13 November 2009 Internal T.I. 2009-0318491I7 - Article IV(6)/IV(7) 'Same Treatment'

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

Principal Issues: Determination of whether the United States tax treatment of Canadian-source income, profits or gains will be considered the same for the purposes of applying Article IV(6) and Article IV(7) of the Canada-United States Income Tax Convention (1980).

Position: Guidelines provided

							November 13, 2009

Legislative Policy Directorate		Headquarters
International, Provincial and 		International and Trusts Division
Strategic Policy Division 			J. MacGillivray
320 Queen Street, 20th Floor			(613) 957-2103
Place de Ville, Tower "A"
Ottawa ON  K1A 0L5
							2009-031849
	Attention: Blair Hammond 

Meaning of "Same Treatment" in Article IV(6) and Article IV(7) of the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital signed on September 26, 1980, as amended by the Protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997 and September 21, 2007 (the "Convention")

We are writing in response to your request for our views on whether an item of income, profit or gain will be considered to be subject to the same treatment for the purposes of applying Articles IV(6) and (7) of the Convention.

A. Background

The Protocol Amending the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital Done at Washington on 26 September 1980, as amended by the Protocols Done on 14 June 1983, 28 March 1984, 17 March 1995 and 29 July 1997 (the "Fifth Protocol"), entered into force on December 15, 2008. The Fifth Protocol added Articles IV(6) and IV(7) to the Convention, which state the following:

6. An amount of income, profit or gain shall be considered to be derived by a person who is a resident of a Contracting State where:

(a) The person is considered under the taxation law of that State to have derived the amount through an entity (other than an entity that is a resident of the other Contracting State); and

(b) By reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is the same as its treatment would be if that amount had been derived directly by that person.

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.

Article IV(6) provides that a resident of the United States is considered to derive Canadian-source income, profits or gains for the purposes of the Convention in circumstances where, prior to the enactment of the Fifth Protocol, an entity that was not a resident of the United States was considered to derive the income, profit or gains, even though the resident, being a member or other holder of an interest in the entity (an "interest holder"), was required to include the income, profit or gains in computing the resident's United States tax liability. The entities considered to derive the Canadian-source income were not residents of the United States under the Convention due to their fiscal transparency under the Internal Revenue Code. 1 As fiscally transparent entities, the interest holders in the entities, not the entities themselves, were subject to income tax liability under the Code on income amounts earned or recognized at the entity level. Consequently, the entities could not satisfy the requirement that they be "liable to tax" under United States taxation laws in order to be treated as a resident of the United States for the purposes of the Convention, with the result that the Convention could not apply to the Canadian-source income, profit or gains derived by the entities.

For example, where a resident of the United States was a member of a limited liability corporation formed under United States laws (an "LLC") and the LLC held shares of a Canadian-resident corporation, Article X of the Convention did not apply to dividend income paid by the Canadian-resident corporation on the shares held by the LLC even though the United States-resident member of the LLC was taxable under the Code on the dividend income received by the LLC, by virtue of the LLC's status as a fiscally transparent entity. In such cases, the LLC is not considered to be a resident of the United States for the purposes of the Convention because the members of the LLC, not the LLC, are liable to United States tax on income, profits or gains derived by the LLC. Consequently, the taxes imposed on the LLC under Part XIII of the Income Tax Act (Canada) 2 in respect of the dividend, were not reduced under Article X of the Convention prior to the enactment of the Fifth Protocol.

Income, profits or gains derived in such circumstances will now be considered to be derived by residents of the United States pursuant to Article IV(6), provided the residents are considered to derive the income through the fiscally transparent entity for United States tax purposes, the entity is not considered a resident of the Canada and the United States tax treatment of the income derived through the entity is the same as it would be had the resident derived the income directly. Pursuant to Article 27(2) of the Fifth Protocol, Article IV(6) applies in respect of taxes to be withheld at source from amounts paid or credited on or after February 1, 2009, and, in respect of other taxes, for taxable years beginning after 2008.

