JanuaryFebruary 2008

Anti-Deferral and Anti-Tax Avoidance

By Peter Glicklich, Abraham Leitner and Jennifer MacDonald

U.S.-Canada Protocol Contains Novel Hybrid Entity Provisions

Introduction
After nearly 10 years of negotiations, the Fifth Protocol (the Protocol)1 to the 1980 Canada-U.S. Income Tax Treaty (the Treaty) was signed September 21, 2007, by Canadian Finance Minister, Jim Flaherty, and U.S. Treasury Secretary, Henry M. Paulson, Jr. The Protocol, which is viewed by Canada as modernizing the Treaty,2 generally brings the Treaty into closer conformity with the 2006 U.S. Model Treaty. It was anticipated that the Protocol would address the availability of treaty benets to U.S. and Canadian residents who hold interests in U.S. limited liability companies (LLCs), though there was little consensus about how and to what extent benets would be made available. While it is clear that the drafters of the Protocol intended to make treaty benets available to transactions involving certain hybrid entities, particularly U.S. LLCs, the provisions contained in the Protocol have provoked a restorm of controversy among U.S. and Canadian tax professionals who had been looking forward to some relief from the unfavorable treatment of hybrids in the existing Treaty. The provisions of the Protocol relating to hybrid entities and the ambiguity that they create are the subject of this column.

Overview
Peter Glicklich and Abraham Leitner are Partners and Jennifer MacDonald is an Associate in the New York ofce of Davies Ward Phillips & Vineberg LLP.

In this column, the term hybrid will be used in the conventional sense that the term is generally used by U.S. practitioners to describe entities that are treated

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as ow-through entities under the tax laws of their situations, such as the treatment of S corporations. country of residence and are treated as corporations As discussed below, the Protocol addresses the use under the tax laws of a foreign country. The term of hybrid entities by adding two new paragraphs to reverse hybrids will be used to refer to entities Article IV.6 treated as corporations under the tax law of their country of residence that are afforded ow-though New Article IV(6) treatment under the tax laws of a foreign country. LLCs U.S. hybrid entities are typically LLCs, which under the 1997 check-the-box regulations are classied by The use of U.S. hybrid entities, such as LLCs, for indefault as partnerships if they have more than one vestments into Canada is addressed by the addition member or as entities disregarded as separate from of new Article IV(6) to the Treaty: their owner if they have a single member.3 LLCs may An amount of income, While it is clear that the drafters prot or gain shall be change this default clasof the Protocol intended to considered to be desication by electing to rived by a person who is be treated as corporations make treaty benets available 4 a resident of a Contractfor U.S. tax purposes. to transactions involving certain ing State where: Regardless of their clashybrid entities, particularly U.S. sication under U.S. tax (a) The person is considlaw, however, a U.S. LLC LLCs, the provisions contained ered under the taxation is treated for purposes of in the Protocol have provoked law of that State to have Canadian tax law as a a restorm of controversy derived the amount U.S. corporation. Thus, through an entity (other an LLC that retains its deamong U.S. and Canadian tax than an entity that is fault classication for U.S. professionals who had been a resident of the other purposes is a hybrid entity looking forward to some relief Contracting State); and from the perspective of U.S. and Canadian law. from the unfavorable treatment of (b) By reason of the The hybrid character of hybrids in the existing Treaty. entity being treated as domestic LLCs classied scally transparent unas ow-throughs leads to der the laws of the rst-mentioned State, the unfavorable treatment under the existing Treaty. The treatment of the amount under the taxation law Canadian Revenue Agency (CRA) takes the position of that State is the same as its treatment would that an LLC treated as a ow-through for U.S. tax be if that amount had been derived directly by purposes is not a qualifying resident of the United that person. States under Article IV(1) of the Treaty because it is not liable to tax as required by that Article. Under This provision, which is similar to Article 1(6) this interpretation, even if all of the members of a U.S. of the 2006 U.S. Model Treaty, but narrower in LLC are U.S. treaty residents, the LLC is ineligible for scope, generally deems an amount of income, treaty benets with respect to transactions involving prot, or gain earned by a U.S. investor through Canada. Because from the Canadian perspective, a a domestic ow-through LLC as being derived U.S. LLC is treated as a corporation, the LLC, not its by the U.S. investor because (1) the members of owners, is subject to tax in Canada on the items of the LLC are treated under U.S. law as deriving the income or gain derived in Canada and is therefore income through the LLC, and (2) the LLC is scally subject to Canadian tax without treaty mitigation. transparent, the U.S. tax treatment of the investor As a policy matter, it was generally accepted that in is substantially the same as if it had earned the cases in which all the owners of an LLC are U.S. perincome directly. sons, treaty benets should be available. The Protocol It was the expressed intention of the Protocol nenegotiations, which started in 1999, were to focus gotiators that Article IV(6) provide treaty benets to on this issue.5 It was also expected that the Protocol U.S. members of LLCs: negotiators would address other types of hybrid

