For many years, the US-Canada Income tax treaty (the “Treaty”) did not grant treaty benefits to US Limited Liability Companies (“US LLCs”) because, in the view of the Canadian government, LLCs were not US tax residents since they are typically exempt from US tax1. In the Fifth Protocol to the Treaty, the US and Canadian governments granted treaty benefits to US LLCs2. However, one of the provisions of the Treaty unexpectedly eliminated treaty benefits for US LLCs that invest in Canadian unlimited liability companies (“Canadian ULCs”). As a result, taxpayers should consider alternative investment structures if a US LLC must be used to hold a Canadian investment.
Under the Treaty, US tax residents may claim a variety of benefits with respect to income otherwise subject to tax in Canada, including reduced rates of withholding and elimination of tax on income not connected with a Canadian permanent establishment. Such benefits are available to persons that qualify as residents under Article IV of the Treaty. Generally speaking, a US company that is subject to US tax on its income is a resident for purposes of Article IV. However, Paragraph 6 of Article IV provides special rules for determining when an item of income is derived by a US resident that earns that item of income through a fiscally transparent entity, e.g. a US LLC3. Under this paragraph an item of Canadian source income paid to a US entity that is fiscally transparent will be treated as derived by a US person that is an owner of the transparent entity if that person is treated as (1) earning the income through the entity and (2) the treatment of the item by the US is the same as if the US person had earned the income directly. This provision would normally allow a US LLC to claim benefits under the Treaty with respect to Canadian source income attributable to its US tax resident owners.
However, if a fiscally transparent entity earns an item of income from a Canadian ULC, Paragraph 7(b) of
Article IV of the Treaty adds another requirement that taxpayers must satisfy to receive Treaty benefits with respect to the income. Specifically, Paragraph 7(b) provides that such income is not derived by a resident of a Contracting State where:
The person is considered under the taxation of the law of [the source] State to have received the amount from an entity that is a resident of the other State, but by reason of the entity being treated as fiscally transparent under the laws of the [residence] State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State.
Thus, while Paragraph 6 of Article IV of the Treaty allows fiscally transparent entities to claim Treaty benefits, Paragraph 7(b) may eliminate these benefits under certain conditions. For example, assume that a Canadian ULC, which the US disregards as a separate entity, pays a dividend to a US LLC owned entirely by US tax residents. Under Paragraph 6 of Article IV, the LLC could claim that the Treaty reduces the normal Canadian tax rate that applies to dividends paid to non-Canadian persons. However, under Paragraph 7(b), the US LLC could not claim the reduced Treaty rate because the ULC is treated as fiscally transparent under US law and the US income tax treatment of the dividend payment would differ if the ULC were not fiscally transparent for US tax purposes. Specifically, the US disregards a dividend payment made by a ULC because it is fiscally transparent but would treat the dividend payment as income received by the LLC.
This difference in treatment results in the loss of resident status with respect to the dividend and the LLC’s potential claim of Treaty benefits is extinguished. This position, espoused and articulated by the Canadian Revenue Authority (CRA), came as a surprise not only to the public but to the US government since it was clearly the intent of the US Treasury team negotiating the Fifth Protocol to grant Treaty benefits to US LLCs.
A possible solution approved by the CRA was the so-called “two-step distribution”.4
The two-step dividend distribution involves (1) increasing the paid up capital (“PUC”) of the Canadian ULC and (2) distributing assets equal in value to the amount of the PUC. The mechanics of the two-step dividend distribution are as follows:
- The Canadian ULC would convert surplus into an increase in the PUC of its outstanding shares. The increase in PUC would occur through a corporate resolution where the outstanding shares of the Canadian ULC would be increased by the ULCs income, net of the corporate level tax. From a Canadian tax perspective the increase in PUC would be treated as a deemed dividend and a taxable event. This deemed dividend would qualify for treaty relief from the US – Canada income tax treaty and the reduced treaty withholding rate would apply on this deemed dividend.5
- The second step is a distribution of assets upon a reduction of PUC by an amount equal to the PUC that was increased in Step 1. From a US tax perspective this is not a taxable event and the distribution would be completely disregarded.6
With the two-step distribution, Art IV (7)(b) would not apply to deny treaty benefits to the deemed dividend
that results from the increase in PUC because the tax treatment of this payment is the same regardless of
whether the Canadian ULC is treated as a corporation or a disregarded entity for US federal income tax purposes. More specifically, the deemed dividend resulting from the two-step distribution is disregarded
in both cases. As a result the provisions of Paragraph 7(b) do not apply.
