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

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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 2010-2011 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 non-abusive and non-abusive use of hybrids

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•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

02010-2011 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

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I: INTR(~DUCTlON ,

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• 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") 02010-2011 Cassels Brock 5 M1~~ <<4 ^ . "Lr~~ .. .Y.~- ;~. T . ~QUCTIQN.. :. - .:: a,

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• 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")

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• 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

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• 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

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~~i. ~INTR~DUCT(ON

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• 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

• 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

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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

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i4 HYBRID RULE =K ~ ~~`~~~ ~ _{~~~ ~, ,} ~`~'~ ~ ~~

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• 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

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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 2009-031849117)

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::1 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 2010-2071 Cassels Brack ~'~

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~` II. HYBRID RULE

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CRA addressed "same treatment" test at length in CRA document 2009-031849117. 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)

02010.2011 Cassels Brock 75

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Example ~ - Article IV~~Applyinq to r ~;~

i;Provide Treaty Benefiits ~::. f .~.,` ~ ~'~~~q~[ ,

£je_

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 _CanCO

• consequently, U.S. Co. is not a FTE

entitled to claim Treaty benefits

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-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 02010-2071 Cassels Brock U:S. CO. 50% Resident of a Third Country or even Canada: 50% LLC-FTE license loan Cai'1C0 not a FTE

• 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

U LC FTE

•CRA will consider that an amount has been derived under U.S. tax law if the amount is not disregarded but treated differently if the ULC is not a FTE

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~'~~ 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}

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Example 5 = Branch Tax E `xy~

.~CRA Document 209 — 033995` ~~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 2010-0355661 E5 02010-2011 Cassels Brock 19 U.S. Corporation LLC _FTE Carrying on business in Canada 20

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Example 6 ,,' - - 1

Branch Tax ~~T _{T ~~=s-:} _,,.

~'~CRA D:~~,ument 2~Q:~,9 — 0339951 E5~ • CRA confirms S Corp is

treated as a resident of the U.S. for purposes of

the Treaty _S_Corp

• branch tax benefits apply to the S corp

Carrying on business in Canada

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.EXclt11~~~' 7

Branch Tax

• U.S. Co. is entitled to branch tax benefits • also see CRA Document

2008-0272871 C6 regarding a U.S.

partnership checking the box to be treated as a corporation X2010-2011 Cassels Brock U.S. Co. Subco u:s:

aa~,e~sn~P . Elects under U.S. tax to be treated as a core

Carry on business in Canada

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~-• 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

X2010-2071 Cassels Brock ,~,`1~ , a "~.k f ' ,~ _{s~ '~, ~j~~ ~sY 3t ~ ~ '~} ~~~" U.S. individual Carrying on Business in Canada

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

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• 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

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

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Ill. ANTI-HYBRID RULES J

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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

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 2009-031849117)

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111. Af~TI-HYBRID RULES

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Sale of ULC Shares by a U.S. Holdco • however, CRA states that if U.S. Co.

transferred shares to another ULC and

212.1 applied to create a deemed dividend, Article IV(7)(b) could apply

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I~1. ANTI-HYBRID RULES ~. ,.~ N`

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 2009-0346291 E5 for additional comments

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Example 9

.Dividends Paid to a S Corp

~CRA Document 2009-0319481 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

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• 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

m 2010-2011 Cassels Brock r_ ~~~~~~~ . S Corp dividend ULC FTE 31 ~, U.S. LP holder royalty ULC FTE 32 16

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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)

02010.2011 Cassels Brock

(~. 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

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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

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!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 2009-0343641 R3)

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IV.' PLANNING TECHNIQUES

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• 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)

X2010-2011 Cassels Brock

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"~{V. PLANNING TECHNIQUES

• also Article IV(6) permits a U.S. person to obtain Treaty benefits when its investment is held through aU.S. and

non-Canadian entity, provided that the entity is a FTE for U.S. tax purposes

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• the TE gives the example of a U.S. resident owning a French entity that earned

Canadian-source dividends

X2010-2017 Cassels Brock

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IV. PLt~NNING TECHNIQUES

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• 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

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-~ iV. PLAN(VING TECHNIQUES

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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 2009-0348581 R3, 2009-0350471 R3, 2009-0350921 R3 and 2009-0341681 R3)

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

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lV.. PLANNING TECHNIQUES `''~~ :+

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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 2010.2011 Cassels Brock

ail. PLANNING TECHNIQUES

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• 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

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• RoundTable and Ruling did not expressly address Article IV(6)

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(V. 4~LANN1~1~ TECHNIQUES

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• 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 2009 — 0345351 C6)

• therefore, Article IV(6) would not apply and this two-step approach will not be effective

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f~l. PLANNING TECHNIQUES ~.

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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 2010-2017 Cassels Brock 4~

Example ~ ~ — Grandparent A~~

:~CRA Document 201 ~ - 03721 ~

• 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

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Example 12 - Affiliate Making the Loan _~;,; (GRA Document 209-0348581 R3 (also see

2009-0348091 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 02010.2011 Cassels Brock U.S. Co. U.S. Subco %~ royalty,%~ " FTE .~ ULC ..:,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

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-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

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• CRA has considered this approach on numerous occasions

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Example 13 - ULC Strucfiured as a Partnership '~~ Services !V(7)(b}

~CRA Document 2009-0345901 R3~

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• U.S. treatment of U.S. Individuals

fee in terms of goo

quantum, timing and — --S Corp

X% character of fee is the

same as it would be if

ULC was not a FTE not a FTE

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• CRA ruled Article PartnershipA IV(7)(b) was not

applicable X% Partnership B not a FTE Services (pertormed Outside Canada) ULC FTE 02010-2017 Cassels Brock • 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

OO 2010-2011 Cassels Brock ;'::U.S. Co. roan US Sub . 90% 10% IJLC FTE 53 27

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~.~y ONTARIO . ~~t~^ BAR ASSOCIATION

t.n'r:m<:h at d+e ~~` fanadi~~n Bar A+scr.:is;'u.

Ken Snider Phone: (416) 860-2947 Email: [email protected]

www.casselsbrock.com

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2700 Scotia Plaia; 40 King Street West, Toronto, Canada MSH 3C2 Phone 416 869 5300