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Income that the residents of one country earn through a hybrid entity will in certain cases be treated by the other country (the source country) as having been earned by a resident of the residence country. On the other hand, a corollary rule provides that if a hybrid entitys income is not taxed directly in the hands of its investors, it will be treated as not having been earned by a resident. Example. U.S. investors use an LLC to invest in Canada. The LLCwhich Canada views as a corporation but is a ow-through vehicle in the United Statesearns Canadian-source investment income. Provided the U.S. investors are taxed in the United States on the income in the same way as they would be if they had earned it directly, Canada will treat the income as having been paid to a U.S. resident. The reduced withholding tax rates provided in the tax treaty will apply.7 However, the Protocol falls short of spelling out exactly how all the conditions for Treaty relief are met. First, because the LLC is the taxpayer from a Canadian perspective, it should not be sufcient to allow the LLCs members to claim an exemption from or reduction of Canadian taxes without also giving the LLC the ability to benet from its members entitlement to treaty protection. Although it is clear that the negotiators intended new Article IV(6) to benet LLCs, there is no current mechanism under Canadian law that would permit such a transfer of benets. By contrast, Reg. 1.894-1(d) permits the foreign owners of a hybrid entity to claim U.S. treaty benets in the same situation and Reg. 1.1441-6(b) (2) provides the procedure for a hybrid entity to claim such benets through the use of an intermediary withholding certicate. Second, for withholding taxes to be reduced or for the treaty beneciary to be exempt from withholding taxes under the Treaty, it is generally necessary for the recipient of the income or gain to be the benecial owner of the income, rather than having derived the income.8 Because the term benecial owner is not dened in the Treaty, it should be given the meaning it would have under the domestic law of the source country, as provided by Article III(2) of the Treaty, unless the context otherwise requires. Unfortunately, the term benecial owner apparently does not have an established meaning under Canadian domestic law. The one place in which benecial owner is dened under U.S. tax law, the regulations specically provide that the term is not being dened for payments of income for which a reduced rate of withholding is claimed under an income tax treaty.9 The Treasurys technical explanation of the U.S. Model Treaty provides that in the absence of a denition in a treaty, the term benecial owner means the person to which the income is attributable under the laws of the source State.10 As stated above, under Canadian domestic law, the LLC would be treated as the benecial owner. However, because the LLC is not a qualifying resident under Article IV(6), it is not entitled to treaty benets in its own right. Obviously, this result is not what the drafters of the Protocol intended. The case of a hybrid entity could be treated as one to which the exception of Article III(2) applies, since the context clearly indicates that the members of a ow-through LLC are intended to be treated as the benecial owners. The commentary to the OECD Model Treaty states that the term benecial owner is not used in a narrow technical sense, rather, it should be understood in its context and in light of the objects and purposes of the Convention . ...11 Under this analysis, benecial owners should probably be dened, at least in the case of income derived from Canada, as the persons who derived the income under Article IV. It is anticipated that the uncertainty about how Article IV(6) will effectively provide treaty benets to U.S. LLCs or their members, as well as other technical issues with the wording of new Article IV(6), may be addressed in the Technical Explanation to be issued by the U.S. Treasury, which Canada generally accepts as reective of its own position.

