19 May 2010 Roundtable, 2010-0366531C6 - Canada-United States 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 Article IV(6) of the Convention could apply to an amount deemed to be paid pursuant to paragraph 78(1)(b) of the Act

Position: Yes

Reasons: See response

International Fiscal Association Annual Conference

May 19, 2010

Application of Article IV(6) of the Canada-US Tax Convention to Paragraph 78(1)(b) Deemed Payments

Assume that a Canadian corporation ("Canco") is wholly-owned by a United States limited liability corporation ("LLC"). The LLC is, in turn, wholly-owned by XCo, a resident of the United States for the purposes of the Canada-U.S. Tax Convention (1980) (the "Treaty"). The LLC is disregarded under the taxation laws of the United States and, therefore, is fiscally transparent for the purposes of Article IV(6) of the Treaty.

Canco is indebted to LLC under the terms of an interest-bearing debt (the "Debt"). Interest on the Debt accrues during Canco's 2009 taxation year but will not be paid by the end of Canco's 2011 taxation year. Canco and the LLC file an agreement, described in paragraph 78(1)(b) of the Act, with the effect that the 2009 accrued interest on the Debt, is deemed to be paid by Canco to LLC on January 1, 2012. Under the taxation laws of the United States, the interest on the Debt is included in XCo's income on an accrual basis without regard to the timing of the interest payments.

Question

Will Article IV(6) of the Treaty apply such that the interest on the Debt that is deemed to have been paid pursuant to paragraph 78(1)(b) of the Act will be considered to have been derived by XCo for the purposes of the Treaty?

CRA Response

Article IV(6) of the Treaty provides:

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.

Paragraph IV(6) was added to the Treaty by the Fifth Protocol and is applicable in respect of taxes withheld at source for amounts paid or credited on or after February 1, 2009.

Subsection 78(1) of the Act provides:

Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer to a person with whom the taxpayer was not dealing at arm's length at the time the outlay or expense was incurred and at the end of the second taxation year following the taxation year in which the outlay or expense was incurred, is unpaid at the end of that second taxation year, either

(a) the amount so unpaid shall be included in computing the taxpayer's income for the third taxation year following the taxation year in which the outlay or expense was incurred, or

(b) where the taxpayer and that person have filed an agreement in prescribed form on or before the day on or before which the taxpayer is required by section 150 to file the taxpayer's return of income for the third succeeding taxation year, for the purposes of this Act the following rules apply:

(i) the amount so unpaid shall be deemed to have been paid by the taxpayer and received by that person on the first day of that third taxation year, and section 153, except subsection 153(3), is applicable to the extent that it would apply if that amount were being paid to that person by the taxpayer, and

(ii) that person shall be deemed to have made a loan to the taxpayer on the first day of that third taxation year in an amount equal to the amount so unpaid minus the amount, if any, deducted or withheld therefrom by the taxpayer on account of that person's tax for that third taxation year.

The purpose of subsection 78(1) is to limit the accrual of deductible expenses, such as interest, owing by a taxpayer to a person (creditor) who was not dealing at arm's length with the taxpayer at the time the expense was incurred. Subsection 78(1) provides that if the expense is not paid by the end of the second taxation year following the end of the taxation year in which the expense was incurred, the amount of the expense is added to the taxpayer's income in the third taxation year unless the taxpayer and the creditor agree to be assessed as if the amount were in fact paid on the first day of the third taxation year and were replaced on the same day by a loan of equal amount (less applicable withholding taxes).

In the situation described above, the income referred to in Article IV(6) of the Treaty is the Canadian-source interest that is payable under the terms of the Debt and that is considered, under the taxation laws of the United States, to be derived by XCo through LLC. Therefore, provided that the treatment of the interest under the taxation laws of the United States is the same as its treatment would be if the interest had been derived directly by XCo, such interest will be considered to have been derived by XCo for the purposes of the Treaty. In our view, in the situation described above, it is the tax treatment of the Canadian-source interest on the Debt under the taxation laws of the United States and not the treatment (or non-treatment) of the paragraph 78(1)(b) deemed payment that is relevant to the application of Article IV(6).