17 May 2012 IFA Roundtable, 2012-0444151C6 - Hybrid Partnerships and Branch Tax Liability

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: Application of Article X(6) with respect to profits earned through a partnership that is a resident of the United States for the purposes of the Canada-United States Tax Convention.

Position: If the partnership would be eligible to claim benefits under Article X(6), the member can claim those benefits in computing branch tax liability on the member's share of the partnership income included in the member's taxable income earned in Canada. Alternatively, if the member can otherwise claim benefits under Article X(6), those benefits would apply to its share of the partnership's profits earned through a Canadian permanent establishment.

Reasons: The partnership is a company and a resident of the United States under the Canada-United States Tax Convention. Consistent with previous approach to providing treaty benefits in respect of income earned or received by partnerships that are residents of the United States under the Canada-United States Tax Convention.

International Fiscal Association (IFA) Conference
Canada Revenue Agency Roundtable
May 17, 2012

Branch Tax Rate

Question

Assume that two corporations not resident in Canada are the partners of a partnership formed under United States laws. One partner is a resident of the United States under the Canada-United States Tax Convention (the "US Treaty"); the other partner is resident in a country with which Canada does not have a tax treaty. The partnership carries on identical business activities in both the United States and Canada through permanent establishments in both countries. The partnership has elected to be classified as a corporation for United States tax purposes.

Would the CRA be willing to clarify that Article X(6) of the US Treaty applies to business profits of partnerships that have "checked-the-box" to be classified as a corporation for United States tax purposes?

Response

It is our understanding that a partnership formed under United States laws is a "domestic corporation" under the Internal Revenue Code if the partnership elects to be a corporation. The partnership is then subject to United States corporate income tax liability on the same basis as any other corporation formed under United States laws. As a result, the partnership will be considered a "company" under Article III(1)(f) of the US Treaty and will also be considered a resident of the United States under Article IV(1) of the US Treaty.

From a Canadian tax perspective, a partnership that is a resident of the United States under the US Treaty remains a partnership for the purposes of the Act. If the partnership carries on business in Canada through a permanent establishment, each non-resident member of the partnership must include their share of the profit earned through the permanent establishment in the computation of the member's "taxable income earned in Canada" under Part I of the Act. Where the non-resident member is a corporation, branch tax may also be payable by the member under Part XIV of the Act in respect of those profits. The rate of branch tax imposed under subsection 219(1) is 25%. Under Article X(6) of the US Treaty, the amount of branch tax that Canada is allowed to impose on the "earnings of a company" attributable to permanent establishments in Canada is limited to 5 percent of such earnings, to the extent the branch tax was not previously imposed on those earnings.

While branch tax liability is imposed on the members of the partnership and not on the partnership itself, a member of the partnership, who is required to include a share of the profits of the partnership in computing the member's branch tax liability, can access benefits under Article X(6) of the US Treaty ("partnership-level benefits") to the extent that the partnership could have claimed such benefits had the partnership been the entity subject to Canadian branch tax.

Although a partnership that has elected to be a domestic corporation for United States tax purposes is considered a resident of the United States under the US Treaty (a "US-resident partnership"), the partnership would not be a "qualifying person" as defined in Article XXIX A(2) of the US Treaty. As a general matter, a company will only be a qualifying person if the company's share capital meets certain requirements. Due to the absence of share capital, it is not possible for the partnership to satisfy these conditions. For the same reason, treaty benefits are not allowed to the partnership under the "derivative benefits" test in Article XXIX A(4) of the US Treaty.

Consequently, "partnership-level benefits" under Article X(6) may only apply to business profits earned by a US-resident partnership through a Canadian permanent establishment in accordance with the "active trade or business" test under Article XXIX A(3), or, if treaty benefits are granted by the Canadian competent authority, under Article XXIX A(6). To satisfy the "active trade or business" test:

(a) the US-resident partnership must be engaged in the active conduct of a trade or business in the United States (other than the business of making or managing investments, unless those activities are carried on with customers in the ordinary course of business by a bank, an insurance company, a registered securities dealer or a deposit-taking financial institution);

(b) the US-resident partnership's earnings from carrying on a business through the Canadian permanent establishment must be connected with or incidental to the trade or business activity referred to in (a); and

(c) the trade or business activity referred to in (a) must be substantial in relation to activity carried on by the US-resident partnership through the Canadian permanent establishment.

Additionally, a member of the partnership that is itself eligible to claim treaty benefits under Article X(6) may still apply the reduced branch tax rate to its share of the partnership's profits earned through a Canadian permanent establishment.

In this regard, certain considerations result from the manner in which benefits under Article X(6) are calculated. For example, where "partnership-level benefits" are calculated based on the US-resident partnership's earnings pursuant to Article X(6), it is the CRA's view that no reduction would be made under Article X(6)(b) for any Canadian income tax liability of the members in respect of the earnings from the Canadian permanent establishment, nor would those earnings be computed to take into account expenses directly incurred by the members of the partnership. Consequently, where Article X(6) benefits are claimed based on the US-resident partnership's entitlement to treaty benefits, the member of the partnership may find that its share of the partnership's Article X(6) earnings amount exceeds the amount upon which Part XIV tax is otherwise payable under subsection 219(1).

Further issues may also arise with respect to the $500,000 earnings exemption available under Article X(6)(d). While the exemption may be deducted in the computation of the US-resident partnership's earnings, the deductible amount of the exemption must be reduced for previous exemption claims made by the partnership, and any other company not dealing at arm's length with the partnership with respect to the same or a similar business.

In the event that a member of a US-resident partnership computes its Part XIV tax liability under Article X(6), and the resulting branch tax liability varies from the amount that would otherwise be payable by the member (e.g., if the member is resident in a non-treaty jurisdiction or another jurisdiction offering a treaty-reduced rate exceeding 5%), it would be advisable to submit an explanation to support the claim for Article X(6) treaty benefits along with the Schedule 20 accompanying the member's T2 Corporation Income Tax Return ("T2"). In circumstances where the T2 is filed electronically, the CRA may initially detect a discrepancy between the branch tax rate and the rate applicable to the country in which the member is resident. Before proceeding with the assessment of the tax return, it is anticipated that CRA personnel will contact the member to ascertain the reason for the discrepancy, and provide the member an opportunity to substantiate the claim for Article X(6) treaty benefits at that time.

Jackson MacGillivray
2012-044415
May 17-18, 2012