Canada-U.S. Cross-Border Structures and the Anti-Hybrid Rules

Transcription

1 O~~TARIO. ~ BAR ASSOCIl~TION 4 3.rnch c! tl:,. Conadian Ba~A sa..iai::::; Ken Snider Canada-U.S. Cross-Border Structures and the Anti-Hybrid Rules Taxation Law Spring Cleaning: A Potpourri of Leading Tax Topics April 14, 2011 OO Cassels Brock Article IV(6) and IV(7) of the Canada-U.S. Tax Convention (the "Treaty) are very puzzling and difficult provisions widely acknowledged that provisions were overreaching and had many unintended consequences provisions do not distinguish between nonabusive and abusive use of hybrids Cassels Brock 1

2 '1i ~: ~ Article IV(6) (the "Hybrid Rule") was the relief to deal with the longstanding problem of U.S. LLCs not enjoying Treaty protection Article IV(7)(a) addresses an entity that is fiscally transparent in the source country, not resident in the residence country, and is not treated as fiscally transparent in the residence country Cassels Bwck a Canadian example would be a partnership created under the laws of Canada but treated as a corporation for U.S. tax purposes Cassels Brack II

3 I: INTR(~DUCTlON, -~, Article IV 7(b) addresses an entity that is resident in the source country but treated as fiscally transparent under the laws of the residence country. The only Canadian hybrid is an unlimited liability company ("U LC") +R Cassels Brock 5 M1~~ <<4 ^. "Lr~~...Y.~- ;~. T. ~QUCTIQN.. :. -.:: ~t s~_,~ V: ~.,. a,.?,.,:., CRA has provided substantial administrative guidance which condones certain self-help strategies but which are consistent with the policy objectives of preventing certain tax arbitrage transactions involving fiscally transparent entities (a "FTE") D Cassels Brock 6 3

4 - ~ + "a _.,, r ~~ y. ~.'....''.M1. ':.a:. t.':..' - ~ ~ Lyt Unfortunately there remains many traps. Use of LLCs, S corporations and partnerships are far from neutral in respect to Canada inbound investment and LLCs continue to be problematic in common situations these provisions require us to approach structuring Canada/U.S. cross-border transactions from a new perspective Cassels Brock 7 in the context of Canadian inbound transactions, we must consider: (a) the legal and tax status of: payor (e.g. ULC (FTE or not a FTE)) the recipient (e.g. LLC (FTE or not a FTE), a partnership, a S corporation), members or shareholders of the recipient, and (b) the types of income (e.g. interest, dividends, royalties, business income, capital gains) that are relevant in the circumstances Cassels Brock n

5 ~~i. ~INTR~DUCT(ON if the hybrid and anti-hybrid rules in Article IV(7) do not preclude Treaty benefits, it is necessary to then consider whether the person in the residence country claiming the benefits will satisfy the LOB provision in respect of the particular Treaty benefit sought this presentation assumes that the U.S. person satisfies the LOB provision in respect of the benefit sought Cassels Brock t <:4 this presentation will first briefly review the scope of the hybrid and anti-hybrid rules in the context of Canada inbound transactions, and review examples of Canada inbound structures that either facilitate or result in the loss of Treaty benefits Cassels Brock,o 5

6 11. HYBRID RULE. a Article IV(6) an amount of income, profit or gain shall be considered to be derived by a resident of the U.S. when the amount is considered under U.S. tax laws to be derived through an entity that is not a resident of Canada; and Cassels Brock 11 i4 HYBRID RULE =K ~ ~~`~~~ ~ ~`~'~ ~ ~~ ~~~ ~,, ~' `u'~ by reason of that entity being considered fiscally transparent under U.S. tax law, the treatment of that amount under U.S. tax laws is the same as its treatment would be if that amount was derived directly by that person Observations while article IV(6) is generally considered a helpful rule it can also operate to deny Treaty benefits Cassels Brock m

7 I{. HYBRID RULE compare the treatment of the amount in the actual situation and in a hypothetical situation if the entity was not used; if it is different, this provision will deny benefits the question of what constitutes "same treatment" is discussed in TE, and in various CRA documents (see CRA Document ) Cassels Brock ~~, : ::1.i.: HYB ID RULE:7~ _~'' TE provides IRS will use section 894 of the Code the test involves an analysis of the timing of the receipt, character and source of the amount under the tax laws of the country of residence of the recipient OO Cassels Brack ~'~ 7

