Foreign Income & Taxpayers
The use of a limited liability company (LLC) in the United States for domestic purposes provides a number of benefits. For instance, an LLC provides the legal protection offered to a corporate body while, for U.S. tax purposes, still being able to retain the flowthrough of profits and losses to the LLC’s members. The benefit of the flowthrough of profits and losses stems from the lack of integration that exists in the United States between the corporate tax system and the individual tax system. That is, profits earned in a corporation and subsequently passed through as dividends to the shareholder may create a higher U.S. income tax burden than if the income had been taxed only at the shareholder level.
The Code allows an LLC to elect to be treated as either a corporation subject to U.S. federal income taxes like any other U.S. domestic corporation, a partnership, or, in the case of single-member LLCs, a disregarded entity. The election to be treated as a partnership or to be a disregarded entity provides for the flowthrough of profits and losses to the members and is the focus of this item.
A U.S. corporation can obtain similar results by electing to be an S corporation, which is treated as a flowthrough entity the income of which is generally taxed at the shareholder level.
Under its own Income Tax Act (ITA), Canada has viewed both an LLC and an S corporation as corporations, notwithstanding that their profits and losses flow through to their shareholders or members. However, when applying the provisions of the Canada-U.S. Income Tax Convention (the treaty), the Canada Revenue Agency (CRA) has viewed an LLC as not meeting the definition of a resident of the United States for purposes of the treaty while at the same time viewing an S corporation as being a U.S. resident for purposes of the treaty. Of course, because an LLC has not been given the status of a resident of the United States, it has in the past been disallowed the benefits of the treaty.
In TD Securities (USA) LLC vs. The Queen, 2010 D.T.C. 1137 (Can. Tax Ct.), a case decided in April 2010, the Tax Court of Canada (Tax Court) had the opportunity to review the CRA’s position on the residency of an LLC for purposes of the treaty. The Tax Court decided in favor of the taxpayer, TD Securities (USA) LLC (TD LLC), by concluding that it was a resident for purposes of the treaty and therefore allowed the benefits of the treaty where applicable. This item examines the Tax Court’s opinion as well as how it will affect the amendments under the Fifth Protocol to the Canada-U.S. treaty.
The CRA has not appealed the TD Securities decision, although it may be too early to determine to what extent it will accept the court’s opinion in the future. The CRA has a history of limiting the benefits of a court decision to the facts of a particular case, and therefore it may decide not to apply the court’s holding to other cases.
CRA’s Previous View of the Residency of an LLC Under the Treaty
As stated, prior to ratification of the treaty, the CRA had taken the position that an LLC was not a resident of Canada for purposes of the treaty. The position was founded on the point that an “LLC which is treated as a partnership under the Internal Revenue Code of the United States does not qualify as a resident of the United States for the purposes of the Treaty under Article IV thereof, for the reason that such LLC is not subject to tax in the United States” (see CRA Document No. 9729780). This technical interpretation attempts to reconcile the positions taken by the CRA with respect to residency status for treaty purposes of an LLC and an S corporation. In actuality, the original opinions date back to earlier years. Furthermore, the CRA states that it will not allow for the lookthrough to the members of the LLC in considering whether the members may benefit from treaty exemption.
Fundamentally, the CRA based its position on a risk assessment rather than reason, in this author’s opinion. More specifically, the CRA stated that “if a LLC was granted the benefits of the Treaty, it would be possible for Canadian resident members to avoid both U.S. and Canadian tax on income from a business carried on in Canada by the LLC if the LLC did not have a permanent establishment in Canada” (CRA Document No. 9729780).
Unlike the position for an LLC, the CRA arrived at the opposite conclusion about an S corporation. In the CRA’s analysis, the view was that even if profits and losses flowed to the shareholders of the S corporation under the Code, because the shareholders of an S corporation were restricted to U.S. citizens or residents or trusts, the beneficiaries of which were U.S. citizens or residents, U.S. taxation was somewhat assured. The CRA never further reconciled the discrepancies between these two positions.
