Applying Hybrid Entity Rules in the Canada-U.S. Treaty in a Transfer Pricing Context

A Canada Revenue Agency technical interpretation (Doc. 2018-0753621I7) released in December 2019 addresses the interaction between the hybrid rules in the 1980 Canada-U.S. tax convention and the transfer pricing rules under the Income Tax Act (Canada). The technical interpretation addresses a fact pattern in which, for Canadian tax purposes, a dividend is deemed to have been paid by a Canadian corporation to a U.S. fiscally transparent entity (FTE), while for U.S. tax purposes, there is not a readily identifiable corresponding item of income.

More specifically, Canadian transfer pricing rules deemed a dividend to have been paid by a Canadian fiscally opaque entity to a U.S. FTE in connection with a purchase below fair market value. For U.S. tax purposes, the dividend was disregarded but its amount was reflected in the purchase price. That situation makes it difficult to satisfy the condition in the hybrid rules that the item of income that Canada seeks to tax be derived under U.S. tax laws.

The CRA concluded — against a backdrop of earlier CRA views denying treaty benefits in somewhat similar circumstances — that treaty benefits were available. In reaching that conclusion, the agency took a broad view of what amounts can be said to be derived under U.S. tax law.

The technical interpretation thus demonstrates both the flexibility of, and the lack of clarity in, the operative concepts in the treaty’s hybrid rules.

Background

The Hybrid Rules Generally

Articles IV(6) and (7) of the treaty address taxpayers’ entitlement to treaty benefits for amounts derived through or paid by a hybrid entity — that is, an entity characterized as fiscally transparent in one jurisdiction and fiscally opaque in another. For example, unlimited liability corporations (ULCs), which can be incorporated in some Canadian provinces, are corporations for Canadian tax purposes but can be treated as FTEs for U.S. tax purposes, such that under U.S. tax law, a ULC’s income is considered income received directly by its shareholders.

Article IV(6) is generally a relieving rule that ensures entitlement to treaty benefits when they might otherwise not be available because income is earned through an entity, such as a limited liability company, that the United States treats as an FTE but Canada treats as fiscally opaque.¹ In general terms, Article IV(6) provides that an amount of income, profit, or gain is considered derived by a person resident in one contracting state if:

• the amount is considered under that state’s tax laws to be derived by that person through an entity (other than an entity that is a resident of the other contracting state); and

• by reason of that entity being considered fiscally transparent under the first state’s laws, the treatment of the amount under those laws is the same as it would be if the amount had been derived directly by that person.

The application of Article IV(6) can be demonstrated by the fact pattern in Figure 1.

Canco is a Canadian resident corporation, the sole shareholder of which is a U.S. LLC — a disregarded entity (and therefore an FTE) for U.S. tax purposes. The only member of the LLC is Parentco, a U.S. C corporation that is generally entitled to treaty benefits. Canco pays a dividend to the LLC.

If Canco paid the dividend directly to Parentco, Article X of the treaty would reduce the rate of Canadian tax that would need to be withheld on the dividend under the ITA. Because the LLC is an FTE, however, it is not clear that the dividend would qualify for that treaty benefit in the absence of Article IV(6).²

However, the dividend passes both parts of the test in Article IV(6):

• the amount is considered under U.S. tax laws to be derived through an entity not resident in Canada (the LLC); and

• because the LLC is fiscally transparent, the dividend is treated as being derived by Parentco just as it would be if it had actually been derived by Parentco for U.S. tax purposes.

As a result, under the treaty, the dividend is derived by Parentco. While that derivation by Parentco is the critical condition that must be met for the treaty benefit to be available, it is technically the LLC that receives the benefit in the form of a reduced Canadian tax rate under Article X. That is because the LLC is not fiscally transparent from a Canadian perspective and, as the recipient of the dividend, is the entity liable to Canadian tax.³

Article IV(6) is relatively easy to apply in an example like the one above, in which the item of income at issue is regarded in both jurisdictions, even if the treatment differs. For example, the CRA has concluded that when a Canadian corporation (treated as such for tax purposes in both jurisdictions) makes to an LLC a cross-border distribution that is treated as a dividend by Canada but as a return of capital by the United States, the distribution would be considered to be derived by the LLC’s members under Article IV(6).⁴

However, some amounts that exist or are deemed to exist under Canadian tax laws may be a nonevent or nonexistent for U.S. tax purposes. If an amount is regarded in only one of the two jurisdictions, the application of Article IV(6) can be less clear.

At the 2009 Canadian Tax Foundation Roundtable, the CRA considered the payment of an actual dividend by a Canadian ULC to its sole shareholder, a U.S. resident. The ULC was a disregarded entity for U.S. tax purposes. The CRA concluded that the better view is that the dividend, being disregarded for U.S. tax purposes, could not be said to be derived by the LLC’s members.

While from a Canadian tax law perspective the ULC has paid a dividend to an FTE (the LLC), from a U.S. perspective the ULC is disregarded and thus neither it nor the dividend exists. Effectively, nothing has happened, so Article IV(6) cannot apply.

