In This Issue. Earnings and Single-Member LLCs: Where Do We Start?...2 Anti-Discrimination and the Canada-UK Tax Treaty...5.

Transcription

1 In This Issue Earnings and Single-Member LLCs: Where Do We Start?...2 Anti-Discrimination and the Canada-UK Tax Treaty...5 A report on cross-border developments in Canadian tax law / March 2011

2 2 Earnings and Single-Member LLCs: Where Do We Start? By Robert W. Nearing & Bernice P. Wong Regulations to the Income Tax Act (Canada) (Act) contain rules with respect to the computation of the earnings of a foreign affiliate of a Canadian-resident taxpayer, which is relevant in calculating the surplus accounts of the foreign affiliate. Historically, the Canada Revenue Agency (CRA) has taken the position that the earnings of a limited liability company (LLC) with only one member should be computed in accordance with Canadian tax rules. 1 However, in at least one audit, the CRA International Audit Division has taken the position that an LLC with a single member that is resident in and carrying on an active business in the US should compute its earnings under US tax rules. It appears that the CRA s recent audit position stems from a concern with the possible inflation of the surplus accounts of single-member LLCs. This position appears to be inconsistent with the definition of earnings as set out in Regulation 5907(1). Earnings and Regulation 5907(1) Regulation 5907(1) defines a foreign affiliate s earnings from an active business for the purposes of computing the foreign affiliate s surplus and deficit accounts. Specifically, Regulation 5907(1)(a) provides that earnings of a foreign affiliate from an active business means: (i) the income or profit from the active business for the year computed in accordance with the income tax law of the country in which the affiliate is resident, in any case where the affiliate is required by that law to compute that income or profit; (ii) the income or profit from the active business for the year computed in accordance with the income tax law of the country in which the business is carried on, in any case not described in subparagraph (i) where the affiliate is required by that law to compute that income or profit; and (iii) in any other case, the amount that would be the income from the active business for the year under Part I of the Act if the business were carried on in Canada, the affiliate were resident in Canada, and the Act were read without reference to certain specified provisions in the Act. Based on the foregoing, a foreign affiliate that is carrying on an active business and that is not required to compute its income or profit under the income tax laws of the country in which it is resident, or in which it is carrying on the active business, must compute its earnings in accordance with Part I of the Act. US Tax Status of Single-Member LLCs We understand that single-member LLCs are disregarded entities for US tax purposes and are therefore not required to compute their income or profit under US tax law. 2 Since single-member LLCs are not required to calculate their earnings under US tax law, it follows that such LLCs are required to compute their earnings under Regulation 5907(1)(a)(iii). 1 CRA Document No (October 23, 1995). 2 Readers should consult with US counsel with respect to US law.

3 3 CRA Audit Position In response to a recent audit query, the CRA has stated that the earnings of a single-member LLC resident in and carrying on business in the US should be computed under Regulation 5907(1) (a)(i). The CRA s basis for this position is that the income of the single-member LLC is required to be computed under US tax laws for the purposes of determining its member s taxable income for US tax purposes and, as such, the earnings of the LLC should also be computed in accordance with US tax laws. The CRA further stated that the intention of Regulation 5907(1)(a)(i) is to alleviate the need to completely re-compute the earnings from an active business of a foreign affiliate in accordance with Part I of the Act where its earnings from the business have already been computed under the tax laws of another country. The foregoing position appears to be inconsistent with a textual, contextual and purposive interpretation of Regulation 5907(1). From a textual perspective, the definition of earnings is unambiguous in its application; each foreign affiliate of a Canadian resident taxpayer is required to compute its income or profit under prescribed rules, depending on the application of foreign income tax laws to that particular foreign affiliate. From a contextual perspective, the Act clearly treats each taxpayer separately. Even a partnership, which is not subject to tax (other than a specified investment flow-through partnership), is required by subsection 96(1) of the Act to compute its income as if the partnership were a separate person. There are no provisions in the Act that require or entitle a taxpayer to disregard an entity when computing the taxpayer s earnings or profit. Further, under Canadian tax law, each foreign affiliate determines its surplus accounts on an unconsolidated basis. Issues sometimes arise where a group of foreign affiliates determine their foreign tax liability on a consolidated basis, such as a group of foreign affiliates resident in and carrying on business in the US. In these circumstances, Regulation 5907(1.1) specifically provides for adjustments to the surplus balance of each member of a group of foreign affiliates where the liability for income or profits tax is computed on a consolidated basis and one of the foreign affiliates is responsible for paying, or claiming a refund of, tax on behalf of a group member. For example, if the total tax liability of the consolidated group has been paid by a single foreign affiliate without any tax-sharing payments being made, Regulation 5907(1.1)(a) adjusts the surplus balance of the foreign affiliate that pays the tax or receives a refund of tax only. If a member of the consolidated group makes a taxsharing payment to the paying foreign affiliate, Regulation 5907(1.1)(b) adjusts the surplus balances of all members. Regulation 5907(1.1) expressly recognizes that each foreign affiliate is to be treated as a distinct legal entity for purposes of computing its surplus accounts (which are based on its earnings ) even where it is a member of a consolidated group for foreign tax purposes. This rule would not be necessary for a single-member LLC if its business earnings could be attributable to its member. From a purposive perspective, the definition of earnings contained in Regulation 5907(1) appears to provide a clear starting point for each foreign affiliate in computing its earnings that are relevant in computing its surplus accounts. This purpose is served by providing a default set of rules under which each foreign affiliate must calculate its earnings where that foreign affiliate is not required to compute its income under the income tax laws of the jurisdiction in which it is resident, or in which it carries on its active business. In all circumstances a foreign affiliate can compute its income with certainty.