S Corporations
S corporations12 do not appear to have been intended to be covered by new Articles IV(6) and (7) of the Treaty. As a result, the pre-existing application of the Treaty to an S corporation would have been expected to continue.13 However, it appears that the Protocol may reopen a question long thought to have been favorably resolved; that is, whether dividends received by a U.S. S corporation from a Canadian subsidiary qualify for the ve-percent rate under Article X(2)(a).14 This favorable treatment, which under the existing Treaty is not available to LLCs, appears to have been based on the theory that it is treated as being subject to tax under Article IV(1) by reason of its residence in the United States, despite the fact

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that it is explicitly statutorily exempt from tax under New Article IV(7) domestic law. Article IV(7)(a) The question raised is whether the new Article IV(6) applies to S corporations. S corporations appear to New Article IV(7)(a) contains a rule that is the cont within the class of hybrid entities to which Article verse of the rule in paragraph 6: IV(6) applies. The shareholder of an S corporation is treated under U.S. law as deriving the income of the An amount of income, prot or gain shall be conS corporation by reason of the S corporations scal sidered not to be paid to or derived by a person transparency. In addition, by reason of Code Sec. who is a resident of a Contracting State where: 1366(b), the shareholder is treated in the same manner as if he or she had derived the income directly. (a) The person is considered under the taxation If Article IV(6) applies, the shareholder, rather than law of the other Contracting State to have derived the S corporation will be treated as having derived the amount through an entity that is not a resident the income. In that case, the parenthetical language of the rst-mentioned State, but by reason of the in Article X(2)(a) should entity not being treated also apply and would as fiscally transparent Although it is clear that the prevent the shareholder under the laws of that of the S corporation from State the treatment of negotiators intended new Article qualifying for the fivethe amount under the IV(6) to benet LLCs, there is percent rate on subsidiary taxation law of that State no current mechanism under dividends, since under is not the same as its Code Sec. 1361 only intreatment would be if Canadian law that would permit dividuals are permitted that amount had been such a transfer of benets. to be shareholders of an derived directly by that S corporation. Perhaps person; Article IV(6) should be understood as applying only to an entity that is not itself a qualifying treaty resiIn other words, an item of income is not treated dent, although the language of the paragraph is not as derived by a treaty resident if it is derived by the so limited. resident through an entity that is not resident in the same country as its owner(s) (the entity could be Domestic Reverse Hybrid resident either in the source country or in a third country) and that is not treated as scally transparOne additional point regarding paragraph 6 of Arent in the owner's country of residence. This applies, ticle IV is noteworthy. It explicitly does not apply for example, where a U.S. resident earns Canadian where the hybrid entity is a resident of the source source income through a reverse hybrid Canadian state. Thus, where a U.S. investor holds its shares limited partnership that has led an election to be in a Canadian subsidiary through a Canadian Nova treated as a (Canadian) corporation for U.S. tax purScotia unlimited liability company (NSULC), which poses. Since the U.S. resident is not treated as earning is treated as a corporation for Canadian tax purposes the income earned by the LP for U.S. tax purposes, and a ow-through for U.S. tax purposes, dividend paragraph 7 would deny treaty benets. While this payments received by the NSULC are not eligible for rule may be novel to any Canadian readers, U.S. any treaty benets notwithstanding that the dividends practitioners will no doubt recognize this approach, are treated as having been earned by the NSLUC's as the current law in the U.S. under the Code Sec. U.S. shareholder for U.S. tax purposes. (This rule 894(c) Treasury Regulations.16 Essentially, the rules in is different from the one contained in new Article IV(7)(b) described below, which addresses payments new paragraphs 6 and 7(a) can be thought of as two made by the NSULC to the U.S. shareholder rather aspects of a single rule, namely, that the determinathan payments made to the NSULC.) The exclusion tion of whether income derived through an entity is for such domestic reverse hybrid entities is not treated as derived by a treaty resident is made under unexpected. The U.S. Treasury Regulations under the entity classication rules of the country of resiCode Sec. 894(c) currently include the same rule in dence rather than the country of source. Viewed in the U.S. inbound context.15 Continued on page 55

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Although the Hong Kong IRD will exchange information on a request basis, taxpayers should be fully alert to their rights and obligations in tax reporting and should ensure that the requirements of tax compliance are properly met when crossborder transactions are involved.

ENDNOTES
1

The Limited Arrangement signed in 1998 covers double taxation provisions only on business prots, shipping, air and land transport income, and personal service income (including independent and dependent personal service income, directors fees, and income for artistes and athletes). The Comprehensive Arrangement (CDTA) signed in 2006 has extended the scope to cover double taxation provisions on dividends, interest, royalties, capital gains, pensions, government service, students and other income. Two detailed practice notes were issued by the two contracting parties on the interpretation and implementation of the CDTA. They are the Departmental Interpretation and Practice Notes No.44 (Revised) issued by Hong Kong Inland Revenue in April 2007 and the Guoshiuhan No. [2007] 403 issued by the State Administration of Taxation of Mainland China on April 4, 2007. Hong Kong Property Tax was not covered previously in the 1998 Limited Arrangement. Starting from January 1, 2008, the Foreign Investment Enterprises and Foreign Enterprise Income Tax Law will be repealed and replaced by the new Enterprise Income Tax Law that is applicable to both domestic and foreign enterprises in Mainland China. Hong Kong does not charge any income tax on capital gains, yet capital gains are taxable income in the Mainland of China. The CDTA adopts the tie-breaker rule used in the OECD Convention Model to determine the residency status of an individual who is

