to pay Canadian tax (“Canadian Taxpayer”) for goods or services provided by a foreign related party to the Canadian Taxpayer.
The second type of Inbound Charge to a Canadian Taxpayer is for its portion of costs incurred by a related foreign party on its behalf. As an example of the latter situation, a foreign public company might offer stock-based compensation to qualifying employees in the corporate group, and charge the cost of providing these benefits to the Canadian Taxpayer and other employers of qualifying employees within the group.
In the evaluation of whether subsection 247(2) might apply to adjust an Outbound Charge or an Inbound Charge, all relevant circumstances are to be considered in order to determine the appropriate arm’s length price. Consistent with commentary on OECD transfer pricing principles, the CRA is of the view that stock-based compensation may be relevant in establishing an appropriate arm’s length price. That was the case before the recent changes in paragraph 110(1)(e) affecting the deductibility of stock-based compensation and those changes have not altered CRA’s views on how Outbound Charges affected by stock option expenses should be treated for purposes of subsection 247(2).
However, even though the Inbound Charge satisfies the transfer pricing standard under 247(2), the reimbursement of the cost of providing stock-based compensation to the Canadian Taxpayer’s employees may not be deductible in computing income in Canada. In particular, stock-based compensation expenses are generally not deductible in Canada for income tax purposes under paragraph 7(3)(b) and the language therein is broad.
With respect to the first type of Inbound Charge, it is a question of fact as to whether the Canadian Taxpayer receiving the service can deduct all of the Inbound Charge in computing its income. A stock-based compensation component of the Inbound Charge will not be deductible in computing income if, in the absence of paragraph 7(3)(b), the income of the Canadian Taxpayer would be “less than [it] would have been had a benefit not been conferred on the employee by the sale or issue of the securities.”
For the second type of Inbound Charge, paragraph 7(3)(b) should apply to prevent the Canadian Taxpayer from deducting in computing its income, the stock-based compensation element of the Inbound Charge. However, paragraph 110(1)(e) may allow the Canadian Taxpayer to deduct an amount from its taxable income.
The CRA will continue to assess the impact of changes to the Act on its approach to transfer pricing adjustments.
Question 2: Ukraine/Russia Reporting Requirements
Some Canadian multinationals have subsidiaries in Ukraine or Russia that continued operating during 2022 in those countries. Due to the war, financial reporting from these subsidiaries may not be available for 2022. Will CRA grant any administrative relief in relation to the reporting requirements of Canadian multinationals covering their subsidiaries in Ukraine or Russia in case of tax reporting covering international operations, such as country-by-country reporting, forms T1134, etc.? What is the CRA’s position with respect to such cases?
The CRA recognizes that the on-going Russian invasion and occupation of Ukraine has the potential to present challenges to Canadian multinationals with subsidiaries operating in that country in terms of meeting their foreign reporting obligations for their 2022 taxation year.
It is the practice of the CRA to determine on a case-by-case basis whether relief is appropriate in respect of the filing obligations under sections 233.1 (T106), 233.2 (T1141), 233.3 (T1135), 233.4 (T1134), 233.6 (T1142), and 233.8 (RC4649) of the Act.
In respect of information that is factually not available at the time form T1141 or form T1134 is due to be filed, the due diligence exception in section 233.5 is available provided a description of each of a) the unavailable information, b) the circumstances making the information unavailable, and c) an explanation of the steps taken to obtain the information are provided on the form. The application of section 233.5 would also relieve any potential penalty under subsection 162(5).
If the particular taxpayer’s specific facts and circumstances warrant, the CRA will also consider granting relief under subsection 220(2.1) from the obligation to provide prescribed information or additional documents (e.g., the unconsolidated financial statements of a Ukrainian foreign affiliate that otherwise must be filed with form T1134). Although the CRA may provide relief in respect of the provision of prescribed information normally required in foreign reporting forms, the forms must still be filed by the taxpayer on or before the respective form’s filing due date. Any Canadian multinational that wishes to request relief under subsection 220(2.1) should present their request to their Tax Services Office (TSO) in advance of the filing due date of the form in respect of which relief is being requested.