4 4 Lastly, the CRA s audit position also appears to be inconsistent with longstanding CRA assessing practices that do not disregard the existence of single-member LLCs. For example, before the adoption of the Fifth Protocol to the Canada US Tax Convention, the CRA denied treaty benefits to an LLC on the basis that the LLC was not liable to tax in the US, yet because of the LLC s separate legal personality, the LLC s member was not treated as having carried on the LLC s business and could not claim treaty benefits on a flow-through basis. 3 The CRA has also commented on whether US tax paid by a US foreign affiliate, where that foreign affiliate was the single member of an LLC that earns foreign accrual property income, would be foreign accrual tax and underlying foreign tax. Specifically, the CRA stated: 1. the foreign accrual tax deduction will be allowed under subsection 91(4) of the Act in the year in which the LLC pays the dividend to its single member, being the US foreign affiliate; and 2. the tax is considered underlying foreign tax in the year in which dividends are paid by the LLC. 4 Similar CRA administrative positions exist in relation to the direct holding of an LLC by a Canadian company. 5 3 CRA Document Nos (November 14, 1997) and E5 (January 8, 2004). 4 CRA Document No (November 27, 1998). 5 CRA Document No (March 10, 1998).

5 5 Anti-Discrimination and the Canada-UK Tax Treaty By Lindsay Hollinger Saipem UK Limited v. the Queen 1 is the first Canadian case wherein the Tax Court of Canada has decided with respect to the anti-discrimination provisions contained in a Canadian tax convention, being Article 22 of the Convention Between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland 2 (Treaty). The Facts In Saipem, Saipem UK Limited (the Appellant) and a related corporation, Saipem Energy International Limited (SEI), were both incorporated in the United Kingdom (UK) and non-residents of Canada. SEI carried on business in Canada during its taxation years through a permanent establishment. In the course of carrying on its business, SEI incurred $7,033,957 in non-capital losses. On November 21, 2003, the Appellant s board of directors decided to purchase all outstanding SEI shares and to wind it up. On December 16, 2003, all of SEI s shares were transferred to the Appellant, and on October 13, 2006, SEI was wound up and struck off the register of the UK Companies House. The Appellant also carried on business in Canada through a permanent establishment in 2004, 2005 and For those taxation years, the Appellant deducted SEI s losses in the amounts of $592,697, $839,799 and $5,601,461, respectively, in the course of computing its taxable income in Canada. The Minister of National Revenue (MNR) reassessed the Appellant in respect of its taxation years and denied its deduction of SEI s losses. The MNR held that neither the Appellant nor SEI were Canadian corporations as defined in subsection 89(1) of the Income Tax Act (Canada) 3 (Act) and as required by subsection 88(1.1) of the Act. Background Subsection 88(1.1) of the Act permits a parent corporation to use the non-capital losses of a subsidiary corporation that has been dissolved where the parent owned at least 90 per cent of the subsidiary s issued shares immediately prior to the wind-up. However, subsection 88(1.1) of the Act only applies where, among other things, the parent and subsidiary are Canadian Corporations. The term Canadian corporation is defined in subsection 89(1) of the Act as a corporation that is at a given time resident in Canada at that time, and was either incorporated in Canada or has been resident in Canada throughout the period that began on June 18, 1971 and that ends at that time. The Appellant s Position The Appellant argued that the MNR s denial of its deduction of SEI s losses was contrary to Article 22(1) of the Treaty, which provides: The nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances are or may be subjected. (Emphasis added.) CarswellNat 32, 2011 TCC 25 (TCC) (Saipem). 2 Convention Between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland, September 8, 1978 (amended by the Protocols signed on April 15, 1980 and October 16, 1985) , c. 1 (5th Supp.).

