4.5.2 [a] New Tie-Breaker Rule
If a particular company is a resident of both Canada and the United States, the language of new Article IV(3)[a] provides that where a company is created under the laws in force in a Contracting state, but not under the laws in force in the other Contracting State, it will be deemed to be resident only of the former State.
New Article IV(3)[b] provides that in all other cases the residency of a dual resident company may be determined pursuant to a two-step procedure:
1 – the residency of a dual-resident company may be determined by the competent authorities by a mutual agreement; and
2 – where the competent authorities fail to reach a mutual agreement, the particular dual-resident company will be deemed not to be resident in either Canada or the U.S. for the purposes of the Treaty. The dual-resident company will however be treated as a person resident both in Canada and the U.S. for purposes of their respective tax laws.
4.5.2 [b] Application of Articles IV[6] and [7]
New provisions of Article IV (Residence) deal with the income earned by residents of one State from the sources in the other State through or from a fiscally transparent entity.
The new provisions in Article IV are divided into two rules:
1 – the “positive” rule in Article IV(6) that allows income to be eligible for Treaty relief which such income is earned by a person resident in the residence State through a fiscally transparent entity that is not resident in the source State; and
2 – the “negative” rule in Article IV(7) that deems certain income not to be eligible for Treaty relief when such income is earned by a person resident in the residence State through or from a fiscally transparent entity, which is, generally, resident in the source State.
Fiscally Transparent and Hybrid Entities
For the purposes of application of Article IV[6] and [7] to a particular amount, these provisions apply where the amount is derived by a person through a fiscally transparent entity.
In Canada, fiscally transparent entities include partnerships and “bare” trusts. In the U.S., fiscally transparent entities include:
1 – partnerships, including partnerships organized under foreign law;
2 – common investment trusts described in under IRC section 584;
3 – grantor trusts; and
4 – business entities such as an “S” corporation and a limited liability company, provided that the later is treated as a partnership or is disregarded as an entity separate from its owner for U.S. tax purposes.
“Same Treatment” Test
For purpose of the application of Articles IV [6] and [7] it is relevant to consider the “same treatment” test. Pursuant to the “same treatment” test referenced in the 2008 Technical Explanation, the source State conferring Treaty relief should determine “whether the treatment of an amount of income, profit or gain derived by a person through an entity under the tax law of the residence State is the same as its treatment would be if that amount had been derived directly.’
Treaty relief would be conferred on a particular item of income if it meets the requirements of the same treatment test.
The 2008 Technical Explanation provides that the same treatment test is conceptually based on the underlying principles of Code section 894[c] and the Regulations thereto that deal with the determination of whether an entity would be treated as fiscally transparent for U.S. tax purposes.
Under Code section 894[c], a foreign person is not entitled to a reduced rate of U.S. withholding tax under a treaty on an item of income derived through an entity that is treated as a partnership (or otherwise treated as fiscally transparent) for U.S. tax purposes if:
1 – such item is not treated for purposes of the taxation laws of such foreign country as an item of income of such person;
2 – the foreign country does not impose tax on an actual distribution of such item of income from such entity to such person; and
3 – the treaty itself does not contain a provision addressing the applicability of the treaty in the case of income derived through a partnership or other fiscally transparent entity.
An item of income paid to an entity is considered to be derived by the entity if the entity is not fiscally transparent with respect to the item of income under the laws of the entity’s jurisdiction. The entity’s jurisdiction may be the place of the entity’s organization, or the place of management and control of the entity.
To claim treaty benefits, an interest holder in the entity may derive the item of income if that interest holder can establish that under the laws of the jurisdiction in which the interest holder is a resident, the entity if fiscally transparent, and the interest holder itself is not considered fiscally transparent with respect to that item of income under the laws of its jurisdiction.
4.5.2 [c] Article VI[6] – Accommodation of Income Derived through a Hybrid Entity
The introduction of new Article IV(6) expands the benefits of the Treaty in respect of income derived by a resident of the residence State from the source State through a hybrid entity.
An amount of income, profit or gain should be considered to be derived by a person resident in the residence State where:
1 – the person is considered under the tax law of the residence State to have derived the amount through an entity (other than an entity that is a resident of the source State); and
2 – by reason of the entity being treated as fiscally transparent under the laws of the residence State, the treatment of the amount under tax laws of the residence State is the same as its treatment would be if that amount had been derived directly by that person.