10

considered to be a resident of both jurisdictions. The criteria used in the rule are the place of the individuals permanent home, the place of his or her center of vital interest, the place of his or her habitual abode. If this cannot be determined by the above criteria, the two competent authorities will resolve the issue by mutual agreement (Article 4(2), CDTA). Similar rules apply to resident persons other than individuals and companies in Hong Kong, such as a partnership, trust or any other body of persons. The provisions of Article 10 will not apply if the benecial owner of the dividends is a resident of One Sides jurisdiction and carries on business through a permanent establishment in that of the Other Side, where the dividend-paying company is situated. The dividends so paid on the shareholding effectively connected with that permanent establishment are treated as business prots and will be taxed under the provisions of Article 7. Section 15(1)(a) of the IRO deems a Hong Kong-sourced trading receipt any royalty income accruing to a nonresident person from the exhibition or use in Hong Kong of any cinematographic or television lm or tape, or any sound recording or advertising material connected with such items. Section 15(1)(b) of the IRO deems a Hong Kong-sourced trading receipt any royalty income accrued to a nonresident person for the use of or the right of use in Hong Kong a patent, design, trademark, copyright

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material, a secret process or formula or any other similar property. Section 15(1)(ba) of the IRO deems a Hong Kong-sourced trading receipt any royalty income accruing to a nonresident person for the use of, or the right to use outside Hong Kong, of patent, copyright, and intellectual materials and the royalty payment is deductible in ascertaining the assessable prots of the payer. Section 15(1)(d) of the IRO deems a Hong Kong-sourced trading receipt any rent accruing to a nonresident person through the hiring or renting of movable property in Hong Kong. The 100-percent rate does not apply to royalty income derived from an associate if the Commissioner of Inland Revenue is satised that no person carrying on a trade, profession, or business in Hong Kong has at any time wholly or partly owned the relevant property. In such cases, the 30-percent rate applies (IRO Section 21A). On request means a tax administration asks specic questions relating to a particular case. Automatic exchange occurs when the tax administrations exchange information concerning specied items of income on a systematic way. Spontaneous exchange refers to the passing on of information obtained by a tax administration during an examination of the taxpayers affairs (such as in a tax audit or investigation) to the other tax administration, where the information may be of interest to the latter (OECD, 1994).

Anti-Deferral
Continued from page 8

treated as derived by a resident of a Contracting State where: (b) That person is considered under the taxation law of the other Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as scally transparent under the laws of the first-mentioned 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 scally transparent under the laws of that State. This rule applies to dividends paid by a ULC that is treated as a ow-through entity for U.S. tax purposes to its U.S. shareholders, and would prevent such dividends from qualifying for a reduction in Canadian withholding tax rates. What is surprising about this rule is that the Code Sec. 894(c) regulations, which extensively address the various possibilities for treaty abuse that arise from the use of

this way, the rule appears as a logical extension of the principle in Article IV(1), that residence status for treaty purposes is dependent on the tax treatment in the country of residence.

Article IV(7)(b)
Article IV(7)(b), on the other hand, is a completely new rule that took practitioners by surprise. This rule states that the income is not

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hybrid and reverse hybrid entities would permit treaty benets in this situation (that is, in the absence of new paragraph 7(b)).17 In fact, the Treasury specically considered the possibility of abuse in the context of such payments by a domestic reverse hybrid entity and concluded that treaty benets should generally be available for such payments, subject to a narrow exception for payments made to a related party that are deductible in the source country where the underlying income earned by the domestic reverse hybrid is treated as a dividend in the country of residence.18 We understand that paragraph 7(b) was included at the request of the Canadian government and was intended to prevent certain double dip nancing structures that utilize a ULC. However, the CRA may not have realized the scope of the provision which, in its current form, will prevent U.S. taxpayers from utilizing ULCs in a broad range of ordinary operating and holding company structures in which double dips and aggressive tax planning play no part.

be effective the rst tax year that begins after the Protocol enters into force (that is, probably in 2009 for calendar-year taxpayers).21 Notwithstanding these general effective date rules, there are several special effective dates for particular provisions. Specically, the new rules contained in new paragraph 7 of Article IV (that limit treaty benets for certain hybrid entity structures, but not the new favorable LLC rule in paragraph 6 of Article IV) is delayed until the rst day of the third calendar year that ends after the treaty goes into force.22 In other words, assuming the treaty goes into force during 2008, paragraph 7 would go into effect on January 1, 2010.

