anti deferral and anti tax avoidance feb2008

7/28/2019 Anti Deferral and Anti Tax Avoidance Feb2008

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JanuaryFebruary 2008

INTERNATIONAL TAX JOURNAL

Peter Glicklich and Abraham Leitnerare Partners andJennifer MacDonaldis an Associate in the New York office ofDavies Ward Phillips & Vineberg LLP.

Anti-Deferral andAnti-Tax Avoidance

By Peter Glicklich, Abraham Leitner and Jennifer MacDonald

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

IntroductionAfter nearly 10 years of negotiations, the Fifth Protocol(the Protocol)1 to the 1980 Canada-U.S. Income TaxTreaty (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 theTreaty,2 generally brings the Treaty into closer confor-mity with the 2006 U.S. Model Treaty.

It was anticipated that the Protocol would address

the availability of treaty benefits to U.S. and Canadianresidents who hold interests in U.S. limited liabilitycompanies (LLCs), though there was little consensusabout how and to what extent benefits would bemade available. While it is clear that the drafters ofthe Protocol intended to make treaty benefits avail-able to transactions involving certain hybrid entities,particularly U.S. LLCs, the provisions contained inthe Protocol have provoked a firestorm of controversyamong U.S. and Canadian tax professionals who hadbeen looking forward to some relief from the unfavor-able treatment of hybrids in the existing Treaty. Theprovisions of the Protocol relating to hybrid entitiesand the ambiguity that they create are the subject ofthis column.

Overview

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


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as flow-through entities under the tax laws of theircountry of residence and are treated as corporationsunder the tax laws of a foreign country. The termreverse hybrids will be used to refer to entitiestreated as corporations under the tax law of theircountry of residence that are afforded flow-though

treatment under the tax laws of a foreign country.U.S. hybrid entities are typically LLCs, which underthe 1997 check-the-box regulations are classified bydefault as partnerships if they have more than onemember or as entities disregarded as separate fromtheir owner if they have asingle member.3 LLCs maychange this default clas-sification by electing tobe treated as corporationsfor U.S. tax purposes.4Regardless of their clas-

sification under U.S. taxlaw, however, a U.S. LLCis treated for purposes ofCanadian tax law as aU.S. corporation. Thus,an LLC that retains its de-fault classification for U.S.purposes is a hybrid entityfrom the perspective ofU.S. and Canadian law.

The hybrid character ofdomestic LLCs classified

as flow-throughs leads tounfavorable treatment under the existing Treaty. TheCanadian Revenue Agency (CRA) takes the positionthat an LLC treated as a flow-through for U.S. taxpurposes is not a qualifying resident of the UnitedStates under Article IV(1) of the Treaty because it isnot liable to tax as required by that Article. Underthis interpretation, even if all of the members of a U.S.LLC are U.S. treaty residents, the LLC is ineligible fortreaty benefits with respect to transactions involvingCanada. Because from the Canadian perspective, aU.S. LLC is treated as a corporation, the LLC, not itsowners, is subject to tax in Canada on the items ofincome or gain derived in Canada and is thereforesubject to Canadian tax without treaty mitigation.

As a policy matter, it was generally accepted that incases in which all the owners of an LLC are U.S. per-sons, treaty benefits should be available. The Protocolnegotiations, which started in 1999, were to focuson this issue.5 It was also expected that the Protocolnegotiators would address other types of hybrid

situations, such as the treatment of S corporations.As discussed below, the Protocol addresses the useof hybrid entities by adding two new paragraphs toArticle IV.6

New Article IV(6)LLCsThe use of U.S. hybrid entities, such as LLCs, for in-vestments into Canada is addressed by the additionof new Article IV(6) to the Treaty:

An amount of income,profit or gain shall beconsidered to be de-rived by a person who isa resident of a Contract-ing State where:

(a) The person is consid-ered under the taxationlaw of that State to havederived the amountthrough an entity (otherthan an entity that isa resident of the otherContracting State); and

(b) By reason of theentity being treated as

fiscally transparent un-der the laws of the first-mentioned State, thetreatment of the amount under the taxation lawof that State is the same as its treatment wouldbe if that amount had been derived directly bythat person.