Complicating the analysis further, Canadian withholding tax sometimes applies to amounts that truly do not exist (or are of a different character) and yet are statutorily deemed to have been paid. Some of those deemed payments may be considered derived under U.S. tax law by an FTE’s members, and some not. For example, when a Canadian corporation (not disregarded for U.S. tax purposes) redeems shares held by an LLC for an amount greater than the shares’ paid-up capital, the resulting deemed dividend is derived by the U.S. taxpayer because it is a cognizable item for U.S. tax purposes, being reflected in disposition proceeds or as a return of capital.

In contrast is a situation in which the Canadian deemed dividend is entirely disregarded for U.S. tax purposes. For example, when a Canadian corporation increases the paid-up capital of its shares, the ITA generally deems the amount of the increase a dividend. If the shareholder deemed to receive that dividend is an FTE (such as an LLC treated as disregarded or a partnership for U.S. tax purposes), the CRA reportedly⁵ will treat the deemed dividend as not derived by the FTE’s members under U.S. tax law, under which the paid-up capital increase has no impact.

The distinction between Canadian deemed transactions that are regarded, although characterized differently, for U.S. tax purposes and those that are disregarded is not always clear. That is evidenced by the technical interpretation, in which the CRA showed that there is interpretative flexibility in making determinations on the derivation of deemed amounts under Article IV(6).

The Transfer Pricing Deemed Dividend

The technical interpretation addresses one type of deemed payment subject to Canadian withholding tax — namely, a deemed dividend triggered under the ITA as a consequence of a Canadian transfer pricing adjustment.

The transfer pricing rules in ITA section 247 generally provide that the Minister of National Revenue can adjust the terms or conditions of transactions between Canadian resident taxpayers and non-arm’s-length nonresidents if the transactions involve terms or conditions that would not have applied between parties dealing at arm’s length.⁶ The principal provision in the transfer pricing rules is subsection 247(2), which empowers the minister to adjust a taxpayer’s income based on that type of recharacterization (a primary adjustment).

In some circumstances in which the minister has made a primary adjustment, subsection 247(12) provides for a secondary adjustment. Specifically, the secondary adjustment deems a dividend to have been paid by the Canadian resident to the non-arm’s-length nonresident when there is a primary adjustment resulting from a purchase for consideration that exceeds the amount that would meet the arm’s-length principle or from a sale for consideration that is lower than that amount.

For example, a Canadian resident corporation sells inventory to its U.S. resident parent. The inventory has an FMV of $100 but the U.S. parent pays only $50. The primary adjustment under subsection 247(2) would adjust the income of the Canadian resident corporation to be $50 higher to reflect the terms and conditions that would have applied if the sale had been made at arm’s length — that is, a sale of the property at the FMV of $100. The secondary adjustment under subsection 247(12) would then deem the Canadian resident corporation to have paid a $50 dividend to the U.S. parent that would be subject to withholding under ITA Part XIII.

The Technical Interpretation

In the technical interpretation, CRA International and Large Business Case Manager Income Tax Rulings (Rulings) was asked to consider the following fact pattern: Parentco, a U.S. resident C corporation, is the only member of Parentco LLC, which in turn is the only member of Sisterco LLC. Parentco LLC and Sisterco LLC are disregarded entities under U.S. tax law.

Parentco LLC is the sole shareholder of Canco. Canco sells property to Sisterco LLC, which pays less than FMV consideration. As a result of the non-arm’s-length sale price of the property, the minister makes a primary adjustment under subsection 247(2), whereby Canco’s income is adjusted to reflect higher, arm’s-length sale proceeds. That, in turn, results in a secondary adjustment in the form of a deemed dividend from Canco to Sisterco LLC under subsection 247(12).

The question for Rulings was whether Article IV(6) of the treaty would apply to the deemed dividend, so that the benefit would be available and the withholding rate would be reduced. On those facts, Article IV(6) could be paraphrased as follows:

According to Rulings, that inquiry gives rise to three uncertainties regarding Article IV(6). First, in the preamble (the first paragraph of Article IV(6)), what amount of income is being tested? Second, in Article IV(6)(a), can it be said that Parentco is considered under U.S. tax law to have derived the deemed dividend resulting from ITA section 247(12) through Parentco LLC and Sisterco LLC? Finally, in Article IV(6)(b), can it be said that the U.S. treatment of the amount of the deemed dividend resulting from the application of ITA section 247(12) is the same as if that amount had been derived directly by Parentco?

In practice, the analysis focuses on the second uncertainty. The key question the technical interpretation thus turns on is: How can an amount that is not a separately regarded item of income for U.S. tax purposes that is deemed to exist under Canadian law be said to have been derived by a U.S. resident under U.S. tax laws?

