2 February 2012 External T.I. 2012-0434311E5 - Canada-U.S. Tax Convention

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

Principal Issues: Whether paragraphs 6 and 7 of Article IV and/or paragraph 2 of Article X of the Treaty apply to a paragraph 214(3)(a) deemed dividend

Position: Question of Fact

Reasons: See Response

XXXXXXXXXX
				2012-043431
				A. Seidel, CMA
				(613) 957-2058

February 2, 2012

Dear XXXXXXXXXX :

Re: Canada-United States Tax Convention - Post Fifth Protocol

This letter replaces the letter issued on November 21, 2011 as 2010-039092. This letter amends the first sentence of Situation #1 to correct a typographical error. Both letters address the application of Part XIII of the Income Tax Act (the "Act") to deemed dividends arising pursuant to paragraph 214(3)(a) of the Act subsequent to the coming into force of the Fifth Protocol to the Canada-United States Tax Convention (1980) (the "Treaty").

Hypothetical Scenario

• an unlimited liability corporation ("ULC") resident in Canada paid an amount in respect of management fees to its U.S. parent ("XCo");
• ULC carries on an active business in Canada;
• ULC is, by virtue of paragraph 18(1)(a) of the Act, unable to deduct the amount paid to XCo;
• XCo and/or its members has/have computed their U.S. income in accordance with the relevant U.S. income tax legislation;
• paragraph 214(3)(a) of the Act applies to deem ULC's payment to be a dividend received by XCo for the purposes of Part XIII of the Act.

General Comments

As stated in paragraph 2 of Information Circular 70-6R5, "Advanced Income Tax Rulings", dated May 17, 2002, an advance income tax ruling is a written statement given by the Directorate to a taxpayer stating how the CRA will interpret and apply specific provisions of existing Canadian income tax law to a definite transaction or transactions which the taxpayer is contemplating. A request for an advance income tax ruling request should be submitted in the manner set out in Information Circular 70-6R5. This Information Circular and other CRA publications can be accessed on the internet at http://www.cra-arc.gc.ca. Written confirmation of the tax implications of completed transactions should be addressed to the relevant tax services office, a list of which is available on the "Contact Us" page of the CRA website. The following comments are provided in accordance with paragraph 22 of Information Circular 70-6R5.

Pre-Fifth Protocol to the Treaty and prior to the Tax Court of Canada's decision in TD Securities (USA) LLC v. Her Majesty The Queen (2010 DTC 1137), it was the CRA's view that a U.S. LLC which has not ticked the box to be treated as a corporation for U.S. income tax purposes, because the members of a LLC, not the LLC, are liable to U.S. tax on the income, profits or gains derived by the LLC, such LLC was not considered to be a resident of the U.S. for the purposes of the Treaty. Accordingly, prior to the Fifth Protocol to the Treaty, the 25% tax imposed on a LLC under Part XIII of the Act in respect of a paragraph 214(3)(a) deemed dividend was not reduced under Article X of the Treaty. The Fifth Protocol to the Treaty added paragraphs 6 and 7 to Article IV and amended paragraph 2(a) of Article X.

Paragraph 6 of Article IV of the Treaty is effective, in respect of taxes withheld at source, for amounts paid or credited on or after February 1, 2009. An amount paid or credited to a fiscally transparent entity (e.g. a LLC or a partnership) by an ULC after January 31, 2009 may be eligible for treaty relief if the amount is considered, by paragraph 6 of Article IV, to be derived by a person who is a resident of the U.S. In this respect, paragraph 6 of Article IV applies if, pursuant to subparagraph (a), a person is considered to have derived an amount under the taxation laws of the U.S. through a fiscally transparent entity and the amount meets the requirement in subparagraph 6(b) of Article IV (i.e. by reason of the fiscal transparency of the LLC or the partnership, the treatment of the amount under the taxation laws of the U.S. is the same as its treatment would be if the person derived the amount directly). On the other hand, paragraph 7 of Article IV of the Treaty contains rules that consider certain amounts as not having been paid to or derived by a resident of a contracting state. The determination of same treatment (or, more accurately, "not the same" treatment) involves an analysis, under the tax laws of the country in which the taxpayer is resident, of the quantum, character and timing of the item of income, profit or gain in two scenarios: (1) the entity is disregarded under the taxation laws of that country and (2) the entity is not disregarded (i.e. not fiscally transparent) for the purposes of those laws.

With respect to an amount of income, profit or gain that is not "disregarded" under the taxation laws of the U.S. but is treated differently under those laws than under the taxation laws of Canada, the CRA is willing to consider, for the purposes of applying paragraph 6 of Article IV of the Treaty, that the amount has been derived by the member(s) of the ULC under the taxation laws of the U.S. However, such amounts would still be subject to the same treatment test in paragraphs (6) and (7) of Article IV.

Part XIII Withholding Issue

What is XCo's Part XIII tax liability in the situations described below?

Situation #1

The ULC is treated as a corporation, i.e. not fiscally transparent, for U.S. income tax purposes. XCo is a corporation resident in the U.S. and is a "qualifying person", within the meaning of Article XXIX-A of the Treaty, that is entitled to Treaty benefits.