Under the taxpayer relief provisions, the CRA also can exercise discretion in cancelling penalties and interest in whole or in part, normally payable under the Act by a taxpayer. After an information return has been filed and processed, a request for penalty and interest relief under subsection 220(3.1) may be submitted. The CRA will consider each request based on the specific circumstances for that request. For more information about relief from penalties or interest and the related forms and publications, please consult canada.ca/penalty-interest-relief.
The question also inquires about relief in respect of foreign subsidiaries located in Russia. Case-by-case consideration would be given to a request for relief in respect of such foreign subsidiaries, just as it would be given in respect of subsidiaries located in any other country.
Question 3: T1134 Supplement Disclosure on Dividends
Part II Section 3(A)(2) of the T1134 supplement requires disclosure of dividends paid by a foreign affiliate.
1. Is the definition of dividends based on Canadian or foreign corporate/tax principles?
As an example, a U.S. limited liability limited partnership or U.S. limited liability company is considered to be a corporation for Canadian tax purposes but is considered as fiscally transparent or as a partnership by default under U.S. tax law. Distributions from these entities are not considered dividends for U.S. purposes and not shown on the financial statements of the foreign affiliate as dividends. However, pro-rata distributions to its members are deemed to be dividends under subsection 90(2) under the Act.
2. If Canadian principles are to be used and the taxpayer does not have information on whether the distributions are made on a pro-rata basis, would the due diligence exception under Part IV be available?
Subsection 90(2) generally provides that for the purposes of the Act, an amount is deemed to be a dividend paid or received on a share of a class of the capital stock of a non-resident corporation that is a foreign affiliate of a taxpayer if the amount is the share’s portion of a pro rata distribution made at that time by the corporation in respect of all the shares of that class, with certain exceptions.
Subsection 90(5) further provides that no amount paid or received at any time is a dividend paid or received on a share of the capital stock of a foreign affiliate of a taxpayer unless it is deemed under Part I of the Act.
The Department of Finance’s notes to subsection 90(2) state that subsections 90(2) and 90(5) together provide “an all-encompassing definition of a dividend from a foreign affiliate for the purposes of the Act”, and the definition also applies for purposes of the Income Tax Regulations “by virtue of their application for all purposes of the Act”.
In the example provided, to the extent that the U.S. limited liability limited partnership and the U.S. limited liability company are non-resident corporations that are foreign affiliates of a reporting taxpayer for Canadian tax purposes, pro rata distributions to their members, that are deemed to be dividends under subsection 90(2) of the Act, are to be reported as dividends in Part II Section 3(A)(2) of the T1134 supplement.
A failure to provide any information required on a prescribed form may result in penalties under sections 162 or 163 of the Act. Where a reporting taxpayer does not have all the information required to fulfil the reporting requirements of subsection 233.4(4) of the Act in respect of their foreign affiliate, it should still file the T1134 form on time indicating clearly, in the Disclosure section of the form, that some information is missing. In that scenario, the availability of the due diligence exception under section 233.5 of the Act or the reasonable effort exception contained in paragraph 162(5)(a) of the Act would be dependent upon the facts and the transactions that give rise to the requirement to file or that affect the information to be reported in the return under subsection 233.4(4) of the Act. The CRA would expect that the determination of the distributions made by the foreign affiliate be based on all the information that can reasonably be obtained in a given situation.
Question 4: Canada-Barbados Income Tax Convention – “Special Tax Benefit”
Paragraph 3 of Article XXX (Miscellaneous Rules) of the Canada-Barbados Income Tax Convention (“the Treaty”) provides:
3. The provisions of Articles VI to XXIV of this Agreement shall not apply to any person or other entity entitled to any special tax benefit:
(a) in Barbados, under the International Business Companies Act, the Exempt Insurance Act, the Insurance Act, the International Financial Services Act, the Society With Restricted Liability Act, or the International Trusts Act, or any substantially similar law subsequently enacted; or
(b) in either Contracting State, under a law of that State which has been identified in an Exchange of Notes between the Contracting States.
Barbados has abolished its Exempt Insurance Company and Qualifying Insurance Company regimes.
The general corporate income tax rates in Barbados are currently based on taxable income as follows: 5.5% on the first BBD 1 million, 3% on BBD 1,000,001 to BBD 20 million, 2.5% on BBD 20,000,001 to BBD 30 million, and 1% on amounts in excess of BBD 30 million.