Conversely, a United States resident who would, prior to the Fifth Protocol, be considered to have received or derived Canadian-source income, profit and gains may no longer be considered to have received or derived such amounts for the purposes of the Convention where Article IV(7) applies. Under Article IV(7)(a), a United States resident will not be considered to derive an amount of Canadian-source income, profit or gains if the resident is considered to have derived the amount through an entity that is not, under the Convention, a resident of the United States, but by reason of the entity not being fiscally transparent under United States tax laws, the treatment of the amount is not the same as it would be if the resident derived the amount directly. Under Article IV(7)(b), a United States resident will not be considered to have received an amount of income, profit or gains if the resident is considered under the Act to have received the amount from a Canadian-resident entity that is fiscally transparent for United States tax purposes if the treatment of that amount for United States tax purposes is not the same as it would be if the Canadian-resident entity was not fiscally transparent. Pursuant to Article 27(3) of the Fifth Protocol, Article IV(7) is effective as of January 1, 2010.

B. Same Treatment

To conclude that Article IV(6) or Article IV(7) applies to an amount of Canadian-source income, the following comparisons of the United States tax treatment of the amount must be made:

1. Under Article IV(6), it is necessary to compare the United States tax treatment of the amount derived by a United States resident through a fiscally transparent entity to the treatment that would result if the United States resident derived the amount directly.

2. Under Article IV(7)(a), it is necessary to compare the United States tax treatment of the amount derived by a United States resident through an entity that is fiscally transparent for Canadian tax purposes, but not for United States tax purposes, to the treatment that would result if the amount had been derived directly by the United States resident.

3. Under Article IV(7)(b), it is necessary to compare the United States tax treatment of the amount received by a United States resident from an Canadian-resident entity that is fiscally transparent for United States tax purposes to the treatment that would result if the Canadian-resident entity were not fiscally transparent for United States tax purposes.

The United States Department of Treasury's Technical Explanation to the Fifth Protocol (the "Technical Explanation") states the following with respect to determining whether the tax treatment of an amount is "the same" for the purposes of applying Article IV(6) and Article IV(7):

Under both paragraph 6 and paragraph 7, it is relevant whether the treatment of an amount of income, profit or gain derived by a person through an entity under the tax law of the residence State is "the same as its treatment would be if that amount had been derived directly." For purposes of paragraphs 6 and 7, whether the treatment of an amount derived by a person through an entity under the tax law of the residence State is the same as its treatment would be if that amount had been derived directly by that person shall be determined in accordance with the principles set forth in Code section 894 and the regulations under that section concerning whether an entity will be treated as fiscally transparent with respect to an item of income received by the entity. Treas. Reg. section 1.894-1(d)(3)(iii) provides that an entity will be fiscally transparent under the laws of an interest holder's jurisdiction with respect to an item of income to the extent that the laws of that jurisdiction require the interest holder resident in that jurisdiction to separately take into account on a current basis the interest holder's respective share of the item of income paid to the entity, whether or not distributed to the interest holder, and the character and source of the item in the hands of the interest holder are determined as if such item were realized directly from the source from which realized by the entity. Although Canada does not have analogous provisions in its domestic law, it is anticipated that principles comparable to those described above will apply.

On July 10, 2008, the Minister of Finance indicated Canadian agreement with the Technical Explanation, including the above excerpt.

In keeping with the principles expressed in the Technical Explanation, we will consider, for the purpose of comparing tax treatments under Article IV(6) or Article IV(7), that an amount of Canadian-source income, profits or gains receives the same United States tax treatment if (i) the timing of the recognition/inclusion of the amount, (ii) the character of the amount, and (iii) the quantum of the amount are the same under the scenarios required to be compared with each other. More particularly, an amount of income, profits or gains derived by a United States-resident interest holder of an entity described in Article IV(6) will be subject to the same United States tax treatment to the interest holder had the amount been derived directly, if, under the Code:

(i) the interest holder is required to take into account, on a current basis, the interest holder's respective share of the item of income whether or not the amount is distributed to the interest holder; and

(ii) the quantum and character of the item is the same as if the item of income were derived directly by the interest holder.