8 ~` II. HYBRID RULE ~; ',,,.:~~, CRA addressed "same treatment" test at length in CRA document CRA put less emphasis on "source" and introduced the test of "quantum" understanding CRA's views on this test is key to understand what planning works and what does not work (subject to GAAR) Cassels Brock 75 v ~, Example ~ - Article IV~~Applyinq to r ~;~ i;provide Treaty Benefiits ~::. f.~.,` ~ ~'~~~q~[, Types of Payments by Canco U.S. Co. 1. dividends 2. royalties 3. interest treatment of all these amounts LLC:. FTE to U.S. Co. are the same, in terms of quantum, character and timing whether or not they license loan are derived directly by U.S. Co. or through the U.S. LLC consequently, U.S. Co. is CanCO not a FTE entitled to claim Treaty benefits je_ m Cassels Brock E1]

9 -Example 2 - Article iv(k Partiall ~'_ `. same as in Example 1 but there is a LLC member not entitled to any Treaty benefits consequently the LLC is subject to Canadian withholding tax rates on the share that is not derived by U.S. Co. using an LP provides a different result as the resident of a third country may have been entitled to the benefits under a different tax treaty with Canada U:S. CO. 50% license LLC- Cai'1C0 Resident of a Third Country or even Canada: FTE loan 50% not a FTE Cassels Brock not recognized as interest or dividend of any of the members of the LLC - they include their share of the earnings of LLC FTE the ULC Article IV(6) does not treat the amount as "derived" by the members ~, ~, no Treaty benefits if amount is disregarded deemed for U.S. tax purposes interest ; dividenc this also applies where there is deemed interest CRA will not accept a claim for Treaty benefits to the event it relates to a disregarded amount paid or credited after 2009 CRA will consider that an amount has been U LC FTE derived under U.S. tax law if the amount is not disregarded but treated differently if the ULC is not a FTE Cassels Brock

10 i,_ :, ~'~~ xample 4 `-- `Dividend to a LLC CRA ruled 5% rate applies Article IV(6) applies so dividends are considered to be derived by the S corporation S Corp LLC FTE dividend Cat9C0 not a FTE Cassels Brock 19 T Example 5 = Branch Tax E `xy~.~cra Document ` ~~E5) ;' branch tax benefits only available if it is considered to be derived under Article IV(6) by a U.S. corporation also see CRA Document E5 U.S. Corporation LLC FTE Carrying on business in Canada Cassels Brock 20

11 Example 6,,' Branch Tax ~~T T ~~=s- :,,. ~'~CRA D:~~,ument 2~Q:~, E5~ i `r CRA confirms S Corp is treated as a resident of the U.S. for purposes of the Treaty branch tax benefits apply to the S corp S Corp Carrying on business in Canada m21h Cassels Brock 21.EXclt11~~~' 7 Branch Tax U.S. Co. is entitled to branch tax benefits also see CRA Document C6 regarding a U.S. partnership checking the box to be treated as a corporation U.S. Co. u:s: aa~,e~sn~p. Subco Elects under U.S. tax to be treated as a core Carry on business in Canada X Cassels Brock 11

12 i'~~~y~l ~~~ ~~.a~. il ~~ e Mo ~-,~,`1~, a "~.k ' f,~ s~ '~, ~j~~ ~sy 3t ~ ~ '~ ~~~" CRA applies Article IV(6) reduces branch tax to 5% for U.S. corporation exempts the U.S. tax exempt from tax no branch tax relief for the LLC in respect of the Bermudian corporation or the U.S. individual U.S. individual X Cassels Brock Carrying on Business in Canada 23 Article IV (7~(b) Receiving an Amount from a Hybrid Entity ~~~ An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of the U.S. where the U.S. person is considered under Canadian tax law to have received an amount from a Canadian resident entity the Canadian resident entity is treated as a FTE under U.S. tax law, and Cassels Brock 12

13 by reason of the U.S. tax treatment of the Canadian resident entity as an FTE, the treatment of the amount under U.S. tax law is not the same as its treatment would be if the entity were not treated as a FTE under U.S. tax law Cassels Brock Observations compare the U.S. tax treatment of the amount in the actual situation with the U.S. tax treatment if the entity were not treated as an FTE under U.S. tax law if it is different this provision will deny benefits same "treatment" test is discussed in TE and various CRA documents Cassels Brock 26 13

14 ~. ~~~ Ill. ANTI-HYBRID RULES J., Sale of ULC Shares by a U.S. Holdco assume U.S. Co. sells shares of ULC that are TCP but do not derive their value principally from Canadian real property at the time of sale consequently, U.S. Co. wishes to claim Treaty protection Cassels Brock 27 III. ANTI-HYBRID RULES Sale of ULC Shares by a U.S. Holdco U.S. Co. is considered to sell assets for U.S. tax purposes so there is potential differences in character and quantum of gain CRA states Article IV(7)(b) does not apply because gain is not derived from proceeds received from the ULC (see CRA Document ) OO Cassels Brock ~~ 14

