E&Y Comments on U.S.-Canada Tax Treaty Protocol
E&Y Comments on U.S.-Canada Tax Treaty Protocol
- AuthorsO'Connor, Margaret
- Institutional AuthorsErnst & Young LLP
- Cross-Reference
- Subject Area/Tax Topics
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 2008-1824
- Tax Analysts Electronic Citation2008 TNT 20-25
January 22, 2008
The Honorable Eric Solomon
Assistant Secretary
Office of Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW, Rm. 3120
Washington, DC 20220-0001
Mr. Bob Hamilton
Senior Assistant Deputy Minister, Tax Policy
Department of Finance, Canada
140 O'Connor Street
Ottawa, Ontario K1A 0G5
Re: Fifth U.S.-Canada Protocol
Dear Assistant Secretary Solomon and Senior Assistant Deputy Minister Hamilton:
This comment letter is submitted by Ernst & Young LLP ("Ernst & Young" or "E&Y") on behalf of some concerned taxpayers in respect of the Fifth Protocol amending the Income Tax Convention between the United States of America and Canada (the "Convention"), signed on September 21, 2007 (the "Protocol"). Specifically, this letter is intended to highlight a concern relating to a potential denial of treaty benefits by Canada that may result under Article 25 of the Protocol, revising Article XXIX A of the Convention, the Limitation on Benefits ("LOB") Article.
We commend the U.S. Department of the Treasury ("Treasury") and the Canadian Department of Finance ("Finance") for their efforts in drafting the Protocol, which provides updated guidance to reflect the growing importance of cross-border economic relations between the two countries. We recognize that those involved in this project devoted much research, thought and analysis to crafting the overall analytical framework for integrating the tax systems of the United States and Canada.
The comments below were prepared by the following E&Y professionals: Margaret O'Connor, Doug Scheetz and Angelo Nikolakakis:
Contact Persons:
Margaret O'Connor
Tel: (202) 327-6229
Fax: (202) 327-6721
margaret.oconnor@ey.com
Doug Scheetz
Tel: (720) 931 4012
Fax: (720) 931 4444
doug.scheetz@ey.com
Angelo Nikolakakis
Tel: (514) 879-2862
Fax:(514)871-8713
angelo.nikolakakis@ca.ey.com
Executive Summary
Taxpayers are concerned that there may be situations in which the provisions of the Protocol may introduce unwarranted uncertainties or hardships into the interpretation and application of the Convention to deserving taxpayers, and submit that these concerns should perhaps be addressed through clarification in a technical explanation to the Convention that is agreed to by the United States and Canada. In particular, there is a concern about the potentially inconsistent and inappropriate application of the LOB Article, which will be applied for the first time by Canada once the Protocol enters into force.
As described more fully below, the concern relates to the potential for the denial by Canada of benefits under the Convention to a U.S. domestic corporation (the "Tested Corporation") which has, in its ownership chain, U.S. limited liability companies ("LLCs" or an "LLC") that are treated as fiscally transparent for U.S. tax purposes (either as disregarded entities or partnerships). The basis for this concern is that Canada may not "look through" the LLCs to the ultimate owner(s) in applying Paragraph 2(d) or (e) of Article XXIX A of the Convention for the purpose of determining whether or not the Tested Corporation is a "qualifying person," eligible for benefits under the Convention.
Background
Canada's approach to entity classification is different from the approach adopted by the United States. With respect to LLCs, Canada has consistently treated these entities as corporations for Canadian tax purposes, regardless of their treatment for U.S. tax purposes. Thus, with respect to an LLC that derives Canadian source income or gains (for its own account and not as an agent for another person), Canada has consistently taken the position that the LLC must itself qualify for benefits under the Convention, or such benefits are denied. Where the LLC is fiscally transparent for U.S. tax purposes, Canada's position has been that the LLC would not be regarded as a "resident" of the United States for the purposes of the Convention, on the basis that it is not itself "liable to tax" under U.S. law. In such a case, Canada's position has been that benefits under the Convention would be denied to the LLC. In contrast, where the LLC is treated as a domestic corporation for U.S. tax purposes, Canada's position has been that the LLC is "liable to tax" under U.S. law, and therefore would be regarded as a "resident" of the United States for the purposes of the Convention, and should itself be eligible for the benefits of the Convention. In either case, however, subject to the changes to Article IV and Article X of the Convention that would be introduced by the Protocol (discussed more fully below), Canada does not simply "look through" the LLC to the ultimate owner(s).