Application of Article IV[6] by Canada
Canada will continue to treat a U.S. LLC as a separate legal entity which is not resident in the U.S. and is not entitled in its own right to Treaty benefits.
The activities of a U.S. LLC will be treated as its own and not be imputed to its shareholders.
The activities of its shareholders would not be relevant for the purposes of these provisions, unless such activities could be imputed to U.S. LLC when the shareholders are acting in an agency capacity.
Canada will not require the shareholders of U.S. LLC to file Canadian tax returns in respect of income that benefits from Article IV(6). Instead, U.S. LLC itself will file a Canadian tax return in which it will claim the benefits under Article IV(6) and supply any documentation required to support the claim.
Article IV(6) and Permanent Establishment
New Article IV(6) expressly provides treaty relief for business income. However, Canada add the U.S. diverge on the application of the treaty relief for business income under Article IV(6).
For U.S. tax purposes, activities of a hybrid entity itself and of its partners would be considered in order to determine if the entity has a permanent establishment in the U.S.; whereas, for Canadian tax purposes, only the activities of the entity itself would be considered to determine if the entity has a permanent establishment in Canada. The activities of the shareholders of the entity, such as a fiscally transparent U.S LLC, would be disregarded, unless the shareholders’ activities create either an agency or service permanent establishment for U.S. LLC.
4.5.2 [d] Article VI[7] – Anti-Avoidance Rule for Hybrid Entity Structures
New Article IV(7) applies to deny Treaty benefits to the income earned by a resident of a residency State through or from a hybrid entity that is not resident in the residence State.
Article IV(7) [a] Income Earned Through a Hybrid Entity not Resident in the Residence State
Article IV(7) [a] is intended to deny Treaty benefits to the income earned by a resident of a residency State through an entity that is not resident in the residence State.
The hybrid entities falling within the scope of this Article include; for Canadian source income, Canadian and foreign partnerships that can be regarded as non-resident corporations for U.S. tax purposes. In the case of U.S. source income earned by Canadian residents, the impugned entities include a U.S. LLC or any other foreign entity treated as a fiscally transparent entity for U.S. tax purpose and regarded as a non-resident corporation for Canadian tax purposes.
Pursuant to the rule in Article IV(7)[a], an amount of income, profit or gain will not be considered to be paid to or derived by a person resident in the residence State where:
1 – the person is considered under the taxation law of the source State to have derived the amount through an entity that is not a resident of the residence State;
2 - Such entity is not fiscally transparent under the tax laws of the residence State (but is fiscally transparent under the tax laws of the source State);
3 – the treatment of the particular amount under the tax laws of residence State is not the same as its treatment would be if that amount had been derived directly by that person.
Article IV(7) [b] Income Earned Through a Hybrid Entity Resident in the Residence State
Article IV(7) [b] is intended to deny Treaty benefits to the income earned by a resident of a residency State through an entity that is resident in the residence State.
The hybrid entities falling within the scope of Article IV(7)[b] include, for Canadian source income, unlimited liability companies organized under the laws of Canadian provinces, such as Nova Scotia Unlimited Liability Company.
In the case of U.S. source income, the impugned entities include a U.S. partnership treated as a corporation for U.S. tax purposes and fiscally transparent for Canadian tax purposes. Where Article IV(7)[b] applies, the income paid by a hybrid entity (such as a Canadian ULC or a U.S. hybrid partnership), including dividends paid by a Canadian ULC, would not be entitled to Treaty relief and will instead be subject to full statutory withholding rates.
Pursuant to the rule in Article IV(7)[b], an amount of income, profit or gain will not be considered to be paid to or derived by a person resident in the residence State where:
1 – the person is considered, under the laws of the source State, to have received income from an entity resident in the source State;
2 – such entity is fiscally transparent under the tax laws of the residence State; and
3 – the treatment of the amount under the tax law of the residence State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the tax laws of the residence State.
Advisor’s Guide to Canada – U.S. Tax Treaty
By: Vitaly Timokhov, Raymond Montero, David Kerzner
Published by: Thomson Carswell
The Accounting and Tax