This provision, which is similar to Article 1(6)of the 2006 U.S. Model Treaty, but narrower inscope, generally deems an amount of income,profit, or gain earned by a U.S. investor througha domestic flow-through LLC as being derivedby the U.S. investor because (1) the members ofthe LLC are treated under U.S. law as deriving theincome through the LLC, and (2) the LLC is fiscallytransparent, the U.S. tax treatment of the investoris substantially the same as if it had earned theincome directly.

It was the expressed intention of the Protocol ne-gotiators that Article IV(6) provide treaty benefits toU.S. members of LLCs:

Anti-Deferral and Anti-Tax Avoidance

While it is clear that the draftersof the Protocol intended to

make treaty benefits availableto transactions involving certain

hybrid entities, particularly U.S.LLCs, the provisions containedin the Protocol have provoked

a firestorm of controversyamong U.S. and Canadian tax

professionals who had beenlooking forward to some relief

from the unfavorable treatment ofhybrids in the existing Treaty.


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Income that the residents of one country earnthrough a hybrid entity will in certain cases betreated by the other country (the source country) ashaving been earned by a resident of the residencecountry. On the other hand, a corollary rule pro-vides that if a hybrid entitys income is not taxed

directly in the hands of its investors, it will betreated as not having been earned by a resident.

Example. U.S. investors use an LLC to invest inCanada. The LLCwhich Canada views as acorporation but is a flow-through vehicle in theUnited Statesearns Canadian-source invest-ment income. Provided the U.S. investors aretaxed in the United States on the income in thesame way as they would be if they had earnedit directly, Canada will treat the income as hav-ing been paid to a U.S. resident. The reduced

withholding tax rates provided in the tax treatywill apply.7

However, the Protocol falls short of spelling outexactly how all the conditions for Treaty relief aremet. First, because the LLC is the taxpayer from aCanadian perspective, it should not be sufficientto allow the LLCs members to claim an exemptionfrom or reduction of Canadian taxes without also giv-ing the LLC the ability to benefit from its membersentitlement to treaty protection. Although it is clearthat the negotiators intended new Article IV(6) to

benefit LLCs, there is no current mechanism underCanadian law that would permit such a transfer ofbenefits. By contrast, Reg. 1.894-1(d) permits theforeign owners of a hybrid entity to claim U.S. treatybenefits in the same situation and Reg. 1.1441-6(b)(2) provides the procedure for a hybrid entity to claimsuch benefits through the use of an intermediarywithholding certificate.

Second, for withholding taxes to be reduced or forthe treaty beneficiary to be exempt from withholdingtaxes under the Treaty, it is generally necessary for therecipient of the income or gain to be the beneficialowner of the income, rather than having derivedthe income.8 Because the term beneficial owneris not defined in the Treaty, it should be given themeaning it would have under the domestic law ofthe source country, as provided by Article III(2) ofthe Treaty, unless the context otherwise requires.Unfortunately, the term beneficial owner appar-ently does not have an established meaning underCanadian domestic law. The one place in which

beneficial owner is defined under U.S. tax law,the regulations specifically provide that the term isnot being defined for payments of income for whicha reduced rate of withholding is claimed under anincome tax treaty.9 The Treasurys technical explana-tion of the U.S. Model Treaty provides that in the

absence of a definition in a treaty, the term beneficialowner means the person to which the income isattributable under the laws of the source State.10 Asstated above, under Canadian domestic law, the LLCwould be treated as the beneficial owner. However,because the LLC is not a qualifying resident underArticle IV(6), it is not entitled to treaty benefits in itsown right. Obviously, this result is not what the draft-ers of the Protocol intended.