Application of Two-Step Distribution by Canadian ULCs to US LLCs
Surprisingly, while the CRA has ruled that US S Corporations may use the two-step distribution process to claim Treaty benefits,7 the CRA has refused to allow US LLCs to utilise the technique to claim benefits.8
The basis for this decision defies the policy decision to grant Treaty benefits to US LLCs and is highly technical. Specifically, prior to the adoption of the Fifth Protocol, the CRA took the position that US LLCs are not entitled to treaty benefits because US LLCs are not tax resident in the US since they are not subject to US tax at an entity level. After enactment of the Fifth Protocol, the CRA still took the position (as they currently do) that US LLCs are not tax residents for purposes of the Treaty.
However, the CRA, recognised that US LLCs may be entitled to Treaty benefits under Paragraph 6 of Article
IV of the Treaty to the extent items of income paid to a US LLC are attributable to any members that are US tax residents. However, the CRA’s position is that in order for Paragraph 6 to apply, a US LLC must receive an “amount” of income for US tax purposes. But the US does not recognise the deemed dividend arising from the two-step distribution procedure, and therefore the US LLC does not receive an “amount” of income for US tax purposes. As a result, Paragraph 6 of Article IV does not apply and the US LLC fails to qualify as a resident for the purposes of the Treaty according to the CRA. Strangely, a US S Corporation may use the two-step
distribution process to avoid losing residence status under Paragraph 7 of Article IV because the CRA views S Corporations as US tax residents even though they are generally exempt from US tax. Thus, because an S Corporation need not rely on Paragraph 6 of Article IV to qualify as a US tax resident, its failure to
receive an “amount” of income as a result of the two-step distribution does not undermine its claim of
The CRA’s position regarding US LLCs has encouraged taxpayers to develop alternative ways for US LLCs to invest in Canada. A possible solution may be to interpose a holding company from a different jurisdiction between the Canadian ULC and the US LLC, such as a Dutch BV or a Luxembourg SARL. The Dutch BV and Luxembourg SARL are each treated as corporations for Canadian tax purposes but both may elect to be disregarded for US tax purposes. The use of non-US intervening entities would avoid the application of Article V of the Treaty to items of Canadian source income paid by a ULC. Instead such payments would be governed not by the US-Canada Income tax treaty but by any treaty in force between Canada and the country in which the intervening holding company is resident. For example, if a Luxembourg SARL were interposed between a US LLC and a Canadian ULC, the Canada-Luxembourg tax treaty would apply because the SARL is a resident of Luxembourg. Thus, dividends paid by the Canadian ULC would be taxed under the Canada -Luxembourg Treaty and not the USCanada treaty.10
Of course, the CRA could argue that the US-Canada Treaty should apply because the parties inserted the SARL to take advantage of the Canada-Luxembourg tax treaty. However, provided the SARL has substance, the CRA is unlikely to prevail because the Canada- Luxembourg treaty has no antitreaty shopping provisions.11
In fact, the CRA has lost a number of court cases where it has challenged similar Luxembourg-based structures
on treaty shopping grounds12 and, as a result, in November of 2013, the CRA issued a position paper in
which it stated that it will continue to challenge treaty shopping and may seek to address the issue through a
legislative solution. In summary, investing in Canada through a US LLC presents a number of technical issues under the USCanada tax treaty. Taxpayers should carefully plan any such investment and may need to consider an alternative investment structure in order to ensure the highest possible after-tax investment returns.