Similarly, where a resident of the United States is considered, under the Act, to have derived an amount of income, profit or gain through an entity that is fiscally transparent for Canadian tax purposes (i.e., a partnership), the resident will be considered, pursuant to Article IV(7)(a), not to have derived the amount for the purposes of the Convention if, by reason of the entity not being fiscally transparent under the provisions of the Code, the timing of the recognition of the amount, or its quantum or character to the United States resident differs from the timing, quantum or character of the amount if the entity were not fiscally transparent for United States tax purposes. By virtue of the entity's lack of fiscal transparency for United States tax purposes in such circumstances, it would be expected that the treatment of the amount to the United States resident would vary with respect to all of these factors. With respect to an item of income received from a Canadian-resident entity that is fiscally transparent for United States tax purposes, we would consider that income item to be subject to the same treatment in the hands of the recipient for the purposes of Article IV(7)(b) if the quantum and character of the item of income and the timing of its inclusion in the income of the recipient is the same as it would be if the entity were not fiscally transparent.

With respect to the geographic source of an amount, it is our view that it is relevant only if it affects the treatment of the amount, as an item of income, under the taxation laws of the United States. By itself, geographic source is simply an attribute of an item of income which may or may not be relevant to the tax treatment of that item. For example, if a Canadian taxpayer is required to include in income and pay income tax on all the interest the taxpayer receives during a taxation year and the taxpayer received interest from sources inside and outside Canada, we would not consider the interest received from outside Canada to be subject to different tax treatment than domestic-source interest solely because it has a different geographic source. Similarly, if the geographic source of an amount received by a United States-resident corporation ("USCo") from a Canadian unlimited liability company ("ULC") that is fiscally transparent for United States tax purposes would be considered to be different if the ULC were not fiscally transparent and the difference was only relevant to the computation of USCo's foreign tax credits, we would not consider the difference, in itself, to be sufficient to engage Article IV(7)(b). In our view, the availability of foreign tax credits is not relevant in determining how the amount, as an item of income, is treated.

Character

Generally, the character of an amount of income, profit or gains will be the same for United States tax purposes under Article IV(6) or Article IV(7) if the actual income item of the United States resident is treated as interest, a distribution subject to dividend taxation, royalties, gains, or business income and that characterization is preserved in the treatment of the item in the hypothetical scenario to which a comparison must be made.

Where Article IV(7)(b) applies to an amount of income, profit or gain paid by a Canadian-resident entity that is fiscally transparent for United States tax purposes, it will generally be the case that a United States resident will be treated as having received a non-taxable branch or partnership distribution as opposed to the receipt of an income item for United States tax purposes.

The application of Article IV(7)(b) is predicated on an amount being considered, under the taxation laws of the "source" Contracting State, to have been received by a resident of the other Contracting State. In applying this provision to a payment of an amount described in Part XIII of the Act, it is recognized that the type of income amount (e.g. interest) may not be taxed to the United States resident on a receipt basis, but instead on an accrual or other non-receipt basis. The payment of the income amount may therefore, in and of itself, not result in the realization of income to the United States resident for United States tax purposes regardless of the fiscal transparency of the Canadian-resident payer. However, in applying Article IV(7)(b), it is our view that the amount paid could, if the Canadian-resident payer of the amount were not fiscally transparent for United States tax purposes, be viewed as having been previously recognized and included in income for United States tax purposes, whereas the amount paid could not be viewed as such if the Canadian-resident payer was fiscally transparent.

Timing

The timing of the recognition of an amount of Canadian-source income, profit or gain by a United States resident will be considered to be the same for the United States tax purposes under Article IV(6) or Article IV(7) if the income item to which the amount relates is included in income or is considered to be received by the United States resident in a particular taxable year and, under the hypothetical scenario to which a comparison must be made, the inclusion or receipt of that income item to the resident would occur in the same taxable year.

With respect to recognition of an item of income derived through an entity that is treated as a partnership for United States tax purposes, we would consider the amount to be taken into account on a current basis where, solely as a result of the interest holder and the partnership having different taxable years, the income is included in the interest holder's income in a taxable year that ends after the taxable year of the partnership. In circumstances where an interest holder does not separately account for each item of income, we would consider the item of income to be subject to the same treatment provided that the net income or loss allocated to the interest holder is the same as if the interest holder separately claimed each item.

Quantum

In determining whether the quantum of an amount of Canadian-source income, profit or gain is the same under a comparison of scenarios in Article IV(6) or Article IV(7), it is expected that the item involved would be reported in United States dollars for United States tax purposes, while the actual amount (i.e., the amount of a dividend paid, an amount of interest or royalties or sale proceeds) may be denominated in Canadian dollars. Where income is derived or received by a partnership or an entity treated as a partnership for United States tax purposes with a taxable year that varies from that of its partners, the quantum of an amount of income, profit or gain will not be viewed to be different solely because of a difference in the foreign exchange rate to be applied to convert the Canadian dollar amount into United States dollars.