The case of a hybrid entity could be treated as oneto which the exception of Article III(2) applies, sincethe context clearly indicates that the members of a

flow-through LLC are intended to be treated as thebeneficial owners. The commentary to the OECDModel Treaty states that the term beneficial owneris not used in a narrow technical sense, rather, itshould be understood in its context and in light of theobjects and purposes of the Convention . ...11 Underthis analysis, beneficial owners should probably bedefined, at least in the case of income derived fromCanada, as the persons who derived the incomeunder Article IV.

It is anticipated that the uncertainty about howArticle IV(6) will effectively provide treaty benefits to

U.S. LLCs or their members, as well as other technicalissues with the wording of new Article IV(6), may beaddressed in the Technical Explanation to be issuedby the U.S. Treasury, which Canada generally acceptsas reflective of its own position.

S CorporationsS corporations12 do not appear to have been in-tended to be covered by new Articles IV(6) and (7)of the Treaty. As a result, the pre-existing applicationof the Treaty to an S corporation would have beenexpected to continue.13 However, it appears that theProtocol may reopen a question long thought to havebeen favorably resolved; that is, whether dividendsreceived by a U.S. S corporation from a Canadiansubsidiary qualify for the five-percent rate under Ar-ticle X(2)(a).14 This favorable treatment, which underthe existing Treaty is not available to LLCs, appearsto have been based on the theory that it is treated asbeing subject to tax under Article IV(1) by reasonof its residence in the United States, despite the fact


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Anti-Deferral and Anti-Tax Avoidance

that it is explicitly statutorily exempt from tax underdomestic law.

The question raised is whether the new Article IV(6)applies to S corporations. S corporations appear tofit within the class of hybrid entities to which ArticleIV(6) applies. The shareholder of an S corporation is

treated under U.S. law as deriving the income of theS corporation by reason of the S corporations fiscaltransparency. In addition, by reason of Code Sec.1366(b), the shareholder is treated in the same man-ner as if he or she had derived the income directly.If Article IV(6) applies, the shareholder, rather thanthe S corporation will be treated as having derivedthe income. In that case, the parenthetical languagein Article X(2)(a) shouldalso apply and wouldprevent the shareholderof the S corporation from

qualifying for the five-percent rate on subsidiarydividends, since underCode Sec. 1361 only in-dividuals are permittedto be shareholders of anS corporation. PerhapsArticle IV(6) should be understood as applying onlyto an entity that is not itself a qualifying treaty resi-dent, although the language of the paragraph is notso limited.

Domestic Reverse HybridOne additional point regarding paragraph 6 of Ar-ticle IV is noteworthy. It explicitly does not applywhere the hybrid entity is a resident of the sourcestate. Thus, where a U.S. investor holds its sharesin a Canadian subsidiary through a Canadian NovaScotia unlimited liability company (NSULC), whichis treated as a corporation for Canadian tax purposesand a flow-through for U.S. tax purposes, dividendpayments received by the NSULC are not eligible forany treaty benefits notwithstanding that the dividendsare treated as having been earned by the NSLUC'sU.S. shareholder for U.S. tax purposes. (This ruleis different from the one contained in new ArticleIV(7)(b) described below, which addresses paymentsmade by the NSULC to the U.S. shareholder ratherthan payments made to the NSULC.) The exclusionfor such domestic reverse hybrid entities is notunexpected. The U.S. Treasury Regulations underCode Sec. 894(c) currently include the same rule inthe U.S. inbound context.15

New Article IV(7)Article IV(7)(a)New Article IV(7)(a) contains a rule that is the con-verse of the rule in paragraph 6:

An amount of income, profit or gain shall be con-sidered not to be paid to or derived by a personwho is a resident of a Contracting State where:

(a) The person is considered under the taxationlaw of the other Contracting State to have derivedthe amount through an entity that is not a residentof the first-mentioned State, but by reason of the

entity not being treatedas fiscally transparentunder the laws of thatState the treatment of

the amount under thetaxation law of that Stateis not the same as itstreatment would be ifthat amount had beenderived directly by thatperson;

