Article 29A - Limitation on Benefits

Canco (which is purely a holding company for FA carrying on business in a third country) pays a dividend to USco, which is owned by individuals resident in a non-treaty country but which is engaged in the active conduct of a trade or business in the U.S. FA is in the same business as USco and its activities are all connected to USco’s business. Would Art. XXIX-A(3) of the Canada-US Treaty be available respecting such dividend?

CRA noted that of the three tests set out in Art. XXIX A(3) –

1. the US is engaged in the active conduct of a trade or business in the U.S.;
2. the income is “derived from [Canada] in connection with, or incidental to, that trade or business (including any such income derived directly or indirectly by [the U.S. resident] through one or more other [Canadian residents] (the “connected test”); and
3. the trade or business carried on in the U.S. is substantial in relation to the activity carried on in Canada giving rise to the income in respect of which treaty benefits are claimed -

the connected test will not be satisfied.

To the extent that this denial is not considered appropriate in the circumstances, the taxpayer may request special relief through the CRA competent authority under Art. XXIX-A(6).

The sole beneficiary of a trust (the “Trust”) that is resident in the U.S. for purposes of the Canada-U.S.Treaty is the parent of a US group of entities (“US Parent”), and the Trust's sole beneficiary is a wholly-owned U.S. subsidiary of US Parent (“US Opco”). Canco, also in the group, carries on business in Canada. The US group of entities has funded the Trust which has then financed Canco by way of debt. May US Opco be considered related to the Trust for purposes of Art. XXIX-A, para. 3? After noting the relevance of domestic definitions of a term under Art. III, para. 2, CRA stated that "the phrase 'person related thereto' should take its meaning from subsection 251(2)." After then referring to the ss. 104(1) and (2) rules, it then stated:

Accordingly, the reference to the trust in paragraph 104(2) of the Act is a reference to the trustee having ownership or control of the trust property pursuant to paragraph 104(1) of the Act. Therefore, that trustee will be deemed to be an individual in respect of the trust property.

According to subparagraph 251(2)(b)(i) of the Act, “related persons” or persons related to each other includes a corporation and a person who controls the corporation, if it is controlled by one person. The trustee will be an individual in respect of the trust property and if the beneficiary is a corporation that is solely controlled by the trustee, the trust and the beneficiary will be “related persons” or persons related to each other for purposes of the Act. ...

As such, in the hypothetical scenario described, given that US Parent, which is the sole trustee of the Trust, wholly owns US Opco, being the beneficiary of the Trust, and thus controls US Opco, in our view, US Opco may be considered a “person related thereto” in respect of the Trust for the purposes of paragraph 3 of Article XXIX-A in connection with Canadian taxes to which the Treaty applies.

To help fund the indirect acquisition of NR-Target (which was not resident in Canada or the U.S.) by Canco (an indirect subsidiary of non-resident "Parent"), US-Holdco1 (a U.S. resident which was not a "qualifying person") subscribed in U.S. dollars for Canco's shares and made the U.S.-dollar "Loan2" to Canco. Canco used U.S. dollars funded by XX and such U.S. dollar subscription and loan proceeds to make a capital contribution to NR-Holdco3 (an non-resident subsidiary held by it and a wholly-owned U.S. subsidiary) and a non-interest bearing U.S.-dollar loan to NR-Holdco4 (a wholly-owned subsidiary of NR-Holdco3). NR-Holdco4 used those loan proceeds and a capital contribution from NR-Holdco3 to acquire all the shares of NR-Target.

Canco made interest payments on Loan2 to US-Holdco1 ("Interest Payments"), which were funded out of cash generated from sales to US-Opco2 of products manufactured in Canada. US-Opco2 (a U.S. resident) primarily markets and distributes XX products in the U.S.

Is the requirement in para. XXIX-A(3) of the Canada- U.S. Convention that the Interest Payments be income be derived "from the other Contracting State (Canada) in connection with…that (US) trade or business" met based on a "funding approach"? Can this requirement only be met in respect of Canadian-sourced income?

The Directorate responded:

The situation submitted involves essentially interest payments made by a Canadian payer to a US resident in respect of borrowed funds used to acquire shares of a corporation resident in a third country, where the interest payments were funded out of cash generated from sales of products it manufactured in Canada.