The taxpayer in TD Securities successfully challenged this position. In addition to the conclusion reached, the case is of interest because it represents a recent example of what tools Canada will use to interpret the treaty.
Fifth Protocol Amendments
Before entering into the facts of the TD Securities case, it is important to view the impact of the Fifth Protocol amendments on an LLC and its members even though they did not apply for the taxation years under appeal in TD Securities. The same amendments apply equally to S corporations, although the reliance on this article, given the CRA’s view that an S corporation is a resident for U.S. tax purposes, is of lesser importance.
In an effort to resolve the issue of fiscally transparent entities, under which an LLC and an S corporation would be categorized, Article IV(6) of the treaty was added. This article reads as follows:
An amount of income, profit or gain shall be considered to be derived by a person who is resident of a Contracting State where:
- The person is considered under the taxation law of that State to have derived the amount through an entity (other than an entity that is resident of the other Contracting State); and
- By reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is the same as its treatment would be if that amount had been derived directly by that person.
In effect, this article provides that income, profit, or gain are to be considered derived by a “resident of a Contracting State” even if, as is the case for the LLC, the entity itself is not seen as a resident for treaty purposes. Said another way, if the LLC derives income in Canada, it will be considered derived by a person who is a resident of the United States. Although this is a relieving provision, as discussed below, a taxpayer cannot rely upon it by itself to provide the benefits that would otherwise be permitted if the LLC were considered a resident of the United States on its own accord for all purposes.
TD LLC is an LLC governed by the state of Delaware. The sole member of TD LLC is TD Holdings II Inc., a Delaware corporation that is a resident of the United States for treaty purposes. TD Holdings II was a subsidiary of Toronto Dominion Holdings (USA) Inc. (TD USA), another Delaware corporation. TD USA was a subsidiary of the Toronto-Dominion Bank of Canada, a Canadian chartered bank.
For a number of commercial reasons, TD LLC carried on business in Canada for the benefit of its U.S. customers. TD LLC accordingly filed a Canadian income tax return to report its profits that would be subject to Canadian income tax on the basis that the Canadian business was carried on in Canada through a permanent establishment. (Any nonresident carrying on business in Canada is subject to Canadian income tax. In most cases, the income tax convention will limit the Canadian right to impose income tax to the profits derived by the nonresident through a permanent establishment found in Canada. Prior to the Fifth Protocol, an LLC was automatically subject to Canadian income tax on the business it carried on in Canada because it could not rely upon the permanent establishment exemption found in the treaty.)
In applying the ITA, an additional branch tax applies at a rate of 25% of Canadian net after-tax income (Part XIV, Additional Tax on Non-Resident Corporations, of the ITA). This tax mimics the dividend withholding tax that will apply when the Canadian business is carried on through a Canadian corporation and passed through to its shareholder. The taxpayer accepted the obligation to pay the branch tax; however, it applied the benefit of the reduced rate of 5% that would be granted if Article X(6) of the treaty were applicable. In the CRA’s opinion, TD LLC was not eligible for the reduced rate because the taxpayer was not a resident of the United States for purposes of the treaty.
The Crown’s arguments reverted somewhat to CRA’s previous technical interpretations. Its primary argument was that an LLC was not itself subject to tax in the United States. In the Crown’s view, “treaties should be interpreted liberally and purposively but, in the end, effect must be given to the words chosen” (TD Securities, ¶22). In addition, even if it is somehow viewed to be liable to U.S. taxes by virtue of its income being taxed in Holdings II, it could not be said to be by “reason of [TD LLC’s] domicile, residence, place of management, citizenship, place of incorporation or any other criterion of a similar nature as required by Article IV of the Treaty” (TD Securities, ¶23).