15 . ~ Af~TI-HYBRID RULES Sale of ULC Shares by a U.S. Holdco however, CRA states that if U.S. Co. transferred shares to another ULC and applied to create a deemed dividend, Article IV(7)(b) could apply D Cassels BrocK 29 I~1. ANTI-HYBRID RULES ~..~, N` d Sale of ULC Shares by a U.S. Holdco if shares of ULC are redeemed Article IV(7)(b) could apply to deemed dividends and capital gain as it is received from a FTE see CRA Document E5 for additional comments Cassels Brock 15

16 Example 9.Dividends Paid to a S Corp ~CRA Document E~ S Corp and ULC are FTE for U.S. tax purposes U.S. tax treatment of the dividend was not the same in this situation and the hypothetical of the ULC not being FTE dividend disregarded if ULC 100% is a FTE and the dividend would be taxed as a distribution if the ULC was not a FTE also, CRA commented that the dividend was not considered to be derived by a U.S. resident under Article IV(6) because ULC is a FTE as a result, the rate of withholding tax is 25% of the amount of the dividend ~~~~~~~. S Corp ULC dividend FTE Cassels Brock 31 ~'11~~ J r_ licence fee not subject to Article IV(7)(b) ULC is disregarded and consequently for U.S. purposes it is considered to be paid by a U.S. person no difference in quantum, character, timing or geographic source of royalties to LP holder if ULC were not a FTE ULC FTE royalty ~, U.S. LP holder m Cassels Brock 32 16

17 IV. PLANNING TECHNIQUES The following are planning alternatives A. U.S. Person Carries on Business in Canada or Through a Partnership (which is a FTEI avoids the potential issues of using a ULC necessary to confirm that there are Treaty benefits for branch tax (and interest if paid to a related party) Cassels Brock J (~. F~'Ll'~(~NING TECHNIQUES if the U.S. person is a C corp or an S corporation, there will not be a problem under the Anti-Hybrid Rule Cassels Brock 34 ' J 17

18 1V. PLANNING TECHNIQUES,.~: if the U.S. person is an LLC, alook-through approach is adopted but if any member is not a U.S. corp or a U.S. tax exempt, the LLC will pay branch tax of 25% on the remaining share (see example 7). Consider using a LP this approach carries the standard disadvantages of using a branch rather than a Canadian subsidiary Cassels Brock _..!1/. ~~'L~1~N1NG TECHNIQUES..;~ B. "Blocker" Corporation if using an ULC is very important from a U.S. tax perspective (e.g. U.S. foreign tax credit planning) and there are no other satisfactory alternatives, consider a corporate "blocker" in a third jurisdiction (e.g. Luxembourg) so that benefits are claimed under a different tax treaty CRA has ruled favourably (see CRA Document R3) Cassels Brock 36

19 IV.' PLANNING TECHNIQUES "3!~ _. f the "blocker" would be a FTE under U.S. tax I aw blockers may serve other purposes even if there is not a problem under Article IV(6) and (7) (e.g. better capital gains protection under the tax treaty between Canada and the third country, avoiding tax compliance obligations for a multitude of equity fund partners, avoiding a LOB problem) X Cassels Brock _ "~{V.,~. PLANNING TECHNIQUES also Article IV(6) permits a U.S. person to obtain Treaty benefits when its investment is held through anon-u.s. and non- Canadian entity, provided that the entity is a FTE for U.S. tax purposes Cassels Brock 19

20 IV. PLANNING TECHNIQUES ~n the TE gives the example of a U.S. resident owning a French entity that earned Canadian-source dividends X Cassels Brock ~, ~ ~{ '... IV. PLt~NNING TECHNIQUES ', if the French entity is fiscally transparent in the United States, then, regardless of its treatment under Canadian or French law, the U.S. resident will be considered to derive the Canadian dividends directly for the purposes of the Treaty this will override the 15% withholding tax rate in the Canada-French tax treaty Cassels Brock LSJ

21 '~ -~ iv. PLAN(VING TECHNIQUES =:: `a ~~;. f.... C. Increase in PUC and Distribute Capital - "Same Treatment" Approach at the 2009 Roundtable CRA outlined various ways to avoid the loss of Treaty benefits there were subsequent tax rulings (see CRA Documents R3, R3, R3 and R3) Cassels Brock IV. PLANNING TECHNIQUES PUC Increase the CRA has approved the following technique for avoiding Article IV(7)(b) from applying the ULC increases its paid-up capital (PUC), and later pays a distribution to its shareholder as a return of capital ~ Cassels Brock 21