Currently, under the Insurance Act, Cap. 310 (Barbados), a Class 2 licence entitles the company to insure third-party risks wherever situated. The corporate tax rate on all insurance companies with a Class 2 licence is 2%.
Does Article XXX(3) of the Treaty exclude such an insurance company from the listed benefits of the Treaty? In other words, does the 2% rate constitute a "special tax benefit" within the meaning of Article XXX(3) of the Treaty?
We understand that as part of recent tax reform in Barbados, amendments have been made to the Barbados Income Tax Act (“BITA”) to include the general corporate income tax rates as noted above, and to also specify the corporate income tax rates applicable to a Class 1, 2 or 3 licensee under the Insurance Act, Cap. 310 as follows:
(a) a Class 1 licensee under the Insurance Act, Cap. 310 shall be 0 per cent;
(b) a Class 2 licensee under the Insurance Act, Cap. 310 shall be 2 per cent;
(c) a Class 3 licensee under the Insurance Act, Cap. 310 shall be 2 per cent.
We understand that in conjunction with the tax reform corresponding amendments have been made to the Insurance Act, Cap. 310., the Act which governs insurance companies in Barbados, to define the different classes of licensees as follows:
Classes of licensee
3A (1) There shall be three classes of licensee under this Act as follows:
(a) Class 1 licensee which shall be an insurance company which underwrites related party business;
(b) Class 2 licensee which shall include an insurance company which underwrites risks of third parties;
(c) Class 3 licensee which shall include an insurance intermediary, an insurance management company and an insurance holding company
The preamble to Article XXX(3) of the Treaty is broadly worded and makes reference to “any special tax benefit” received by any person or entity under the Insurance Act or any substantially similar law. Given that there is a tax regime in Barbados that is specific to Insurance companies, a Class 2 licensee is considered to receive a “special tax benefit” for the purposes of Article XXX(3) of the Treaty. Accordingly, such companies are not entitled to the benefits provided under Articles VI to XXIV of the Treaty.
Question 5: Canadian tax issues for U.S. resident employers of Canadian resident employees under remote work arrangements
Traditional work arrangements between office-based employees and employers involved employers making offices available for the employee to work out of, and an expectation that employees would physically work from those offices on a full-time basis. However, well before the COVID-19 pandemic hit, employees and employers were exploring more flexible remote work arrangements (“RWA”) that would enable employees to work remotely and not have to work from the employer’s offices. COVID-19 accelerated the pace of change in this regard and RWAs became more common.
Given Canada’s proximity to the U.S., many Canadian resident individuals are employed by U.S. resident employers. Foreign companies are looking beyond their borders to find skilled labour.
Assume you are dealing with a U.S. resident corporate employer (“USco”) with Canadian resident individual employees. USco was formed under the laws of the U.S. as a C-corporation that is taxed in the U.S. as a separate taxpayer on a worldwide basis. USco is a resident of the U.S. for purposes of the Canada-U.S. Income Tax Convention (the “Treaty”) and is entitled to benefits under the Treaty (i.e., USco is a “qualifying person” for purposes of Article XXIX-A of the Treaty). We would like to hear the CRA’s thoughts around whether USco may be considered to be (i) carrying on business in Canada for purposes of the Act, and, if so (ii) earning income through a permanent establishment (as defined for purposes of the Treaty) in Canada if, for example, 50 of the 1,000 USco employees are Canadian residents. Assume that the employees are allowed, but not required, to work from home for two or three days a week.
There has been no change in CRA’s position regarding cross-border RWAs. Although the volume of remote work may have increased, neither the relevant legislation nor the Treaty has been altered. Whether USco is carrying on business in Canada will depend upon what the employees are actually doing whilst working from home in Canada. Prior CRA positions stated that while the determination of the place where a particular business (or a part of the business) is carried on necessarily depends upon all the relevant facts, such place is generally the place where the profit-producing contracts are concluded, or profit generating operations take place (as opposed to where the profits are realized).
The CRA provides guidance regarding factors to consider when determining the location of the source of business income in Income Tax Folio S5-F2-C1. This publication also highlights factors that should be given consideration for particular types of businesses.