In addition, the determination of whether the quantum of the amount is not the same under Article IV(7)(b) is made without reference to losses, deductions or credits available under the Code in computing the United States tax liability of the recipient of the amount, or in the computation of the consolidated taxable income of a group of corporations which includes the recipient. In other words, the determination of same treatment will be made by reference to the gross amount of the item of income.

C. Examples

The following examples are intended to illustrate the potential application of Articles IV(6), IV(7)(a) and IV(7)(b). Please note that our responses are limited to the technical application of these provisions. In the context of any particular fact situation, the availability of treaty benefits can only be determined after due consideration of the general anti-avoidance rule in section 245 of the Act.

Example 1 - Sole-member LLC

USCo is a resident of the United States and a "qualifying person" for the purposes of the Convention. USCo is the sole member of a limited liability company incorporated under United States laws ("USLLC"), which holds all of the shares of a Canadian-resident corporation ("Canco") and a patent relating to a manufacturing process. USLLC is disregarded as an entity separate from its owner under the Code (a "disregarded entity") and is therefore fiscally transparent for United States tax purposes; Canco is not fiscally transparent for United States tax purposes.

In addition to holding the shares of Canco, USLLC has loaned money to Canco on an interest-bearing basis and granted to Canco the right to use the patented manufacturing process in exchange for a license fee.

The payments by Canco to the USLLC of (i) dividends on the shares of Canco, (ii) interest on the loan by USLLC to Canco, and (iii) the license fee in respect of the patented manufacturing process will be subject to tax under Part XIII of the Act.

For United States tax purposes, the treatment of these amounts to USCo as items of income will be the same, in terms of quantum, character and timing, whether or not they are derived directly by USCo or indirectly through the USLLC. Accordingly, Article IV(6) will apply to the payments made by Canco to USLLC. In the result, USCo will be considered to derive the dividends, interest and license fees for the purposes of applying the various provisions of the Convention in determining the extent to which Canada may impose tax in respect of those amounts.

Example 2 - Multi-member LLC

Assume the facts in Example 1 except that USCo holds a 90% membership interest in USLLC. USCo's wholly-owned subsidiary, USSub, itself a resident of the United States and a qualifying person for the purposes of the Convention, holds the other 10% membership interest in USLLC.

As a consequence, USLLC is treated as a partnership for United States tax purposes, but remains fiscally transparent such that USCo and USSub are considered to derive their proportionate shares of any dividends, interest or license fees derived by USLLC. In this example, Article IV(6) will apply to the payments made by Canco to USLLC such that USCo and USSub will be considered to derive their proportionate shares of the dividends, interest and license fees for the purposes of applying the various provisions of the Convention in determining the extent to which Canada may impose tax in respect of those payments.

Example 3 - Disposition of Canco shares by LLC

Assume the facts in Example 1. USLLC then realizes a taxable capital gain from the disposition of the shares of Canco. The shares of Canco are taxable Canadian property to USLLC, but for the purposes of the Convention, the value of those shares at the time of the disposition is not derived principally from real property situated in Canada. For United States tax purposes, USCo will be considered to have disposed of the shares of Canco and will compute its income for United States tax purposes in the same manner as if it had held the shares of Canco directly for the taxation year of USco in which the disposition takes place.

In this example, Article IV(6) will apply such that USCo will be considered to have derived the gain from the disposition of the shares of Canco by USLLC for the purposes of applying Article XIII of the Convention in determining the extent to which, if any, Canada may impose tax in respect of those gains.

Example 4 - US-owned partnership receives payments from a Canadian corporation

USCo and USSub, the subsidiary of USCo, are both residents of the United States and qualifying persons for the purposes of the Convention. USCo and USSub are the partners of a partnership formed under the laws of a Canadian jurisdiction ("CanLP") and hold 90% and 10% partnership interests in CanLP, respectively. CanLP holds the shares of a corporation resident in Canada ("Canco") and a patent relating to a manufacturing process. CanLP has made an interest-bearing loan to Canco and granted Canco the right to use its patented manufacturing process in exchange for a licence fee. Canco is not fiscally transparent for United States tax purposes.

