26 November 2013 CTF Roundtable, 2013-0507961C6 - Article XXIX-A LOB provisions

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: Provide a brief overview of the experience of Rulings with application of the US Treaty LOB provisions.

Position: General comments provided.

Reasons: See response.

CTF Annual Tax Conference
CRA Round Table – November 26, 2013

Article XXIX-A of the Canada-US Tax Convention
Limitation on Benefits

Question

Can the CRA provide a brief overview of recent rulings requests considered by the directorate related to the Limitation on Benefits (LOB provisions) in Article XXIX-A of the Canada – US tax treaty?

CRA Response

Since the release of the Fifth Protocol to the Canada-US tax treaty, the Income Tax Rulings Directorate (IT Rulings) has had several opportunities to consider the application of paragraphs (2), (3) and (4) of the LOB provisions in the context of corporate distributions resulting from bankruptcy, as well as interest payments in relation to cross-border financing structures. We have also had occasion to consider tax treaty implications of corporate distributions from Canadian corporations to US shareholders where the distributions were considered to be a return of capital.

It is worth noting however, that not unlike other income tax ruling requests, the ability for IT Rulings to confirm the application of paragraphs (2), (3) or (4) of Article XXIX-A in any particular situation has ultimately proven to be highly dependent on the facts of each situation. In order to provide some insight into our experience with these provisions, we have provided an overview of situations that have been recently considered by IT Rulings.

Article XXIX-A(2) – "qualifying person"

At the 2009 TEI-CRA Liaison Meeting (Document 2009-0347701C6), the CRA was asked to consider whether a company with multiple classes of voting shares, where one or more of the share classes were either thinly traded or not traded at all, could be considered a "qualifying person". In particular, IT Rulings was asked to consider the application of subparagraph 2(c) of Article XXIX-A, which requires the principal class of shares of a company to be primarily and regularly traded on one or more recognized stock exchanges. In its response, the CRA confirmed that each class of shares of a company should be considered separately when determining whether those shares are "primarily and regularly traded" for purposes of Article XXIX-A(2)(c).

More recently, this issue was raised in the context of a ruling request involving a company with several classes of shares, including one class of super-voting shares. Given the aforementioned views expressed in the 2009 conference response, such that consideration be given to each class of shares in the determination of whether the shares are "primarily and regularly traded" for purposes of Article XXIX-A(2)(c), the CRA expressed its concern in respect of the super-voting shares. Consequently, faced with the prospect of receiving an unfavourable ruling in light of the facts presented, this ruling request was withdrawn by the taxpayer.

In another example (Document 2011-0429261R3), IT Rulings did confirm that a particular US corporation was entitled to treaty benefits where the facts supported that it was a "qualifying person" for purposes of the Canada – US tax treaty. However, in that situation, the application of Article XXIX-A(2)(c) was largely facilitated by the fact that the authorized share capital of the particular US corporation consisted only of a single class of publically-traded voting common stock.

From these experiences, in situations where a particular corporation has multiple classes of shares with either varying degrees of voting privileges or varying trading frequencies on a recognized stock exchange, the ability to obtain confirmation of the application of Article XXIX-A(2)(c) from IT Rulings may prove to be more difficult. However, IT Rulings will continue to consider situations in this regard as they are presented.

Article XXIX-A(3) – "active trade or business" test

Also in recent years, several rulings (Documents 2009-0349141R3, 2011-0424211R3, 2012-0458361R3) have been issued by IT Rulings confirming the availability of treaty benefits by virtue of Article XXIX-A(3) to a person resident in the US that was not otherwise a "qualifying person" pursuant to XXIX-A(2). Briefly, in the context of these rulings, we note that under the "active trade or business" test provided under Article XXIX-A(3), a resident of the US (US Person) deriving an item of income from Canada (Canadian-source income) would generally be entitled to benefits with respect to that income if:

i. the US person, or a person related to the US person, is engaged in an active trade or business in the US;

ii. the Canadian-source income in question is derived in connection with, or is incidental to, that US trade or business; and

iii. the size of the active trade or business in the US is substantial relative to the activity in Canada that gives rise to the Canadian-source income for which benefits are sought.