Finally, the Crown expressed its concern that Article IV(6) of the treaty, which arose as a consequence of the Fifth Protocol amendments, would be rendered meaningless if an LLC were considered a resident for purposes of the treaty. More specifically, the concern was that “the Fifth Protocol amendments have set out certain conditions which must be met to claim relief which would be rendered meaningless if a U.S. LLC could claim relief otherwise than under paragraphs 6 and 7 of Article IV by the Fifth Protocol amendments” (TD Securities, ¶24).
The taxpayer argued that the phrase “liable to tax in” is not defined in the treaty and that the phrase therefore should be defined by the Tax Court “by reference to Canadian law, and is different from the mere determination whether a person is required to pay tax on its income under the U.S. Code” (TD Securities, ¶26). Alternatively, counsel argued that “consistent with the Model Tax Convention on Income and on Capital of the Organisation for Economic Co-operation and Development (OECD), a liberal interpretation and application of the treaty designed to achieve its purpose must give a meaning to the phrase ‘resident of a contracting state’ that includes a U.S. LLC” such as the taxpayer. The taxpayer highlighted that neither Canada nor the United States reserved upon or made material observations relating to these references. The taxpayer also relied upon the 1999 OECD Report on the Application of the OECD Model Tax Convention to Partnerships (OECD Partnership Report).
Tax Court’s Analysis
The Tax Court of Canada accepted the taxpayer’s argument that it had the responsibility to determine if TD LLC was in fact a resident under the terms of the treaty. In making that determination, the Tax Court focused on three aspects of treaty interpretation. The court examined (1) the prior practice of the two countries in applying the terms of the treaty; (2) what guidelines are acceptable to the courts in interpreting the terms of a treaty; and (3) how each country itself views an LLC under its own domestic laws.
On the first aspect, the Tax Court looked to past amendments to the treaty. For instance, the definition of a resident of a contracting state was expanded under the Third Protocol to the treaty in 1995 to include not-for-profit organizations and pension funds that were constituted in a contracting state and generally exempt from income tax due to their status in their state of residence. The definition was expanded to allow these entities a reduction or, in certain circumstances, an exemption from Canadian withholding tax. The technical notes to the Third Protocol reflected these changes as “addition as a clarification that corresponded to the interpretation previously adopted by both Canada and the U.S.” (TD Securities, ¶38). A similar provision was added in the Third Protocol in the same year to apply to political subdivision or local authorities or an agency.
The Tax Court concluded from these examples that “both examples of where specific amendments to the definition of ‘resident of a Contracting State’ were added to the treaty even though both countries agreed they were not needed, were confirmatory or clarifying in nature, and had interpreted and applied the pre-amendment treaty to treat each person as resident as defined because the context required or because it was implicit” (TD Securities, ¶40).
The Tax Court then moved to the Fifth Protocol amendments. In relation to these amendments, the court cited Treasury’s technical explanations of the amendments, explanations that Canada had accepted. The technical explanations detailed Canada’s position that a U.S. LLC would remain the “visible” taxpayer, notwithstanding that Article IV(6) of the treaty would allow for the treaty benefits to flow through to the U.S. resident shareholders. This position implies that even with the most recent amendments, some flexibility is required in interpreting the treaty.
This need for flexibility is best illustrated with an example. When applying the position that the LLC is a visible taxpayer to an assessment of whether a U.S. LLC is conducting business in Canada through a permanent establishment, Canada would make the assessment based on the presence and activities of the U.S. LLC itself, notwithstanding that the benefits of the treaty are granted to the members acting in their own right. So even in filing the income tax return in Canada to reflect the treaty exemption, it is the U.S. LLC that files the return, even though the benefit on a technical reading does not apply to it.
The Tax Court summarized the first aspect of its review by stating:
Like the earlier U.S. Treaty amendments dealing with not-for-profit organizations and government entities, this is another example of the Canadian and U.S. tax administrators interpreting and applying the chosen language of the Treaty to deal with residence in a workable manner to achieve a result consistent with its purpose and context.