USCo and USSub have elected to treat CanLP as a corporation that is a foreign corporation (i.e., not considered to be a United States resident under the Code) for United States tax purposes with the result that CanLP will not be fiscally transparent for United States tax purposes, and will be required to include dividends, interest and license fees from Canco in the computation of its income under the Code. Amounts received by CanLP from Canco will not be considered to have been received by USCo or USSub under the Code. Subject to the application of United States anti-deferral rules, USCo and USSub will not include any amount in income in respect of CanLP's earnings until the time that CanLP makes a distribution to its partners, which will be subject to dividend taxation for United States tax purposes, regardless of the character of the underlying income to CanLP.

The payments by Canco to CanLP of (i) dividends on the shares of Canco, (ii) interest on the loan to Canco, and (iii) the license fee in respect of the patented manufacturing process will be subject to tax under Part XIII of the Act. For United States tax purposes, USCo and USSub will not be considered to have received these amounts. However, had USCo and USSub not made the election to treat CanLP as a foreign corporation for United States tax purposes, USCo and USSub would be required to include in income their respective shares of these amounts. As a result, the United States tax treatment to USCo and USSub of these amounts is not the same as it would be if USCo and USSub had derived these amounts directly. Article IV(7)(a) will therefore apply with the result that USCo and USSub will not be considered to have derived the dividends, interest and license fees for the purposes of applying the various provisions of the Convention in determining the extent to which Canada may impose tax in respect of those amounts.

This conclusion would not change even if USCo and USSub included an amount in respect of CanLP's earnings in computing their incomes for United States tax purposes by reason of the application of United States anti-deferral rules governing controlled foreign corporations or passive foreign investment corporations.

Example 5 - US-owned partnership disposes of taxable Canadian property

Assume the facts in Example 4. CanLP then disposes of the shares of Canco and a taxable capital gain is realized from the disposition. The shares of Canco are taxable Canadian property, but for the purposes of the Convention, the value of those shares at the time of the disposition is not derived principally from real property situated in Canada. For United States tax purposes, CanLP will be considered to have disposed of the shares of Canco. USCo and USSub will not be considered to have a disposition of the shares of Canco for United States tax purposes and will not include any amount of gains realized by CanLP from the disposition. Had an election not been made to treat CanLP as a corporation for United States tax purposes, USCo and USSub would be required to include their respective shares from any gain on the disposal of the Canco shares as if they directly realized the gain from the disposition of the shares of Canco.

In this case, the United States tax treatment to USCo and USSub of the gains realized on the disposition by CanLP of the shares of Canco will not be subject to the same treatment under the taxation laws of the United States as they would be if CanLP were fiscally transparent. Article IV(7)(a) will therefore apply to the capital gain realized on the disposition of the Canco shares by CanLP with the result that USCo and USSub will not be considered to derive the gain for the purposes of applying the various provisions of the Convention in determining the extent to which, if any, Canada may impose tax in respect of those payments.

This conclusion would not change even if USCo and USSub were required to include an amount in respect of CanLP's gain in computing their incomes for United States tax purposes by reason of the application of United States anti-deferral rules governing controlled foreign corporations or passive foreign investment corporations.

Example 6 - US-owned partnership carries on business in Canada

Instead of holding the shares of Canco, assume that CanLP carries on business in Canada within the meaning of the Act, but the business activity is not carried on through a permanent establishment for the purposes of the Convention. Under the Act, each partner of CanLP, USCo and USSub, is considered to have earned income through CanLP in proportion to its respective interest in the partnership, and, subject to the Convention, each partner's share of CanLP's income for a fiscal period of CanLP ending within a taxation year of the partner is included in the computing income of the partner.

For United States tax purposes, and subject to United States anti-deferral rules, the income generated from the Canadian business activity is not included in the income of the partners of CanLP when that income is earned. USCo and USSub will only be liable to tax in respect of the earnings from that business activity when distributed by CanLP, which distribution will be subject to dividend taxation under the Code. Had the partners of CanLP not elected to treat CanLP as a corporation for United States tax purposes, USCo and USSub would have included their respective shares of CanLP's income from the Canadian business activities for a taxable year of CanLP that ends in a taxable year of those corporations; that income would be treated as trade or business income for United States tax purposes. From the perspective of both USCo and USSub, the election to treat CanLP as an entity that is not fiscally transparent for United States tax purposes results in the treatment of the Canadian business income not being the same under the taxation laws of the United States than it would be had the election not been made. Article IV(7)(a) therefore applies with the result that the income from the Canadian business activity of CanLP will be considered not to be derived by USCo and USSub.