Paragraph 3 of Article X specifies that a "dividend", for purposes of the Treaty, includes any income that is subjected to the same taxation treatment as income from shares under the laws of Canada such that paragraph 2 of Article X allows Canada to apply Part XIII tax to paragraph 214(3)(a) deemed dividends. Absent the relief in subparagraphs 2(a) and (b) of Article X of the Treaty, the Part XIII tax applicable to a paragraph 214(3)(a) amount that is deemed to be a dividend paid to a non-resident would be 25% of the deemed dividend. Where a non-resident (i.e. XCo) is a qualifying person that meets the share ownership test in subparagraph 2(a) of Article X of the Treaty, it is our view that the 5% withholding rate would apply to a paragraph 214(3)(a) deemed dividend. Were the non-resident a qualifying person that did not meet the share ownership test in subparagraph 2(a) of Article X, the 15% withholding rate in subparagraph 2(b) of Article X would apply to a paragraph 214(3)(a) deemed dividend.

Situation #2

The ULC is treated as a disregarded entity for U.S. income tax purposes. XCo is a partnership under the taxation laws of the U.S. The members of XCo are two corporations ("YCo" and "ZCo") that each own 50% of the partnership interests in XCo, are each resident in the U.S. for purposes of the Treaty and are each a "qualifying person" within the meaning of Article XXIX-A of the Treaty.

The Fifth Protocol to the Treaty amended subparagraph 2(a) of Article X to treat a company which beneficially owns dividends paid by a corporation resident in Canada and derived through an entity that is considered fiscally transparent under the laws of the U.S. (e.g. a partnership) as owning its allocable share of the voting stock of the dividend payer that are held by the partnership. Consequently, where XCo holds 100% of the shares of the ULC and the members of XCo (i.e. YCo and ZCo) are corporations that are resident in the U.S. holding more than a 10 per cent ownership interest in the fiscally transparent entity, such corporations will be considered to own that same percentage of the shares of the ULC for the purposes of applying subparagraph 2(a) of Article X. Were a member of XCo to have less than a 10% ownership interest in XCo, such a member would be subject to a 15% withholding rate under subparagraph 2(b) of Article X.

Notwithstanding the above, YCo and ZCo will not be eligible for benefits under the Treaty in respect of amounts paid by ULC to XCo after 2009, if YCo and ZCo are, by reason of subparagraph 7(b) of Article IV of the Treaty, considered not to have derived the amounts paid to XCo. Subparagraph 7(b) would apply where the receipt of an amount by XCo from an ULC that is not a disregarded entity would not have the same treatment as an amount received from a ULC that is a disregarded entity. In the former situation YCo and ZCo would be seen as receiving a management fee or shareholder benefit. In the latter situation, since YCo and ZCo would be considered to be carrying on business in Canada directly and thereby earning business profits, any amount paid to XCo would be "disregarded" for US income tax purposes. As this results in "not the same" treatment, no Treaty benefits would be available to YCo or ZCo.

Situation #3

The ULC is treated as a disregarded entity for U.S. income tax purposes. XCo is an entity (e.g. a LLC) that is fiscally transparent under the taxation laws of the U.S. The members of XCo are ACo and BCo, each of which is a "qualifying person" within the meaning of Article XXIX-A of the Treaty.

The member(s) of a fiscally transparent entity are required to include, on a current basis, their share of the earnings of a disregarded ULC in the computation of their U.S. taxable income. Where a fiscally transparent entity under the taxation laws of the U.S. holds all of the shares of an ULC that is a disregarded entity under those laws, there may be situations where an amount, such as a distribution of ULC's accumulated earnings to its shareholder(s), in and by itself, would not be recognized as an item of income in the hands of the member(s) of the U.S. fiscally transparent entity nor would it have any other U.S. tax consequences (i.e. the amount is "disregarded"). Although some have argued that where the earnings of a fiscally transparent entity are considered, under the taxation laws of the U.S., to be derived directly by its member(s), a cross-border distribution in respect of such earnings, including shareholder appropriations, should be considered to be derived by the member(s) of the fiscally transparent entity, others have argued that such amounts would, under the taxation laws of Canada, be distinct from the underlying earnings of the ULC. It is our view that paragraph 6 of Article IV 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 US.

Situation #4

The ULC is treated as a corporation for U.S. income tax purposes. XCo has elected to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code (an "S Corporation"). The S Corporation is, pursuant to subparagraph 2(e) of Article XXIX-A, a qualifying person for purposes of the Treaty. An individual owns all of the shares of the S Corporation. The CRA has taken the position that, for the purposes of the Treaty, any Canadian source income received by a S Corporation may be considered to be derived by the shareholders of the S Corporation (and not by the S Corporation) pursuant to paragraph 6 of Article IV of the Treaty. However, while an S Corporation is a fiscally transparent entity for U.S. tax purposes, it continues to be ordinarily accepted by the CRA that it is itself a resident of the U.S. for the purposes of the Treaty. As a result, where an S Corporation has at least a 10% ownership interest in an ULC, the Canadian withholding tax rate on a deemed dividend is limited to 5% pursuant to subparagraph 2(a) of Article X of the Treaty. The withholding tax will be 15% where a S Corporation owns less than 10% of an ULC.

Yours truly,

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