Article IV and Article X
As you know, Paragraph 6 of Article IV, the Residence Article, was added by the Protocol in order to address such long-standing concerns over the denial by Canada of benefits under the Convention that arise where an LLC which is fiscally transparent for U.S. tax purposes is owned by U.S. persons and derives Canadian source income or gains. This Paragraph would treat "income, profit or gain" as having been derived by a person that is a resident of a contracting state where the person is considered under the laws of the residence state to have derived that amount through an entity (other than an entity that is a resident of the other state) and by reason of the entity being treated as fiscally transparent under the taxation laws of the residence state the treatment of the amount under the laws of the residence state is the same as its treatment would be if it had been derived directly by that person. For example, under this provision, Canadian source income earned by an LLC that is treated as a partnership for U.S. tax purposes would be treated as the income of a resident of the United States to the extent that the LLC is owned by residents of the United States. Clearly, this provision contemplates the ability to "look through" a fiscally transparent LLC, to determine whether income is derived by a resident of the United States.
In addition, the Protocol adds a special rule to Paragraph 2(a) of Article X, the Dividends Article, specifically attributing to a resident corporation the voting stock of a source state corporation that is owned by an entity that is fiscally transparent under the laws of the residence state for the purpose of determining whether or not the 10 percent ownership threshold would be satisfied. Thus, the voting stock in a Canadian corporation that is owned by an LLC, treated as a disregarded entity for U.S. tax purposes, would be attributed to its U.S. corporate owner(s).
The LOB Article
In the context of the LOB Article, assume that the Tested Corporation is a resident of the United States, and that all of its shares are directly held by an LLC, treated as a disregarded entity for U.S. tax purposes. Also, assume that the owner of the LLC is a U.S. resident that is a "qualifying person" under the Convention. If the Tested Corporation is not a "qualifying person" under Paragraph 2(c) of the LOB Article (the "publicly traded test"), the question becomes whether the share ownership by the LLC would disqualify the Tested Corporation under Paragraph 2(d) or (e) of the Article.
Under Paragraph 2(d), the Tested Corporation can be a "qualifying person" if five or fewer companies that are "qualifying persons" under Paragraph 2(c) "own directly or indirectly more than 50 percent" of the aggregate vote and value of the Tested Corporation, "provided that each company ... in the chain of ownership is a qualifying person." In the example provided above, even assuming that the owner of the LLC is a "qualifying person" under Paragraph 2(c), it is not clear that the Tested Corporation would be treated by Canada as a "qualifying person." Specifically, it is not clear whether the interposition of the LLC would preclude the Tested Corporation from being a "qualifying person" under Paragraph 2(d). From a U.S. perspective, since the LLC would be treated as a fiscally transparent entity, the United States would conclude that the Tested Corporation is a "qualifying person," on the basis that all its shares are owned by a "qualifying person" under Paragraph 2(c).
Under Paragraph 2(e), the Tested Corporation can be a "qualifying person" provided that "50 percent or more" of the aggregate vote and value of the Tested Corporation "is not owned, directly or indirectly, by persons other than qualifying persons." This particular provision does not include the same language as in Paragraph 2(d), providing that each company in the chain of ownership must be a "qualifying person." However, the test in this provision is phrased in the negative rather than in the affirmative (i.e., "not owned, directly or indirectly" rather than "owned, directly or indirectly"). Consequently, at issue is whether the existence of an LLC in the ownership chain would disqualify the Tested Corporation under the facts described previously. Here too, from a U.S. perspective, since the LLC would be treated as a fiscally transparent entity, the United States would conclude that the Tested Corporation is a "qualifying person," on the basis that none of its shares are owned by a person other than "qualifying person." What is not clear is whether Canada would adopt a similar interpretation.