In the specific situations considered by IT Rulings, the first two criteria noted above, i.e., (i) active trade or business in the US and (ii) Canadian-source income derived in connection with or incidental to the US business, were clearly satisfied based on the facts provided. However, for the purpose of determining whether the third criterion was satisfied in each case, i.e., whether the size of the US business was considered substantial in relation to the Canadian operations, IT Rulings has generally considered a number of factors including, but not limited to: the relative amount of assets, revenues, income, compensation expenses, and the overall number of employees involved in the US business in comparison to those in respect of the Canadian activities.

From these situations, we note that such rulings are generally issued under the caveat that the US person, or the person related thereto, continues to carry on its active business activities in the US, and that those US business activities remain substantial in relation to the activities carried on in Canada. Any material change in the type, composition, or the size of either the businesses carried on by the US person or person related thereto, or the relevant Canadian activities, would generally render such rulings inapplicable.

IT Rulings has also considered the application of Article XXIX-A(3) in certain situations involving dividends paid from a Canadian subsidiary corporation to its US parent corporation under circumstances of bankruptcy. In these specific situations, IT Rulings confirmed the availability of treaty benefits to the US parent under Article XXIX-A(3) on the basis that the US person was viewed as being engaged in the active conduct of a trade or business in the US, despite the fact that business activities in the US had ceased as a result of the bankruptcy and at the time of the proposed dividend from Canada, while noting that the purpose of the dividend was to pay the US parent corporation's creditors under the bankruptcy proceeding.

Article XXIX-A(4) – "derivative benefits" test

Where both an ownership test and a base erosion test are satisfied (i.e., under subparagraphs XXIX-A(4)(a) and (b), respectfully), benefits under the Canada-US tax treaty are available in respect of dividends, interest and royalties received by a person resident in either Canada or the US, despite that person not otherwise being considered a "qualifying person" under XXIX-A(2), and not otherwise eligible to claim such benefits pursuant to Article XXIX-A(3).

For example, in a situation where a Canadian resident pays an amount in respect of dividends, interest or royalties to a US person that is a company with one class of shares, the ownership test under Article XXIX-A(4)(a) would require that shares of the US person representing more than 90 percent of the aggregate votes and value of all of its shares (other than "debt substitute shares") be owned, directly or indirectly, by persons that are each a "qualifying person" or a person that:

i. is a resident of a third State with which the US has a treaty, and is entitled to all of the benefits under that treaty;

ii. would qualify for benefits under paragraph 2 or 3 of Article XXIX-A if the person were a resident of the US, and if its business were carried on in the US for purposes of paragraph 3; and

iii. would be entitled to a rate of tax on the item of income in respect of which benefits are sought, at least as low under the convention between the person's country of residence and the Contracting State granting benefits (i.e. Canada) as it is under the Canada – US treaty.

Where this ownership test is satisfied, a second base erosion test must also be met, requiring that the amount of expenses that are paid or payable by the US company in question, directly or indirectly, to persons that are not a qualifying person under the convention, and that are deductible from the US company's gross income, account for less than 50 percent of the gross income of the company. For purposes of applying this test, the relevant expenses and gross income under consideration are those from the fiscal period immediately preceding the period in which the test is being applied. However, as noted in the Technical Explanation to the Fifth Protocol, where the period in which the test is being applied is the first fiscal period of the US company the relevant expenses and gross income that first fiscal period would be considered.

In a recent case (Document 2012-0471921R3), IT Rulings considered a situation where a taxpayer was able to provide facts to support the view that the ownership test in Article XXIX-A(4)(a) was satisfied at the time that a dividend was proposed to be paid from a Canadian subsidiary to its parent company, a US person. As the base erosion test under Article XXIX-A(4)(b) was being applied in the first fiscal period of the US person, IT Rulings was unable to confirm whether the conditions of the base erosion test in paragraph (b) were satisfied throughout that fiscal period. However, on the basis of the facts provided, IT Rulings confirmed the availability of treaty benefits in respect of the proposed dividend, subject to the base erosion test being satisfied by the taxpayer for the taxation year in which the dividend was proposed to be paid.

Kim Duval
2013-050796