01 July 2010 Issue 7 Michael Cadesky

New benefits

US LLCs under the Canada-US treaty.

By an amendment to the Canada-US Treaty ratified 15 December 2008, Canada granted treaty benefits to US LLCs to the extent that they are owned by US residents (reduced withholding being effective from 1 February 2009). Prior to this, US LLCs were not entitled to treaty benefits absent an election to be taxed as a corporation for US tax purposes. The denial of treaty benefits resulted from a longstanding position of the Canada Revenue Agency (CRA) that a US LLC that was a so-called flow-through entity for US tax purposes was not a taxpayer. The reason was that it was not liable for tax; its owners were. Consequently, treaty benefits were denied, even if income was wholly attributed to US taxpayers. This position, originating in a 1993 Technical Interpretation, stood unchallenged for almost two decades until the decision of TD Securities (USA) LLC 2010 TCC 186 (Tax Court of Canada).

In TD Securities, a US LLC was wholly-owned by a US corporation. It carried on a business in Canada and paid tax on its profits. It was also assessed 25 per cent branch profits tax on top of this. The Treaty rate would have been 5 per cent. Perhaps surprisingly, the Tax Court of Canada rejected the argument that treaty benefits were unavailable.

Treaties must be interpreted broadly as best fits their object and purpose. With this in mind, it was appropriate to grant Treaty benefits. In this regard, it was stated:

‘The decision in this case stands for no more than the proposition that, properly interpreted and applied in context in a manner to achieve its intended object and purpose, the US Treaty’s favourable tax rate reductions apply for years prior to the Fifth Protocol Amendments to the Canadian-sourced income of a US LLC if all of that income is fully and comprehensively taxed by the US to the members of the LLC resident in the US on the same basis as had the income been earned directly by those members.’

It may well be that others can benefit from application of the principles of this case.

From 1 February 2009 onwards, relief is provided under the Canada-US Treaty itself, but prior to this, if denied treaty benefits, it may be possible to obtain a refund of Canadian taxes paid.

Under Canadian domestic law, refunds of withholding tax must be made within two years of the end of the calendar year in which the withholding tax liability arose. This means that one could go back to 1 January 2008. However, under the general procedures of the Canada-US Treaty, (Article XXVI), a six-year limitation applies upon application to Competent Authority. This takes one back to 1 January 2004!

The non-treaty withholding tax rate that Canada levies is typically 25 per cent, on such things as interest, dividends, and royalty payments and, as mentioned, branch profits tax. Also, in certain circumstances Canada taxes capital gains, which would be exempt by treaty. With the application of the Treaty, a 10 per cent withholding tax rate would have applied on interest, a 5 per cent or 15 per cent rate would have been levied on dividends, depending on the circumstances and 5 per cent applied to branch profits tax. The withholding tax rate on royalties would be reduced from 25 per cent to either 10 per cent or nil, depending on the nature of the royalty. Clearly then, there may be a substantial benefit from qualifying under the treaty.

The process for obtaining a refund is an application to US Competent Authority with a copy to Canadian Competent Authority for notification purposes. The basis would be that the actions of the CRA were not in accordance with the terms of the Canada-US Treaty (as it read prior to the 2008 amendments), on the basis that the US LLC was indeed a treaty resident.

Whether or not to consider applying for a refund of Canadian taxes will depend on each set of circumstances, and there is no assurance that such an application will be successful. In TD Securities, the US LLC was wholly-owned by a US corporation such that all income of the US LLC was subject to tax. It is unclear how a case might be decided if the US LLC was not wholly-owned by US taxpayers. The Treaty now provides for a proration of benefits, but there is no guarantee that such an approach would be accepted by a Canadian Court or Competent Authority. However, it can also be stated with certainty that failing to apply for a refund through the Competent Authority procedures will result in no tax refund.

It will be interesting to see how this matter evolves, and how many persons might consider an application to the US Competent Authority on this matter.

 

Authors

Michael Cadesky