Rulings began by referring to CRA Doc. 2009-0345351C6 (the 2009 roundtable answer) for the proposition that a regarded amount can be derived by the members of an LLC when treated differently under U.S. and Canadian taxation law. Rulings then applies that principle to the deemed dividend in the fact pattern by turning to what it referred to as the economics of the example. It made two general comments about the U.S. treatment of the kind of non-FMV sale that leads to a secondary adjustment. First, if a Canadian resident buys property for excessive consideration, the result in Canada is a deemed dividend, while for the nonresident in the United States, that same amount is additional profit on a sale. Second, if a Canadian resident sells property for insufficient consideration, the result in Canada is also a deemed dividend, while for the nonresident in the United States, that same amount is the excess in the value of the property acquired over the consideration paid, and thus would be reflected in a lower tax cost of the property.

By analyzing the matter that way, the CRA could identify amounts that in the United States are regarded and correspond to (even while having a different character than) the fictitious Canadian dividend — and was thereby able to distinguish the example from ones involving amounts that are entirely disregarded in the United States. Because Canco sold property for insufficient consideration, the example falls into the second category above. Rulings concluded that the amount is regarded as the reduced cost of inventory: “Parentco is considered to have derived an amount (that is not disregarded) through US Sisterco LLC. More specifically . . . Parentco will have a reduced cost of inventory.”

That helpful analysis is consistent with the rule’s context and purpose. It is notable that Rulings considered a reduction in the cost of inventory to be an amount of income, profit, or gain. In doing so, it confirmed that the term “amount” is broad enough to include an amount missing from what the cost would have been if the sale of the property had taken place at arm’s length. It thus effectively distinguished the transfer pricing deemed dividend from a Canadian deemed dividend arising on a paid-up capital increase that is entirely disregarded for U.S. tax purposes.

Avoiding a mechanistic or literal approach toward what counts as the derivation of an amount of income, profit, or gain is consistent with Canadian courts’ long-standing approach to treaty interpretation. As stated in J.N. Gladden Estate v. The Queen, [1985] 1 CTC 163 (F.C.T.D.):

It is appropriate to avoid taking a literal and legalistic approach to Article IV(6) when applying it to the deemed dividend. Because Canada is already taxing the amount of the secondary adjustment’s deemed dividend as a result of the primary adjustment (whereby Canco’s sale proceeds are increased under the transfer pricing rules to the arm’s-length price), it would be consistent with the treaty’s objective of avoiding double taxation to grant benefits for the deemed dividend. That is achieved by giving Article IV(6), including its concept of “derived by,” a liberal interpretation.

As a result of that analysis, Rulings concluded that Article IV(6) applies such that Parentco can be said to have derived the deemed dividend through Sisterco LLC. As noted above, it is actually Sisterco LLC that enjoys the treaty benefits from a Canadian tax perspective, because under Canadian law, Sisterco LLC is not fiscally transparent and is the entity liable to pay tax on the deemed dividend. The combined application of articles IV(6) and X results in Sisterco LLC paying or bearing Canadian withholding tax at a reduced rate.

The Hypothetical Competent Authority Process

Although the CRA concluded that treaty relief would be available for Canadian withholding tax on the deemed dividend, it went on to consider whether there would be a remedy under the competent authority process if treaty benefits were denied by Article IV(6). If the deemed dividend were subject to Canadian 25 percent withholding tax under ITA Part XIII, double taxation would result (because there would also be an additional profit realized by Sisterco LLC on the sale of the inventory acquired on the transaction) and the competent authority process could be engaged. Using that hypothetical situation, Rulings suggested that the U.S. competent authority could be expected to make a corresponding adjustment to give effect to what the results would have been in an arm’s-length transaction. That adjustment could take one of many forms. Rulings suggested two possibilities: the inclusion of a dividend in Parentco’s income along with a contribution to the capital of Sisterco LLC, or an increase in the cost of the property to Sisterco LLC.

Rulings then answered two final questions. First, it said the amount of the corresponding adjustment would be the same as the amount of the deemed dividend. Next, it said Article IV(6) would likely apply if the corresponding adjustment took the form of a dividend to Parentco LLC because the connection between the adjustment and the dividend might be sufficient, and because both items emanate from transfer pricing primary adjustments negotiated by the competent authorities.

Rulings thus said it thought Canada’s competent authority would allow Parentco to benefit from Article X and reduce the ITA Part XIII assessment because the conditions of Article IV(6) would be met.

Implications

The CRA’s conclusion that Article IV(6) would apply to the deemed dividend is appropriate, despite other agency positions, such as the 2009 roundtable answer (which denied treaty benefits for a dividend paid by a ULC to an LLC) and its reported view that treaty benefits are unavailable when a paid-up capital increase results in a deemed dividend to an LLC. The key distinction between those earlier fact scenarios and the transfer pricing example appears to be Rulings’ identification of the reduced cost of inventory in the United States as a regarded amount.

The technical interpretation clarifies the interpretation of Article IV(6) in that it sets out the CRA’s view that a deemed dividend need not be considered an amount paid to the U.S. hybrid entity to be considered by Canada to be regarded for U.S. tax purposes and derived by the relevant treaty resident. It also appears to demonstrate flexibility in the “regarded” concept, with the CRA being willing to consider a change in a tax attribute (the reduced cost of inventory) corresponding to a fictitious dividend to be a regarded amount. Further, the hypothetical competent authority analysis seems to suggest that the search for a regarded amount can be nuanced and far ranging.