We understand from informal conversations with Finance that Canada may not treat the Tested Corporation as a "qualifying person" under either Paragraph 2(d) or 2(e) under the facts described herein. That is, the Tested Corporation could be considered by Canada to be disqualified under the LOB Article because its shares are owned "directly" by a person other than a "qualifying person" (i.e., the LLC), even though all the shares of the Tested Corporation are owned "indirectly" by "qualifying persons," and even though the LLC would be treated as fiscally transparent (i.e., a disregarded entity) for U.S. tax purposes. The basis for this, in part, would be that Canada would treat the LLC as a company, but not as a resident of the United States for the purposes of the Convention, if it is fiscally transparent for U.S. tax purposes. This is not consistent with the U.S. approach to conferring U.S. treaty benefits, in that the United States would generally "look through" an entity to its owners if the entity is treated as fiscally transparent in its country of residence, regardless of its classification for U.S. tax purposes.
Concluding that the Tested Corporation under the facts described herein is not a "qualifying person" under the Convention would be in direct conflict with the underlying policy of the LOB Article, as well as with the policy reflected by Paragraph 6 of Article IV and Paragraph 2(a) of Article X. In general, the LOB Article is designed to prevent residents of third countries from benefiting from what is intended to be a reciprocal agreement between two contracting states, in this case the United States and Canada. Also, the provisions of the LOB Article represent an attempt to ensure that a technical resident of a contracting state has sufficient substantive nexus with that contracting state to justify granting treaty benefits and keep would-be treaty-shopping entities from being beneficiaries under a treaty. The sample fact pattern posited above does not involve any third-country resident or any planning aimed at obtaining treaty benefits by circumventing the general purposes and aims of the Convention. Rather, the Tested Corporation, a resident of the United States, is owned directly by an LLC and indirectly by "qualifying persons," subject to U.S. taxation directly on their pro-rata share of the LLC's income. The Tested Corporation therefore has a substantial nexus with the United States. Moreover, a determination that such a Tested Corporation is not a "qualifying person" under the Convention could lead to inappropriate double-taxation of the Tested Corporation.
This is an extremely important matter, and the issue may not be able to be addressed in many cases even with proper planning. Although, in the example posited, it may be possible to eliminate the LLC, there would undoubtedly be cases where this would not be feasible. For example, in the context of the test in Paragraph 2(e), there are likely many situations in which the shares of a relatively widely-held Tested Corporation would be owned by investors (i.e., members of the public) through fiscally transparent LLCs. If the LLCs cannot be looked-through from a Canadian perspective in applying this test, many Tested Corporations could be disqualified despite the fact that they are ultimately owned by "qualifying persons," and despite the fact that one of the significant purposes of the Protocol is to address the long-standing concerns of U.S. residents investing in Canada through fiscally transparent LLCs.
Accordingly, we respectfully request that representatives of the United States and Canada jointly address these issues and formally confirm agreement that a Tested Corporation may look through fiscally transparent LLCs in the Tested Corporation's ownership chain to the ultimate owner(s) in determining whether the Tested Corporation is a "qualifying person" for the purposes of Article XXIX A of the Convention.
Ernst & Young appreciates this opportunity to comment on the Protocol and your consideration of our suggestions and recommendations. We would be happy to discuss any questions you may have at your convenience.
Ernst & Young LLP
Washington, D.C.
Michael F. Mundaca
Deputy Assistant Secretary for International Tax Affairs
Department of the Treasury
Benedetta A. Kissel
Deputy International Tax Counsel
Department of the Treasury
John L. Harrington
International Tax Counsel
Department of the Treasury
Brian Ernewein
General Director, Tax Legislative Division
Department of Finance, Canada
Gérard Lalonde
Director, Tax Legislation Division
Department of Finance, Canada
Lawrence Purdy
Senior Chief, Tax Legislation Division
Department of Finance, Canada
Olli Laurikainen
Manager, International & Trusts Division
Income Tax Rulings Directorate
Canada Revenue Agency
- AuthorsO'Connor, Margaret
- Institutional AuthorsErnst & Young LLP
- Cross-Reference
- Subject Area/Tax Topics
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 2008-1824
- Tax Analysts Electronic Citation2008 TNT 20-25