… Paragraph XXIX-A(3)…[inter alia requires:] …The item of income is derived from the source state (Canada) in connection with or incidental to that (US) trade or business (including any such income derived directly or indirectly by that resident person (US person) through one or more other persons that are residents of the source state (Canada)) ("Connected Test")

…[I]nterest paid or credited by a Canadian resident to a US person might be considered "derived in connection with" a US active business in the following circumstances:

1. the interest is paid or credited in respect of an account payable issued by [sic] the US person in the course of carrying on its US active business,
2. the interest payments are in respect of borrowed money used for the purpose of earning income from a business carried on in Canada that is upstream, downstream or parallel to the US active business ("Canadian-Connected Business"), or
3. the interest payments are funded out of the cash flow from such a Canadian-Connected Business.

The last two assertions rely on an interpretation of the "connection standard" that allows it to be met based on either a "use test" or a "funding approach".

…[I]t is clear that the taxpayer cannot rely on the "use test" as the borrowed money was used to acquire shares of non-resident corporations. As for the "funding approach", it is not clear… whether the Canadian-Connected Business generated sufficient net cash flow in the relevant periods. To the extent of any shortfall…for example, the Interest Payments might be partially funded from foreign affiliate dividends… no relief would be available… .

....[Y]ou may want to suggest to the taxpayer to initiate a request for the grant of treaty benefits under [para. XXIX-A(6)].

ForSub, which is a U.S.-resident wholly-owned C-Corp subsidiary of ForCo, an LLC, will acquire from ForCo an interest-bearing note (the CanSub Note) owing by an indirect wholly-owned ULC subsidiary of ForCo (CanSub). CanSub, through a partnership, carries on the same business operations as are carried on by wholly-owned LLC subsidiaries of ForCo. ForCo and ForSub are not "qualifying persons" (as defined in Art. XXIX A, para. 2 of the Canada- U.S. Treaty), and they will not file a consolidated income tax return.

Ruling that, by virtue of Art. XXIX A, para. 3, ForSub will be entitled to the Treaty benefits for interest on the CanSub Note.

UK Parent owns US Parent, which owns US Holdco (whose shares are taxable Canadian property) which owns Can Sub. US Parent sells US Holdco. Does Art. XXIX-A, para. 3 of the Canada-U.S. Treaty (i.e., the LOB) apply, assuming US Parent is carrying on a business that is upstream, downstream or parallel to the business carried on by Can Sub, and would the gain be derived from Canada where Canada taxes it under domestic law? CRA responded:

[W]e would consider the gain realized in US Parent from the disposition of its US Holdco shares to be income derived from Canada for purposes of applying paragraph 3 of Article XXIX-A of the Treaty, since the value of the US Holdco shares would be principally derived from property that is "taxable Canadian property" as defined in subsection 248(1).

Q. 5(a) Super-voting shares

Where a company has multiple classes of voting shares, with one or more of the classes thinly traded or not at all, each class of shares should be considered separately when determining whether those shares are "primarily and regularly traded" for purposes of Art. XXIX-A(2)(c) of the Canada-U.S. Convention. A ruling request for such a company with a class of super-voting shares was withdrawn when CRA expressed its concern on this issue. In 2011-0429261R3, a "qualifying person" ruling under Art. 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 publicly-traded voting common stock.

Q. 5(b)

Criteria for substantial business. In 2009-0349141R3, 2011-0424211R3 and 2012-0458361R3, where the issue was whether the size of the US business was substantial in relation to the Canadian operations under Art. XXIX-A(3), Rulings considered:

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.

Q. 5(b)

Dividends to bankrupt U.S. parent. Respecting dividends paid by a Canadian subsidiary corporation to its bankrupt US parent, Rulings confirmed the availability of Art. 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…while noting that the purpose of the dividend was to pay the US parent corporation's creditors… .

Q. 5(c)

Base erosion test in first year. In 2012-0471921R3, the ownership test in Art. XXIX-A(4)(a) was satisfied at the time that a dividend was proposed to be paid from a Canadian subsidiary to its U.S. parent. However, as the base erosion test under Art. XXIX-A(4)(b) was being applied in the first fiscal period of the US person, Rulings was unable to confirm whether the conditions of the base erosion test in paragraph (b) were satisfied throughout that fiscal period. Rulings confirmed the availability of Treaty benefits for the dividend, subject to the base erosion test being satisfied by the taxpayer for the current taxation year.