In other words, an item of income is not treatedas derived by a treaty resident if it is derived by theresident through an entity that is not resident in thesame country as its owner(s) (the entity could be

resident either in the source country or in a thirdcountry) and that is not treated as fiscally transpar-ent in the owner's country of residence. This applies,for example, where a U.S. resident earns Canadiansource income through a reverse hybrid Canadianlimited partnership that has filed an election to betreated as a (Canadian) corporation for U.S. tax pur-poses. Since the U.S. resident is not treated as earningthe income earned by the LP for U.S. tax purposes,paragraph 7 would deny treaty benefits. While thisrule may be novel to any Canadian readers, U.S.practitioners will no doubt recognize this approach,as the current law in the U.S. under the Code Sec.894(c) Treasury Regulations.16 Essentially, the rules innew paragraphs 6 and 7(a) can be thought of as twoaspects of a single rule, namely, that the determina-tion of whether income derived through an entity istreated as derived by a treaty resident is made underthe entity classification rules of the country of resi-dence rather than the country of source. Viewed in

Although it is clear that thenegotiators intended new Article

IV(6) to benefit LLCs, there isno current mechanism under

Canadian law that would permitsuch a transfer of benefits.

Continued on page 55


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INTERNATIONAL TAX JOURNAL 55


Although the Hong Kong IRD will exchangeinformation on a request basis, taxpayers shouldbe fully alert to their rights and obligations in tax

reporting and should ensure that the requirementsof tax compliance are properly met when cross-border transactions are involved.

ENDNOTES

1

The Limited Arrangement signed in 1998covers double taxation provisions only onbusiness profits, shipping, air and land trans-port income, and personal service income(including independent and dependentpersonal service income, directors fees,and income for artistes and athletes). TheComprehensive Arrangement (CDTA) signedin 2006 has extended the scope to coverdouble taxation provisions on dividends,interest, royalties, capital gains, pensions,government service, students and otherincome.

2 Two detailed practice notes were issued bythe two contracting parties on the interpreta-tion and implementation of the CDTA. They

are the Departmental Interpretation andPractice Notes No.44 (Revised) issued byHong Kong Inland Revenue in April 2007and the Guoshiuhan No. [2007] 403 issuedby the State Administration of Taxation ofMainland China on April 4, 2007.

3 Hong Kong Property Tax was not covered pre-viously in the 1998 Limited Arrangement.

4 Starting from January 1, 2008, the ForeignInvestment Enterprises and Foreign Enter-prise Income Tax Law will be repealed andreplaced by the new Enterprise Income TaxLaw that is applicable to both domestic andforeign enterprises in Mainland China.

5 Hong Kong does not charge any income taxon capital gains, yet capital gains are taxable

income in the Mainland of China.6 The CDTA adopts the tie-breaker rule used inthe OECD Convention Model to determinethe residency status of an individual who is

considered to be a resident of both jurisdic-tions. The criteria used in the rule are theplace of the individuals permanent home,the place of his or her center of vital interest,the place of his or her habitual abode. If thiscannot be determined by the above criteria,the two competent authorities will resolvethe issue by mutual agreement (Article 4(2),CDTA).

7 Similar rules apply to resident persons otherthan individuals and companies in HongKong, such as a partnership, trust or anyother body of persons.

8 The provisions of Article 10 will not applyif the beneficial owner of the dividends isa resident of One Sides jurisdiction and

carries on business through a permanent es-tablishment in that of the Other Side, wherethe dividend-paying company is situated.The dividends so paid on the shareholdingeffectively connected with that permanentestablishment are treated as business profitsand will be taxed under the provisions ofArticle 7.

9 Section 15(1)(a) of the IRO deems a HongKong-sourced trading receipt any royaltyincome accruing to a nonresident personfrom the exhibition or use in Hong Kong ofany cinematographic or television film ortape, or any sound recording or advertisingmaterial connected with such items.