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ENDNOTES
1

Ratication and Effective Dates

The Protocol must be ratied by both the United States and Canada before it goes into force. The Protocol will go into force on the date such ratication is completed or.19 Once the Protocol goes into force, it will generally be effective with respect to withholding taxes almost immediately, on amounts paid on or after the rst day of the second month that begins after the date on which the Protocol enters into force (no earlier than March 1, 2008).20 With respect to other taxes, the Protocol will generally

3 4 5

Protocol Amending the Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital Done at Washington on 26 September 1980, as Amended by the Protocols Done on 14 June 1983, 28 March 1984, 17 March 1995 and 29 July 1997. The Protocol was signed on September 21, 2007, at Meech Lake, Quebec. The Protocol, together with the related Backgrounder and Annexes, is available on Canadas Department of Finance Web site at www.n.gc.ca/ news07/07-070e.html. Canadas Department of Finance Web site at www.n.gc.ca/news07/07-070e.html. Reg. 301.7701-3. Id. The Canadian Government had stated publicly (for example, at the International Tax Seminar on May 19, 1999 of the Canadian branch of the International Fiscal Association) that ongoing protocol negotiations are clearly seeking to redress this issue. (The governments comments were not made available for publication in the proceedings of that seminar.) Note that the two new paragraphs, Article IV(6) and (7), are contained in the Residence Article of the Treaty, which is consistent with past U.S. policy under the 1996 U.S. Model, as reected in Article 4(a)(d) of that Model, but differs from the 2006 U.S. Model where the hybrid entity provision is contained in the General Scope article. Arguably, the new hybrid entity provisions contained in the Protocol should have been contained

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15 16 17 18 19 20 21 22

in Article I of the Treaty, as suggested by the 2006 U.S. Model as this is most consistent with their effect. Article IV(6) and (7) do not dene residence, but respectively extend and limit the personal scope of the Treaty. Article IV(7) has no equivalent in the 2006 U.S. Model and is not reected in past U.S. tax treaty practice. This provision has been designed to deal with certain specic bilateral issues; nonetheless, as discussed below, certain of its aspects come as a surprise. From the ofcial Backgrounder to the Protocol released by the Canadian Department of Finance, available at www.n.gc.ca/news07/ data/07-070_1e.html. See, for example, Article X (dividend), Article XI (interest), and Article XII (royalties). Reg. 1.1441-1(c)(6)(i). United States Treasury Department, United States Model Technical Explanation Accompanying the United States Model Income Tax Convention of November 15, 2006. Organization for Economic Co-operation and Development, Model Tax Convention on Income and on Capital: Condensed Version (Paris: OECD, July 2005) paragraph 12 of the commentary on Article 10. Among other requirements, only U.S. individuals or certain domestic trusts are permitted as shareholders of an S corporation. Part of that overall context is that if at a point in time a U.S. corporation does not elect subchapter S treatment and acquires a property for $100 and then at a subsequent point in time (when that property has appreciated to $500) it elects subchapter S status and then sells the property for $1,000, $400 of the $900 gain would be taxed in the hands of the S corporation itself (as in the case of any non-S corp.) and only $500 would ow through with a single tax at the shareholder level. See, CRA document no. 9822230, Sept. 23, 1998, and Income Tax Technical News no. 16, Mar. 8, 1999. Reg. 1.894-1(d)(2)(i). Reg. 1.894-1(d)(1). Reg. 1.894-1(d)(2)(ii)(A). Reg. 1.894-1(d)(2)(ii)(B). Article 3 of the Protocol. Article 3(2)(a) of the Protocol. Article 3(2)(b) of the Protocol. Article 3(b) of the Protocol.

Dual Consolidated
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case, it appears that S should recognize the $100 gain and should consider that gain for purposes of the SRLY offset.44 However, because S is reducing its recapture

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