22 lv.. PLANNING TECHNIQUES `''~~ M r p,.::. :+,Y~.:....,. PUC Increase the PUC increase results in a deemed dividend for Canadian tax purposes but is ignored from a U.S. tax perspective regardless of the treatment of the ULC for U.S. tax purposes _ OO Cassels Brock ail. PLANNING TECHNIQUES _,~~ no Canadian withholding tax applies on the subsequent return of PUC the CRA has ruled that because the U.S. tax treatment of the deemed dividend resulting from the PUC increase is the same regardless of whether the ULC is fiscally transparent or not, Article IV(7)(b) will not apply to deny the treaty-reduced rate (5 percent) of Canadian withholding tax on the deemed dividend Cassels 9rock 4~ 22

23 IV. PLANNING TECHNIQUES RoundTable and Ruling did not expressly address Article IV(6) D Cassels Brock (V. 4~LANN1~1~ TECHNIQUES i..t~~t even if Article IV(7)(b) does not apply to the deemed dividend resulting from the PUC increase, the CRA appears to consider that a U.S. treaty resident has not derived the deemed dividend in circumstances when the dividend "recipient" is an LLC (see CRA Document C6) therefore, Article IV(6) would not apply and this two-step approach will not be effective Cassels Brock '6 23

24 .. _. i:~s,~ f~l. PLANNING TECHNIQUES ~. D. Grandparent (or Affiliate) Approach a very practical solution in many cases to avoid the Anti-Hybrid Rule is for the payment (e.g. interest, royalties) to be made by the ULC to the U.S. parent of the direct U.S. shareholder (or a subsidiary) the treatment of the payment is the same as it would have been had the ULC not been a FTE m Cassels Brock 4~ Example ~ ~ Grandparent A~~ :~CRA Document 201 ~ ~ interest on debt would be treated as income in same manner if it were not fiscally transparent (this would not have been the case had U.S. Holdco made the loan) Article IV(7)(b) not applicable Cassels Brock 24

25 Example 12 - Affiliate Making the Loan ~;,; (GRA Document R3 (also see R3~R~alties and Intet~st S~ CRA ruled Article IV(7)(b) did not apply to interest and royalties paid to U.S. Subco as the amounts would be subject to the same treatment under U.S. tax law as it would be if ULC was not a FTE the geographic source of interest and the royalty would either be the same as it would be if the ULC were not fiscally transparent or would not be relevant CRA ruled that GAAR does not apply U.S. Co. ULC U.S. Subco %~ royalty,%~ " FTE.~ Cassels Brock..:,j 1\!: PLANNfNG TECHNIQUES E. Structurina the ULC as a Partnership for U.S. Tax Purposes TE states that if the U LC is treated as a partnership for U.S. tax purposes rather than as a disregarded entity, Article IV(7)(b) would apply to a dividend Cassels Brock 25

26 i.r _ ~ - IV. PLANNING TECHNIQUES 1~ ~' `~' it does not expressly address whether the payment of a tax deductible amount such as interest or a royalty would result in the same U.S. tax treatment if the ULC was not a FTE however, U.S. Joint Committee on Taxation noted that certain payments by a ULC with more than 1 member would retain their character for U.S. tax purposes Cassels Brock kfws»l- :'a.i~n ~;~~~:. Pi An~r~in~r-rFr.Nrv~n~ i~~.~ CRA has considered this approach on numerous occasions CaSSels Brock

27 Example 13 - ULC Strucfiured as a Partnership '~~ Services!V(7)(b} ~CRA Document R3~. _,~ U.S. Individuals goo U.S. treatment of fee in terms of quantum, timing and -- X% character of fee is the S Corp same as it would be if ULC was not a FTE )(% CRA ruled Article IV(7)(b) was not applicable X% Partnership B not a FTE Partnership A not a FTE Services (pertormed Outside Canada) ULC FTE Cassels Brock 53 interest for U.S. tax purposes ULC is a FTE "partners" are allocated income and'expense for U.S. tax purposes and are netted for U.S. tax purposes each is considered to have an interest expense U.S. Co. is treated as having interest income if not an FTE, U.S. Co. has interest income but not considered to have incurred interest expense Article IV(7)(b) does not apply ;'::U.S. Co. roan IJLC 90% US Sub. FTE 10% OO Cassels Brock 27

28 ~.~y. ~~t~^ ~~` ONTARIO BAR ASSOCIATION t.n'r:m<:h at d+e fanadi~~n Bar A+scr.:is;'u. Ken Snider Phone: (416) ~,, 2700 Scotia Plaia; 40 King Street West, Toronto, Canada MSH 3C2 Phone Cassels Brock 8 Blackwell CLP. Cassels Brock antl Ike CB logo are re9lstered lratle-marks of Cassels Brock &Blackwell LLP. All fights reserved.