Example 7 - ULC with one shareholder

USCo is a resident of the United States and a qualifying person for the purposes of the Convention. USCo holds all of the shares of an unlimited liability company ("ULC"). ULC is resident of Canada under the Convention and carries on business in Canada. USCo has also made an interest-bearing loan to ULC. Under the taxation laws of the United States, ULC is a disregarded entity and thereby fiscally transparent.

USCo is considered, for United States tax purposes, to carry on ULC's business operations and, as a result, USCo includes the income from ULC's Canadian operations in its income. In addition, USCo's shareholdings in ULC and the interest-bearing loan are disregarded for United States tax purposes. If ULC was not a disregarded entity, USCo would recognize interest income from the loan on an accrual basis and would be subject to tax under the Code on dividends received from ULC.

Due to ULC's fiscal transparency under the Code, the loan interest is not recognized for United States tax purposes with the result that the interest income does not receive the same treatment (i.e., an inclusion of interest income on an accrual basis) that would be given to the interest if the ULC were not fiscally transparent. Therefore, Article IV(7)(b) will apply to the interest paid by ULC to USCo such that it will be considered not to be paid to or derived by USCo for the purposes of the Convention.

Example 8 - ULC with more than one shareholder

Assume the facts in Example 7 except that USCo holds 90% of the shares of ULC. The other shareholder of ULC is USCo's wholly-owned subsidiary USSub, which is also a resident of the United States and a qualifying person for the purposes of the Convention. For United States tax purposes, ULC is treated as a fiscally transparent partnership. USCo and USSub are each allocated items of income and expense from ULC on an annual basis in proportion to their shareholdings in ULC; the items of income and expense of ULC may be netted against each other before they are allocated to USCo and USSub. USCo is considered to earn interest from the loan and USCo and USSub are considered to have incurred a proportionate share of the interest expense payable by ULC on the loan from USCo. If ULC was not treated as a fiscally transparent partnership for United States tax purposes, USCo would still realize interest income from the loan to ULC, but USCo and USSub would not be considered to have incurred any portion of the interest expense on the loan.

In this scenario, USSub will be considered to earn interest income from the loan to ULC regardless of ULC's status as a fiscally transparent entity for United States tax purposes. In determining whether Article IV(7)(b) applies to the loan interest, the focus is on the tax treatment of the interest as an item of income without reference to the allocation of other income or expenses from the partnership (i.e., on the amount potentially subject to tax under Part XIII of the Act). As a result, Article IV(7)(b) will not apply to the payment of interest by ULC to USCo.

Example 9 - ULC payment to a person related to the ULC's sole shareholder - effect of consolidated group tax reporting

Assume that USCo has loaned money to ULC as in Example 8, but that USSub is the sole shareholder of ULC. ULC is a disregarded entity for United States tax purposes and its Canadian business operations is considered a Canadian branch of USSub. USCo is considered to have loaned the money to USSub and will include interest income from the loan on an accrual basis. Had ULC not been considered a disregarded entity, USCo would be considered to have made an interest-bearing loan to ULC.

USCo and USSub have elected to file a consolidated group tax return for United States tax purposes. As a consequence, USCo will include the interest income from the loan in the computation of its separate taxable income and USSub will deduct the interest expense on the loan in the computation of its separate taxable income. In computing the consolidated taxable income of USCo and USSub, the interest income inclusion and interest expense deduction will offset each other. Had ULC not been treated as a disregarded entity for United States tax purposes, USCo would include the interest income from the loan in computing its separate taxable income, but the interest expense would not offset that income because the interest expense would be considered to be incurred by ULC for United States tax purposes, which is not part of the group that files the United States consolidated tax return.