Canco and U.S. Holdco

Canco, which is an unlimited liability company, is wholly owned by U.S. Holdco, which is resident in the U.S. for purposes of the Canada-U.S. Income Tax Convention (the "U.S. Treaty"), but is not a qualifying person for purposes of the U.S. Treaty. The expenses of U.S. Holdco which are deductible in computing its income for Code purposes for the XX taxation year and which are paid directly or indirectly to persons who are not qualifying persons under the U.S. Treaty are less than X% of its gross income for such purposes, and it is expected that htis test will be satisfied for the XX taxation years.

Foreign Holdco and Foreign Sub

X% of the shares of U.S. Holdco are owned by Foreign Sub which, in turn, is a wholly-owned owned subsidiary of Foreign Holdco. Foreign Holdco and Foreign Sub are resident in Country 1 (not the U.S. or Canada), are not qualifying persons under the U.S. Treaty and are entitled to all the benefits of the Treaty ("Treaty 2") between Canada and Country 1. The common shares of Foreign Holdco are publicly traded on Exchanges 1, 2 and 3.

Proposed transactions

Canco will sell its investment in a Canadian business held through a Canadian LP to an unrelated 3rd party. It will distribute the net proceeds of disposition to U.S. Holdco by adding an amount to its paid-up capital account pursuant to the applicable provincial Company Act, and then distribute the amount of that addition to U.S. Holdco as a return of capital on its shares. The representation is made that "no income, profit or gain will arise or will be recognized under the taxation laws of the United States as a result of the[se] transactions…."

Rulings

include:

• Art. IV, para. 7(b) of the U.S. Treaty will not apply to treat the s. 84(1) dividend arising to U.S. Holdco as not having been paid to it.
• U.S. Holdco will be entitled to the benefits of the U.S. Treaty in respect of such dividend by virtue of Art. XXIX A, para. 4 provided that it satisfied the base erosion test in its XX taxation year.

Canco has both qualifying active business income from a Canadian business that is connected with an active trade or business (the connected business) of its wholly-owning US parent (USco) and also non-qualifying income of some kind, and pays interest to USco (which is not a qualifying person) on a debt owing to USco. CRA indicated that it will treat an interest payment from Canco to USco as being derived by USco in connection with USco's active trade or business in the United States for purposes of Art. XXIX A, para. 3 of the Canada-US Convention if

(1) the payment is in respect of indebtedness that was incurred exclusively for the purpose of earning income from Canco's connected business, or (2) Canco can establish that the interest payment was funded out of the earnings of the connected business.

The two partners of a partnership which has elected to be a domestic corporation for Code purposes are: a corporation which is resident in the U.S. for purposes of the Canada- U.S. Income Tax Convention; and a corporation resident in a non-Treaty country.

CRA indicated that a member of the partnership 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 the partnership would not so qualify as a "qualifying person" as defined in Art. XXIX A(2) of the US Treaty due to the absence of share capital for the partnership, "partnership-level benefits" under Art. X(6) may 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 Art. XXIX A(3), or, if treaty benefits are granted by the Canadian competent authority, under Article XXIX A(6).

Holdco, which had been a listed U.S. company, was taken private by L5, which is a fund whose members are not known. Holdco and its subsidiary, USCo (neither of which carry on a business of making or managing investments) filed a Chapter 11 Plan (following their filing of a petition in bankruptcy), and a Plan Administrator was appointed. Although a Canadian subsidiary of Holdco (Canco) ceased to sell assets to securitization trusts when the group financial difficulties became severe, it continues to earn income from obligations to it of those trusts, including the receipt of deferred purchase price.

Canco will pay three cash dividends to Holdco, its sole shareholder. "Through the Plan Administrator under the Plan of Liquidation, Holdco will have full discretion and control over the Dividends throughout the period during which the Dividends are paid."

Rulings that the benefits of the Canada-U.S. Treaty will apply to the dividends pursuant to Art. XXIX-A, para. 3, and that the rate of withholding under Art. X will be 5%. In the summary, CRA noted that the dividends will be derived by the parent "in connection with an active trade or business carried on in the United States that is substantial in relation to the activity in Canada that gave rise to the income."