The location where employees perform their duties is relevant to the extent it impacts some general factors that may be relevant in determining whether USco is carrying on a business in a particular place for the purposes of the Act, such as:
- the location where decisions to purchase and sell are made;
- the place where the goods are produced or the services performed;
- whether activities in the jurisdiction are merely ancillary to the main business; and
- the place where a reasonable person would consider the business to be carried on.
The following additional factors could also be viewed as relevant;
- the degree of supervisory or other activity in Canada;
- the presence of a representative or resident expert in Canada.
The determination would depend on the type of activity performed in Canada.
Some activities performed by employees routinely working from home in Canada and providing internal support will not generally cause USco to be carrying on business in Canada. An accountant or a human resource professional providing services only to USco could be an example of this. However, if USco provides consulting services to its clients and the Canadian resident employee working from home is a part of the service team, the physical location of the individual performing the services might inform the determination of the place where the services are performed. If the clients of USco are also resident in Canada, that might be an additional factor in determining whether USco is carrying on business in Canada. Similarly, should the Canadian resident employees of USco act in a product development role, their activities may bring USco within the extended meaning of carrying on business in Canada under the Act. For example, paragraph 253(a) may be applicable if the product development role amounts to “creating or improving, in whole or in part, anything in Canada”. Paragraph 253(b) of the Act may be engaged if the employee “solicits orders or offers anything for sale in Canada”, which generally includes actively seeking and attempting to obtain customers in Canada, beyond “a mere invitation to treat” or advertisement.
Even if USco carries on business in Canada and is required to file a Canadian income tax return, it will be exempt from Canadian income tax unless its activities in Canada meet the threshold of carrying on business through a “permanent establishment” under the Treaty. Consistent with the Commentary on the OECD Model Income Tax Convention, a home office of an employee, in and of itself, does not create a permanent establishment for USco. In most situations, the home office of the employee will not constitute a fixed place of business through which the business of USco is partly or wholly carried on. That might be the case if USco has ready access to the employee’s premises, pays rent for the use of those premises or if there is evidence of an intention to establish the workspace in Canada as an office of USCo that is at USco’s disposal.
Whether or not USco may be viewed as having an “agency” permanent establishment, as provided for in Article V(5) of the Treaty, or a “services” permanent establishment, as provided for in Article V(9) of the Treaty, will again depend on the type of employment duties performed by the employees in Canada. Remotely working employees may create an “agency” permanent establishment in Canada if they routinely enter into contracts in Canada on behalf of USco. In that respect, the extent of the contracting authority granted to Canadian resident employees may be relevant. For example, if a contract entered into by a Canadian employee requires approval by the U.S. office to be binding, such contract would not necessarily be viewed as entered into in Canada, provided the approval by the U.S. office is not merely a formality.
USco may be deemed under Article V(9) of the Treaty to be providing services in Canada through a permanent establishment if Canadian resident employees working from their home in Canada are providing those services for an aggregate of at least 183 days in any 12 months period in respect of a single project, or connected group of projects for Canadian customers (this could include a non-resident that maintains a PE in Canada where the services are provided in respect of that permanent establishment).
On the other hand, Article V(6) of the Treaty reinforces the view that activities of a preparatory or auxiliary nature carried out by employees while working under an RWA will not normally create a permanent establishment for USco.
There are other Canadian income tax considerations which should be addressed by USco. Canadian resident employees create Canadian income tax withholding obligations for USco, regardless of where the services are rendered, but the amount of Canadian tax to be withheld may depend upon how much working time is spent in Canada versus outside of Canada. In the example provided, if the U.S. also taxes the Canadian resident employees on the employment income paid by USco, the employees would be entitled to a foreign tax credit in computing their Canadian taxes payable. The employees may be able to obtain a “letter of authority” from the CRA to authorize USco to reduce the Canadian deductions at source to take into account the foreign tax credit.
Question 6: Application of the Canada-U.S. Income Tax Convention to Structures with Multiple Tiers of Fiscally Transparent Entities
A U.S. resident corporation that has elected to be classified as a “real estate investment trust” (“REIT”) under the applicable provisions of the U.S. Internal Revenue Code (the “Code”) is a regarded entity for U.S. income tax purposes. REIT owns US LLC 1, a disregarded entity for U.S. income tax purposes. US LLC 1 owns US LLC 2, also a disregarded entity for U.S. income tax purposes and a section 216 taxpayer for Canadian income tax purposes. Neither US LLC 1 nor US LLC 2 is a resident of Canada for the purposes of the Canada-U.S. Income Tax Convention (“the Treaty”).