Although the interest expense on the loan would not be taken into account in computing the consolidated taxable income of USCo and USSub if the ULC was not fiscally transparent, only the United States tax treatment of the interest income to USCo as an item of income, not the corresponding expense item, is relevant for the purposes of the analysis in Article IV(7)(b). In both scenarios, USCo is required, for United States tax purposes, to include the same amount of interest income from the loan to ULC in computing its separate taxable income, and therefore the timing, character and quantum of the income are the same notwithstanding the ULC's fiscally transparency for United States tax purposes. Accordingly, Article IV(7)(b) will not apply to the payment of interest by ULC to USCo.

Example 10 - Disposition of the shares of a Canadian ULC

Assume the facts in Example 7 except that USCo disposes of the shares of ULC, which USCo holds as capital property for the purposes of the Act, to an arm's-length purchaser for cash. USCo realizes a taxable capital gain from the disposition of capital property for the purposes of the Act.

As ULC is a fiscally transparent entity for United States tax purposes, USCo will be considered to have sold the assets of ULC. USCo would be considered to have sold shares of ULC for United States tax purposes if ULC was not fiscally transparent. In this case, the character of the income that USCo derives from the disposition would not likely be the same for United States tax purposes; USCo would have income or gains from the sale of assets as opposed to income or gains from the sale of shares where ULC is not fiscally transparent. Moreover, the quantum of the income that USCo would derive under each scenario would likely vary due to differences in the United States tax basis of the shares of ULC as opposed to the tax basis of ULC's assets. However, Article IV(7)(b) would not apply to treat USCo as not having derived a capital gain from the disposition of the shares of ULC since the proceeds of disposition were received from the arm's-length purchaser and not from the fiscally transparent ULC.

Note: If ULC redeemed, cancelled, purchased or otherwise acquired its shares from USCo, Article IV(7)(b) could be applicable to both dividends or gains arising on the disposition of the shares since USCo would be considered to have received such dividends or sale proceeds from ULC. In addition, if USCo disposed of the shares of ULC to another ULC wholly-owned by USCo in circumstances to which section 212.1 applies, Article IV(7)(b) could apply to dividends arising on the disposition.

Example 11 - Back-to-back dividend

Assume the facts in Example 7, with the exception of the loan to ULC. Also assume that ULC holds shares of a Canadian-resident corporation ("Cansub") that is not an unlimited liability company and is therefore not fiscally transparent for United States income tax purposes. Cansub pays a dividend to ULC. On the same day, Canco declares and pays a dividend to USCo in an amount equal to the amount of the dividend it received from Cansub.

USCo is not considered to receive a dividend from ULC for United States tax purposes because ULC is a disregarded entity, but the dividend that was paid by Cansub to ULC is considered to be a distribution from Cansub to USCo subject to dividend taxation under the Code. If ULC was not a disregarded entity, the dividend it paid to USCo would be considered to be a distribution from ULC to USCo subject to dividend taxation under the Code.

For Canadian tax purposes, USCo is subject to tax on the dividend paid by ULC, which is the amount to which Article IV(7)(b) applies; the dividend paid by Cansub to ULC is a distinct amount to which USCo is not liable to tax under the Act and therefore the treatment of that particular amount is not relevant to the analysis under Article IV(7)(b). For United States tax purposes, the particular amount received by USCo from ULC is disregarded whereas the particular amount will not be disregarded if ULC was not fiscally transparent. Therefore, Article IV(7)(b) will apply such that USCo will not be considered to derive the dividend income paid to it by ULC.

Example 12 - Royalty paid to third party

Assume the facts in Example 7, except that a United States-resident corporation, IP Holder, a qualifying person under the Convention, has granted to ULC the right to use a patented manufacturing process in exchange for a license fee. The payment of the license fee by ULC to IP Holder will, subject to the application of Article XII of the Convention, be taxable under Part XIII of the Act. For United States tax purposes, ULC is a disregarded entity, with the result that IP Holder will be considered to have received the license fee from USCo. In this example, there would be no difference in the quantum, character, timing or geographic source of the royalties to IP Holder if ULC were not fiscally transparent for United States tax purposes - the only difference is that IP Holder would be considered to have received the license fee from ULC.

Under these circumstances, Article IV(7)(b) will not apply.

Should you have any questions with respect to the foregoing, please contact Daryl Boychuk at 613-948-5274 or Jackson MacGillivray at 613-957-2103.

for Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

1 26 U.S.C. (the "Code").

2 R.S.C. 1985 c. 1 (5th Supp.), as amended (the "Act").