10 Section 15(1)(b) of the IRO deems a Hong

Kong-sourced trading receipt any royaltyincome accrued to a nonresident personfor the use of or the right of use in HongKong a patent, design, trademark, copyright

material, a secret process or formula or anyother similar property.11 Section 15(1)(ba) of the IRO deems a Hong

Kong-sourced trading receipt any royaltyincome accruing to a nonresident person forthe use of, or the right to use outside HongKong, of patent, copyright, and intellectualmaterials and the royalty payment is deduct-ible in ascertaining the assessable profits ofthe payer.

12 Section 15(1)(d) of the IRO deems a HongKong-sourced trading receipt any rent ac-cruing to a nonresident person through thehiring or renting of movable property inHong Kong.

13 The 100-percent rate does not apply to

royalty income derived from an associateif the Commissioner of Inland Revenue issatisfied that no person carrying on a trade,profession, or business in Hong Kong has atany time wholly or partly owned the relevantproperty. In such cases, the 30-percent rateapplies (IRO Section 21A).

14 On request means a tax administrationasks specific questions relating to a par-ticular case. Automatic exchange occurswhen the tax administrations exchangeinformation concerning specified items ofincome on a systematic way. Spontane-ous exchange refers to the passing on ofinformation obtained by a tax administrationduring an examination of the taxpayers af-

fairs (such as in a tax audit or investigation)to the other tax administration, where theinformation may be of interest to the latter(OECD, 1994).

this way, the rule appears as a logi-cal extension of the principle inArticle IV(1), that residence statusfor treaty purposes is dependenton the tax treatment in the countryof residence.

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

treated as derived by a resident ofa Contracting State where:

(b) That person is consideredunder the taxation law of theother Contracting State to havereceived the amount from anentity that is a resident of thatother State, but by reason ofthe entity being treated asfiscally transparent under thelaws of the first-mentionedState, the treatment of theamount under the taxationlaw of that State is not thesame as its treatment would be

if that entity were not treatedas fiscally transparent underthe laws of that State.

This rule applies to dividendspaid by a ULC that is treated asa flow-through entity for U.S. taxpurposes to its U.S. shareholders,and would prevent such dividendsfrom qualifying for a reduction inCanadian withholding tax rates.What is surprising about this ruleis that the Code Sec. 894(c) regu-lations, which extensively addressthe various possibilities for treatyabuse that arise from the use of

Anti-DeferralContinued from page 8


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hybrid and reverse hybrid entitieswould permit treaty benefits in thissituation (that is, in the absenceof new paragraph 7(b)).17 In fact,the Treasury specifically consid-ered the possibility of abuse in

the context of such payments bya domestic reverse hybrid entityand concluded that treaty benefitsshould generally be availablefor such payments, subject to anarrow exception for paymentsmade to a related party that aredeductible in the source countrywhere the underlying incomeearned by the domestic reversehybrid is treated as a dividend inthe country of residence.18 We

understand that paragraph 7(b)was included at the request ofthe Canadian government andwas intended to prevent certaindouble dip financing structuresthat utilize a ULC. However, theCRA may not have realized thescope of the provision which, inits current form, will prevent U.S.taxpayers from utilizing ULCs in abroad range of ordinary operatingand holding company structures

in which double dips and aggres-sive tax planning play no part.

Ratification andEffective DatesThe Protocol must be ratified byboth the United States and Canadabefore it goes into force. The Pro-tocol will go into force on thedate such ratification is completedor.19 Once the Protocol goes intoforce, it will generally be effectivewith respect to withholding taxesalmost immediately, on amountspaid on or after the first day of thesecond month that begins after thedate on which the Protocol entersinto force (no earlier than March1, 2008).20 With respect to othertaxes, the Protocol will generally

be effective the first tax year thatbegins after the Protocol enters intoforce (that is, probably in 2009 forcalendar-year taxpayers).21

Notwithstanding these generaleffective date rules, there are sev-

eral special effective dates forparticular provisions. Specifically,the new rules contained in newparagraph 7 of Article IV (that lim-it treaty benefits for certain hybridentity structures, but not the newfavorable LLC rule in paragraph 6of Article IV) is delayed until thefirst day of the third calendar yearthat ends after the treaty goes intoforce.22 In other words, assumingthe treaty goes into force during

2008, paragraph 7 would go intoeffect on January 1, 2010.