US LLC 1 makes an interest bearing loan to US LLC 2. The loan is incurred in connection with US LLC 2’s real estate operations in Canada, which constitutes its permanent establishment in Canada, and the interest on the loan is borne by the permanent establishment. A pictorial illustration is provided in figure 1.
Assume that the interest income is subject to Canadian Part XIII withholding tax (either as a result of the application of paragraph 212(13)(f) or proposed paragraph 212(13.2)(b) of the Act).
In technical interpretation 2012-0434311E5, in the context of a disregarded Canadian unlimited liability company making payments to a disregarded U.S. limited liability company (“LLC”), the CRA had stated that Article IV(6) of the Treaty would not apply to treat a particular amount of Canadian-source income, profit or gain as being derived by the U.S. member(s) of a fiscally transparent entity where that amount is “disregarded” under the taxation laws of the U.S. The same conclusion applies in respect of the basic structure described herein.
Will the Treaty apply to exempt the interest from the Canadian withholding tax if the basic structure is modified as described in the scenarios below?
The basic structure is modified to create a regarded interest recipient for U.S. income tax purposes (“first modified structure”) (see figure 2):
- REIT incorporates a new corporation (“US TRS”) with a nominal share capital. REIT and US TRS jointly elect to treat US TRS as a taxable REIT subsidiary under the Code. US TRS is a taxable corporation (and is regarded) for U.S. income tax purposes.
- Both REIT and US TRS are U.S. residents for the purposes of the Treaty and “qualifying persons” within the meaning of Article XXIX-A of the Treaty.
- Neither REIT nor US TRS carries on or has carried on business in Canada through a permanent establishment.
- US LLC 1 and US TRS form US LP, a limited partnership formed under the laws of the U.S. US TRS holds 0.1% general partner interest in US LP, while US LLC 1 holds 99.9% limited partner interest.
- US LP is considered a flow-through entity for U.S. income tax purposes, but is not disregarded.
- US LP, rather than US LLC 1, makes an interest bearing loan to US LLC 2.
- For U.S. income tax purposes, interest paid by US LLC 2 to US LP is viewed as interest paid by REIT to US LP and it is not disregarded.
- On an annual basis REIT and US TRS are allocated interest income received by US LP in proportion to their partnership interests and include it in computing their taxable income for U.S. income tax purposes as interest income.
Alternatively, the basic structure is instead modified to make the payor of the interest regarded for the U.S. income tax purposes (“second modified structure”) (see figure 3):
- US LLC 1 incorporates a new corporation (“US TRS”) with a nominal share capital. US LLC 1 and US TRS jointly elect to treat US TRS as a taxable REIT subsidiary under the Code. US TRS is a taxable corporation (and is regarded) for U.S. income tax purposes.
- Both REIT and US TRS are U.S. residents for the purposes of the Treaty and “qualifying persons” within the meaning of Article XXIX-A of the Treaty.
- Neither REIT nor US TRS carries on or has carried on business in Canada through a permanent establishment.
- US TRS subscribes for 0.1% membership interest in US LLC 2, while US LLC 1 holds 99.99% of the membership interest.
- US LLC 2 is treated as a partnership for U.S. income tax purposes, which is a flowthrough entity, but is not disregarded for U.S. income tax purposes.
- US LLC 1 makes an interest bearing loan to US LLC 2.
- For U.S. income tax purposes, interest paid by US LLC 2 to US LLC 1 is viewed as interest paid by US LLC 2 to REIT and it is not disregarded.
- REIT includes the amount of interest received as interest income from US LLC 2 through US LLC 1 in computing its taxable income for U.S. income tax purposes.
Pursuant to Article XI(1) of the Treaty, interest arising in Canada and beneficially owned by a resident of the U.S. may be taxed only in the U.S. In each of the three scenarios above, interest paid by US LLC 2 shall be deemed to arise in Canada pursuant to Article XI(4) of the Treaty on the basis that US LLC 2 has a permanent establishment in Canada in connection with which the indebtedness was incurred, and such interest is borne by such permanent establishment. Thus, the only question under consideration is whether the interest is beneficially owned by a resident of the U.S.