ECo, which is fiscally transparent for U.S. purposes and resident in the U.S. (a.k.a., Country 1) but is not a qualifying person (as defined in Art. XXIX-A of the Canada- U.S. Convention), makes a loan (the "Charlie Debt") bearing non-participating interest to CCo, which is a CBCA corporation and affiliated with Eco. (Both Eco and CCo are indirect wholly-owned subsidiaries of a public company (ACo), which is resident in Country 2.) ECo is a wholly-owned subsidiary of DCo, which is resident in the U.S. but is not a "qualifying person (as so defined). ECo acts as a lender to various affiliates in various countires (although no financing has been provided to CCo to date), and raises much of the necessary financing through public issuances of debt and commercial paper. CCo uses the proceeds of the Charlie Debt for an income-producing purpose.

Ruling that Art. XXIX-A of the Canada-U.S. Treaty will apply so that the benefits of the Treaty will apply to DCo in respect of any interest paid on the Charlie Debts, and Art. XI, para. 1 of the Treaty will apply to reduce the Canadian withholding tax rate to nil for any interest paid by CCo to ECo.

A U.S. resident citizen is the sole shareholder of a U.S. Subchapter S corporation (S-Corp), which is the sole shareholder of a U.S. LLC (which is fiscally transparent for U.S. purposes) ). US LLC is the sole shareholder of Canco, which is not fiscally transparent. Would the Treaty limit Canada's taxation of a dividend paid by CAnco to US LLC to 5% of its gross amount? CRA responded:

The CRA generally treats an S-Corp as a corporation and a resident of the United States under the Treaty. … Under subparagraph 2(a) [of Article X], the S-Corp would be considered to own the shares of Canco owned by the US LLC. ... The S-Corp will be a qualifying person if it satisfies the ownership and base erosion tests set out in clauses 2(e)(i) and (ii). As 50 percent or more of the aggregate vote and value of the shares of the S-Corp are not owned, directly or indirectly, by persons other than qualifying persons, the ownership test in clause 2(e)(i) [of Article XXIX A] is met. However, whether or not the base erosion test in clause 2(e)(ii) of Article XXIX A is met is a question of fact that can only be determined after an examination of the gross income and the deductible expenses of the S-Corp for the relevant time period.

How will CRA interpret "paid or payable...directly or indirectly" in Art. XXIX A(2)(e) and (4)(b) of the Canada-U.S. Convention? CRA responded:

The CRA will interpret the words "paid or payable...directly or indirectly" contained in Articles XXIX A(2)(e) and (4)(b) of the Treaty consistent with the approach we have taken in interpreting those words under subparagraph 95(2)(a)(ii) of the Act. For example, for the purpose of applying Article XXIX A(2)(e) or (4)(b) of the Treaty, a payment by a company to a qualifying person will be considered to be made indirectly to a non-qualifying person if there is a sufficient link between the payment and a subsequent payment by the qualifying person to a non-qualifying person (e.g. back-to-back arrangement).

The correspondent noted that in Canada, if each class of shares of a public company with multiple classes must be considered separately for purposes of satisfying the de minimis or 10-percent tests in the U.S. tax regulations (treated as being applicable for Canadian purposes under para. 2(c) of the "qualifying person definition) very few Canadian corporations with multiple classes of voting shares will be considered "qualifying persons" for purposes of the LOB clause. CRA stated:

…each class of shares must be considered separately for the purposes of satisfying the de minimis and the 10 percent test. We understand that this interpretation is in line with the views of the U.S. tax authorities.

CRA will therefore interpret the term 'registered securities dealer' to mean:

• a 'registered securities dealer' for the purposes of the Income Tax Act (Canada); or
• a 'dealer in securities' for the purposes of Section 475 of the Internal Revenue Code and whose dealings as such are regulated under US federal or state-level securities legislation.

Will CRA look through LLCs and other entities that are fiscally transparent for US purposes, in applying paras. 2(d) and (e) of "qualifying person" of Art. XXIX A of the Canada-U.S. Treaty? CRA responded:

The principles of new paragraph 6 of Article IV of the Treaty will be taken into account by the CRA when applying the ownership and base erosion provisions of Article XXIX A. Therefore, the CRA will "look through" an entity that is viewed as fiscally transparent under the domestic laws of the residence State (other than entities that are resident in the source State) when applying the ownership/base erosion test in paragraphs 2(d) and 2(e) of the definition of "qualifying person" of Article XXIX A. The CRA recommended that the [Technical Explanation] reflect this interpretation.