ENDNOTES1 Protocol Amending the Convention Be-

tween Canada and the United States ofAmerica with Respect to Taxes on Incomeand on Capital Done at Washington on26 September 1980, as Amended by theProtocols Done on 14 June 1983, 28 March1984, 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 andAnnexes, is available on Canadas Depart-ment of Finance Web site at www.fin.gc.ca/news07/07-070e.html.

2 Canadas Department of Finance Web siteat www.fin.gc.ca/news07/07-070e.html.

3 Reg. 301.7701-3.4 Id.5 The Canadian Government had stated pub-

licly (for example, at the International TaxSeminar on May 19, 1999 of the Canadianbranch of the International Fiscal Associa-tion) that ongoing protocol negotiations areclearly seeking to redress this issue. (Thegovernments comments were not madeavailable for publication in the proceedings

of that seminar.)6 Note that the two new paragraphs, ArticleIV(6) and (7), are contained in the ResidenceArticle of the Treaty, which is consistent withpast U.S. policy under the 1996 U.S. Model,as reflected in Article 4(a)(d) of that Model,but differs from the 2006 U.S. Model wherethe hybrid entity provision is contained inthe General Scope article. Arguably, thenew hybrid entity provisions contained inthe Protocol should have been contained

in Article I of the Treaty, as suggested by the2006 U.S. Model as this is most consistentwith their effect. Article IV(6) and (7) do notdefine residence, but respectively extendand limit the personal scope of the Treaty.Article IV(7) has no equivalent in the 2006U.S. Model and is not reflected in past U.S.tax treaty practice. This provision has beendesigned to deal with certain specific bilat-eral issues; nonetheless, as discussed below,certain of its aspects come as a surprise.

7 From the official Backgrounder to the Proto-col released by the Canadian Department ofFinance, available at www.fin.gc.ca/news07/data/07-070_1e.html.

8 See, for example, Article X (dividend), ArticleXI (interest), and Article XII (royalties).

9 Reg. 1.1441-1(c)(6)(i).10 United States Treasury Department, United

States Model Technical Explanation Accom-panying the United States Model Income TaxConvention of November 15, 2006.

11 Organization for Economic Co-operationand Development, Model Tax Conventionon Income and on Capital: Condensed Ver-sion (Paris: OECD, July 2005) paragraph 12of the commentary on Article 10.

12 Among other requirements, only U.S. indi-viduals or certain domestic trusts are permit-ted as shareholders of an S corporation.

13 Part of that overall context is that if at apoint in time a U.S. corporation does notelect subchapter S treatment and acquires aproperty for $100 and then at a subsequentpoint in time (when that property has ap-preciated to $500) it elects subchapter Sstatus and then sells the property for $1,000,$400 of the $900 gain would be taxed inthe hands of the S corporation itself (as in

the case of any non-S corp.) and only $500would flow through with a single tax at theshareholder level.

14 See, CRA document no. 9822230, Sept. 23,1998, and Income Tax Technical Newsno.16, Mar. 8, 1999.

15 Reg. 1.894-1(d)(2)(i).16 Reg. 1.894-1(d)(1).17 Reg. 1.894-1(d)(2)(ii)(A).18 Reg. 1.894-1(d)(2)(ii)(B).19 Article 3 of the Protocol.20 Article 3(2)(a) of the Protocol.21 Article 3(2)(b) of the Protocol.22 Article 3(b) of the Protocol.

case, it appears that S should rec-ognize the $100 gain and shouldconsider that gain for purposes ofthe SRLY offset.44 However, be-cause S is reducing its recapture

Dual ConsolidatedContinued from page 14


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anti deferral and anti tax avoidance feb2008

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