Pursuant to Article IV(6), an amount of income, profit or gain shall be considered to be derived by a person resident in the U.S. if, under U.S. income tax laws, the person is considered to derive the amount through a fiscally transparent entity that is not a resident of Canada, and by reason of the entity being fiscally transparent under U.S. laws, the U.S. income tax treatment of the amount is the same as the U.S. income tax treatment would be had the person derived the amount directly (the “same tax treatment” condition). In performing a comparative analysis to determine if an item of income receives the same tax treatment as if it had been derived directly by the person resident in the U.S., the timing of income recognition as well as the character and quantum of the income amount for tax purposes would be relevant factors.
CRA's longstanding position for an LLC that is fiscally disregarded in the U.S., is that, without the application of Article IV(6) of the Treaty, the benefits provided under Article XI of the Treaty are not available in respect of the interest paid to the LLC. That conclusion is based on the fact that from a Canadian perspective, the U.S. LLC is not considered to be a resident of the U.S. for purposes of the Treaty.
As pointed out in the question, the CRA had concluded in technical interpretation 2012-0434311E5 that Article IV(6) of the Treaty would not apply to treat a particular amount of Canadian-source income, profit or gain that is “disregarded” under the taxation laws of the U.S. as being derived by the U.S. member(s) of a fiscally transparent entity and the CRA’s conclusion would be the same in respect of the base structure depicted in Figure 1 above.
First Modified Structure
In applying the Treaty to amounts paid to or derived by a partnership, it is CRA’s long standing practice to look through the partnership such that the partners are viewed as the taxpayers who may invoke the benefits of the Treaty, subject, among other things, to the rules provided under Article XXIX-A of the Treaty. Accordingly, where a member of a partnership is a U.S. resident, the CRA considers the member's share of the income of the partnership to be derived by that member for purposes of applying the Treaty.
For purposes of applying Article XI of the Treaty, interest payments made by US LLC 2 to US LP will be considered to be derived by the members of US LP in proportion to their share of the income of US LP. Based on the facts, US TRS would be entitled to the benefits under the Treaty and would be exempt pursuant to Article XI(1) of the Treaty from withholding tax under Part XIII of the Act on the interest income derived by US TRS.
As for the remaining amount of the interest income of US LP that is allocated to US LLC 1, the latter will only be exempt pursuant to Article XI(1) of the Treaty from the Canadian withholding tax if the amount is considered to be derived by REIT pursuant to Article IV(6) of the Treaty. According to the question, for U.S. income tax purposes, US LLC 1 is fiscally transparent and the amount of the interest income of US LP that is allocated to US LLC 1 is considered to be derived by REIT and that interest income is included in computing REIT’s income for the taxation year of REIT in which the payment of interest is received by US LP. Thus, the U.S. income tax treatment of the interest received by US LP and indirectly allocated to REIT is the same as the U.S. income tax treatment would be had REIT derived the amount directly from US LP. Therefore, the same tax treatment condition would be met in this case and Article IV(6) would apply to grant the benefits under the Treaty to REIT in respect of its proportionate share of the interest income, which would also be exempt from withholding tax under Part XIII of the Act pursuant to Article XI(1) of the Treaty.
Second Modified Structure
Based on the assumptions provided, the interest income on the loan owing by US LLC 2 to US LLC 1 would meet the same tax treatment condition for the purposes of applying Article IV(6) of the Treaty since the U.S. income tax treatment of interest income to REIT is the same as the U.S. income tax treatment would be had REIT received the interest income directly from US LLC 2. Therefore, the conditions of application of Article IV(6) of the Treaty would be met to grant the benefits under the Treaty to REIT in respect of the interest income that is derived by REIT for U.S. income tax purposes and for the purposes of the Treaty. Accordingly, the interest income is exempt from withholding tax under Part XIII of the Act pursuant to Article XI(1) of the Treaty.
It should be noted that contemplated legislative proposals that would implement the recommendations in the Action 2 Report of the Organization for Economic Cooperation and Development/G20 Base Erosion and Profit Shifting project, on “Neutralizing the Effects of Hybrid Mismatch Arrangements” may have an impact on the structures described in this response.