6 6 Specifically, the Appellant s principal arguments included that the residency and incorporation requirements in subsection 89(1) of the Act mean that only nationals of Canada could benefit from the provisions of subsection 88(1.1) of the Act. The Appellant also argued that the phrase in the same circumstances as contained in Article 22(1) of the Treaty does not contemplate residency such that the Appellant and a Canadian corporation carrying on a similar business are in the same circumstances, even though one is a resident and one is not. The Appellant also argued that based on Article 22(2) of the Treaty, which reads in part the taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities, non-resident enterprises benefit from Sections 111 and 115 of the Act and pursuant to Article 22(2) of the Treaty should benefit from subsection 88(1.1) of the Act. Analysis Given the lack of Canadian decisions with respect to anti-discrimination provisions in Canadian tax treaties, the court considered a New Zealand decision where the New Zealand Court of Appeal was asked to interpret a similarly worded anti-discrimination provision. In that case, the New Zealand Court of Appeal concluded that discrimination on the basis of residence does not amount to discrimination on the basis of nationality for the purpose of the anti-discrimination provision in the Double Taxation Relief Agreement between the UK and New Zealand, 4 which is worded similarly to Article 22 of the Treaty. The court considered the Appellant s first argument with respect to the application of Article 22(1) of the Treaty and concluded that paragraph (a) of the definition of Canadian corporation imposes a nationality requirement, but paragraph (b) does not. Specifically, subsections 250(4) and 250(5) provide that a corporation that was not incorporated in Canada can be a resident of Canada and a corporation that was incorporated in Canada can be deemed not to be a resident of Canada. Thus, qualifying as a Canadian corporation for purposes of subsection 88(1.1) of the Act is not dependent on a corporation s nationality. In response to the Appellant s second argument that the phrase in the same circumstances does not contemplate residency, the court held that residence is relevant to establish if parties are in the same circumstances. The court found that for purposes of Article 22(1) of the Treaty, the proper comparison would be between the Appellant and a Canadian national who was not resident in Canada and who dissolved a subsidiary corporation. Based on this comparison, Article 22(1) of the Treaty does not apply since a comparable Canadian national who is not resident in Canada would not qualify as a Canadian corporation and would not benefit from subsection 88(1.1) of the Act. Lastly, in accordance with the commentary to the OECD Model Convention and Article 7 of the Treaty (Business Profits), the court found that permanent establishments may carry forward or carry back a loss only where the loss is from its own business activities. Since the Appellant was seeking to deduct a loss that did not result from its permanent establishment, such a deduction was not permitted under Article 7 of the Treaty. Consequently, the court concluded that the MNR s denial of the Appellant s deduction of SEI s losses did not violate Article 22(2) of the Treaty. 4 Double Taxation Relief Agreement between the UK and New Zealand, November 4, 2003, (entered into force July 23, 2004).

7 7 Commentary As previously noted, this is the first Canadian decision on an anti-discrimination article in a Canadian tax treaty, which is somewhat remarkable given the fact that most of Canada s tax treaties contain anti-discrimination provisions. This case follows the Supreme Court of Canada s decision in Crown Forest Industries Ltd. v. R 5 and the Federal Court of Appeal s decision in Prévost Car Inc. v. R. 6 in that the court made liberal use of the commentary to the OECD Model Convention as an aid in interpreting a Canadian tax treaty. Although not surprising, this decision also confirms that residency is key in determining if a corporation is a Canadian corporation, not nationality. Lastly, and most noteworthily, the decision in Saipem also confirms that a distinction based on a taxpayer s residence is not discriminatory under Article 22 of the Treaty CarswellNat 384, [1995] 2 C.T.C. 64, 95 D.T.C. 5389, 125 D.L.R. (4th) 485, [1995] 2 S.C.R. 802, 183 N.R. 124, 97 F.T.R. 159 (SCC) rev d Crown Forest Industries Ltd. v. Canada, 1993 CarswellNat 1181, [1994] 1 C.T.C. 174, 94 D.T.C. 6107, 164 N.R. 222, 74 F.T.R. 270 (FCA) aff d Crown Forest Industries Ltd. v. R., 1992 CarswellNat 297, [1992] 2 C.T.C. 1, 53 F.T.R. 291, 92 D.T.C (Fed. Ct Tr. Div) CarswellNat 480, 2009 FCA 57, 2009 D.T.C (Eng.), [2009] 3 C.T.C. 160, 387 N.R. 161, [2010] 2 F.C.R. 65 (FCA) aff d Prévost Car Inc. v. R., 2008 CarswellNat 1114, 2008 TCC 231, 2008 D.T.C (Eng.), [2008] 5 C.T.C (TCC). Key Contacts in Our Tax Group National Practice Group Leader and Ontario Regional Contact Douglas Cannon dcannon@ British Columbia Regional Contact Rosemarie Wertschek, QC rwertschek@ Alberta Regional Contact Doug S. Ewens, QC dewens@ Québec Regional Contact Frédéric Harvey fharvey@