Question 7: Hong Kong Canada Income Tax Agreement and Article 7(1) of the MLI
The Hong Kong-Canada Income Tax Agreement (Agreement) was signed on November 11, 2012 and is applicable in respect of withholding taxes from January 1, 2013.
Under Article 10 paragraph 2 (Article 10(2)) of the Agreement, where a dividend is paid by a Canadian resident company to a Hong Kong tax resident, the Canadian withholding tax will be reduced to either:
(a) 5% of the gross amount of the dividends if the beneficial owner is a company (other than a partnership) that controls directly or indirectly at least 10% of the voting power in the company paying the dividends (Article 10(2)(a)); and
(b) 15% of the gross amount of the dividends, in all other cases (Article 10(2)(b)).
Paragraph 7 of Article 10 (Article 10(7)) of the Agreement contains a main purpose test which states as follows:
“A resident of a Party shall not be entitled to any benefits provided under this Article in respect of a dividend if one of the main purposes of any person concerned with an assignment or transfer of the dividend, or with the creation, assignment, acquisition or transfer of the shares or other rights in respect of which the dividend is paid, or with the establishment acquisition or maintenance of the person that is the beneficial owner of the dividend, is for that resident to obtain the benefits of this Article.” (Emphasis Added).
Consider the following example:
Mr. A and his spouse (Taxpayers) have been residents of Hong Kong since prior to 2013 and have been resident there since. The Taxpayers are equal shareholders of a Canadian resident corporation (Canco). The Taxpayers plan to incorporate a new Hong Kong company (HKCo) and will each transfer their shares of Canco to HKCo. HKCo will own 100% of Canco after the transfer.
(1) Will dividends paid by Canco to HKCo be eligible for the 5% reduced treaty rate in Article 10(2)(a)?
(2) Will the anti-avoidance rule under Article 10(7) of the Agreement apply to deny the benefit of Article 10(2)?
(3) If yes, will the withholding tax rate be 15% as available prior to the transactions or 25% as provided without the benefit of a tax treaty?
(4) Will the Multilateral Instrument (MLI) have any implications to the withholding tax rate applicable under the Agreement?
For dividends paid after January 1, 2024, Article 7(1) of the MLI identifies the circumstances in which a benefit under Article 10 of the Agreement may be denied.
“Article 7 MLI—Prevention of Treaty Abuse
1. Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.” (Emphasis Added)
Generally, Article 10 of the Agreement provides, among other things, for a reduced rate of withholding tax in respect of dividends paid from a corporation resident in one of the agreeing jurisdictions to a resident of the other. Article 10(2) provides two different rates of withholding, the lower of which is available only to Hong Kong resident corporations which hold at least 10% of the voting power of the Canadian resident corporation paying a dividend (as defined at paragraph 3 of Article 10).
In the situation described in the question, dividends paid by Canco to HKCo would be subject to a 5% withholding rate according to Article 10(2)(a) of the Agreement. Article 7(1) of the MLI will generally not apply to deny the benefits of Article 10(2)(a) of the Agreement on such dividends paid on or after January 1, 2024.
Based on the MLI notifications of the parties to the Agreement, Article 10(7) of the Agreement is applicable only to dividends paid before January 1, 2024. Although not specifically mentioned in the question, it is assumed that the main purposes of any person concerned with the acquisition or transfer of the shares of Canco by the Taxpayers did not include obtaining the benefits of Article 10 of the Agreement and that HKCo had the same purposes when acquiring the Canco shares. In the situation described in the question and in the absence of a main purpose by HKCo to gain access to Article 10 of the Treaty, Article 10(7) will generally not apply to deny the benefits of Article 10(2)(a) of the Agreement on such dividends paid by Canco to HKCo before January 1, 2024. If Article 10(7) of the Agreement had applied, the applicable withholding tax rate would have been 25%. The answer could be different depending on the facts and circumstances of a particular situation. The existence of a main purpose to obtain the benefits of Article 10 of the Treaty can only be answered in consideration of the specific situation.
Question 8: Tax-free Surplus Balance Calculation and Paragraph 88(1)(d) “Bump”
At the 2011 IFA Conference CRA Roundtable (CRA document 2011-0404521C6), the CRA indicated that it would not challenge a paragraph 88(1)(d) bump in respect of the shares of a foreign affiliate (FA) by raising an issue with an FA’s tax-free surplus balance (TFSB) calculation or lack thereof in circumstances where, absent clause 88(1)(d)(ii)(C), the shares of FA could be bumped to fair market value such that there would be no gain on a subsequent distribution of the FA shares to a foreign parent, provided that no dividends were paid or were deemed to be paid on the FA shares following the acquisition of control and the FA shares were distributed to the foreign parent within a reasonable amount of time. Given the CRA’s more recent statements on the necessity of computing surplus to support deductions under section 113, can the CRA confirm its prior position regarding tax-free surplus balance and the bump?
The CRA response to the question posed at the 2011 IFA Conference CRA Roundtable (CRA document 2011-0404521C6) was in connection with the specific situation in which a foreign corporation (Forco) incorporated a Canadian corporation (Holdco) to acquire the shares of a Canadian corporation (Canco) which owned all the shares of an FA, and shortly thereafter Canco wound up into Holdco with Holdco then disposing of the FA shares to Forco. Following the disposition of FA to Forco, the surplus of FA would no longer be relevant in determining the Canadian tax implications to a taxpayer.
In this situation, the CRA indicated that it would not challenge the designation made under paragraph 88(1)(d) (the “ACB bump”) in respect of the FA shares by raising an issue with FA’s TFSB calculation or lack thereof, provided that the FA shares were transferred to Forco by Holdco within a reasonable period of time after the takeover of Canco and provided that neither Canco nor Holdco received, or was deemed to receive, any dividends from FA after the takeover of Canco (the “2011 administrative position”). Any other circumstance in which relevant surplus balances are used in the year to reduce Canadian income tax will also be disqualifying. The 2011 administrative position eliminates the need for TFSB calculations by a taxpayer in the scenario described in the question posed at the 2011 IFA Conference.
The 2011 administrative position is conditional on the sale of FA by Holdco to Forco occurring within a reasonable period of time following the acquisition of Canco. What will be considered to be a “reasonable” period of time is a question of fact and will depend upon the particular circumstances.
The CRA has over the past several years emphasized that taxpayers are required to compute and maintain foreign affiliate surplus calculations to support deductions under subsection 113(1) and in numerous other situations where an FA’s surplus balances are relevant in determining tax payable under the Act (2019 and 2022 IFA Conferences, CRA documents 2019-0798761C6 and 2022-0928101C6 respectively). This requirement is legislative and not administrative, being based on subsection 230(1) of the Act which specifically requires taxpayers to maintain records and books of account in such form and containing such information that will enable determination of taxes payable under the Act.
To be applicable, the 2011 administrative position requires that neither Canco nor Holdco received a dividend from FA subsequent to the takeover of Canco (nor otherwise were required to use available surplus balances). It is also premised on the transfer of the FA shares to Forco within a reasonable period of time after the takeover of Canco, making its surplus balances irrelevant for Canadian tax purposes upon that transfer. Consequently, the 2011 administrative position is not inconsistent with our understanding of the policy partially underlying subsection 230(1) requiring that surplus balances of a foreign affiliate be computed and provided to support deductions under subsection 113(1) and in numerous other situations where a foreign affiliate’s surplus balances are relevant in determining tax payable under the Act.
Accordingly while, as with any other administrative policy, circumstances in the future may dictate that revisions are necessary, the CRA continues to apply the 2011 administrative position provided the conditions are met.
1 I gratefully acknowledge the following CRA personnel, who were instrumental in helping prepare the Round Table: Angelina Argento, Yara Barrak, Petra Bolduc, Frederic Bourgeois, Michael Chan, Ina Eroff, Yves Grondin, Michael Jennings, Jess Johns, Ann Kippen, Sophie Larochelle, Patrick Massicotte, John Meek, Eli Moore, Komal Patel, Tara Rathbone, Charles Taylor, Henrietta Veerman, and Catherine Zhang. Special thanks go to Gina Yew for her unvaluable assistance in coordinating this exercise.
2 Technical interpretation 2009-0318491I7