. . . [The two countries] are content relying upon a sensible approach to the application and interpretation of the words and not the strict meaning or result of the words chosen for the Treaty. (TD Securities, ¶¶48 and 49)
With respect to the second aspect of the Tax Court’s analysis, the court reviewed a number of interpretive aids to income tax conventions (e.g., Prévost Car Inc. v. The Queen, 2009 D.T.C. 5053 (Fed. Ct. App.); The Queen vs. Crown Forest Indus. Ltd., 95 D.T.C. 5389 (Can.) (Crown Forest)). In particular, the Tax Court considered the OECD Model Treaty and the OECD Partnership Report, as the taxpayer suggested. The Tax Court used these interpretive aids to assist in applying the term “liable for tax” in the context of TD LLC. It did so by considering the term in the context of a partnership.
The OECD Model Treaty provides that if a partnership is treated as fiscally transparent in a state, it cannot be liable to tax and therefore cannot be a resident for purposes of the treaty so as to obtain the benefits of that treaty. However, it goes on further to state that if the benefits are refused to the partnership itself, “the partners should be entitled, with respect to their share of the income of the partnership, to the benefits provided by the Convention[s]” (OECD commentary, art. 1, ¶5). This position is founded on the premise that “the state of source should take into account, as part of the factual context in which the treaty is applied, the way in which an item of income, arising in its jurisdiction, is treated in the jurisdiction of the person claiming the benefit of the Convention as a resident” (OECD commentary, art. 1, ¶6.3). The OECD Partnership Report contains a similar conclusion.
The Tax Court used the analogy of partnerships as fiscally transparent entities, as it saw TD LLC to be, to conclude:
While these two conclusions, that a partnership is not liable to tax in its home country if it is treated as fiscally transparent and that its income from a source country that does not regard it as fiscally transparent should nonetheless get the benefit of the tax convention are developed in the context of fiscally transparent entities that are partnerships, this court sees no reason that the conclusions should be any different in the case of a fiscally transparent U.S. LLC. ( TD Securities, ¶76)
With respect to the last aspect of the Tax Court’s analysis, it could not reconcile how the CRA applied a lookthrough approach in applying treaty benefits to partners of foreign partnerships but not to an LLC. It also understood, from the perspective of the IRS, that it had a lookthrough approach to applying the benefits of the treaty to the partners of foreign partnerships. In both instances, the treatment appeared to be consistent with the OECD interpretation except for the CRA’s position on an LLC.
It was clear in this circumstance that Holding II, the single member of TD LLC, was subject to U.S. taxes under the Code, so the United States imposed a comprehensive tax on the income it earned. (In Crown Forest, the Tax Court determined that a resident of a contracting state must be subject to as comprehensive a tax liability as is imposed by a state and, in the case of Canada and the United States, included worldwide income.)
Accordingly, the Tax Court was able to conclude:
The evidence is overwhelming that the object and purpose of the U.S. treaty read in the context of all of the evidence and authorities would not be achieved and would be frustrated if the Canadian-sourced income of TD LLC that is fully taxed in the U.S. under the U.S. Code does not enjoy the benefits of the U.S. Treaty including Article X(6) of the Treaty. (TD Securities, ¶97)
On the basis of this conclusion, the Tax Court felt compelled to conclude that TD LLC was a resident of the United States for purposes of the treaty; otherwise the treaty benefits could not apply. The court felt it could not, as had the OECD and both Canada and the United States administratively, conclude that treaty benefits applied to a “fiscally transparent entity, such as a partnership,” without concluding that TD LLC was a resident of the United States for treaty purposes.
The Tax Court noted that the perceived abuse that was expressed by the Crown that could arise if an LLC were given the status of a resident of the United States, if necessary, would require a subsequent review by the court based on the facts in that circumstance. In the case of TD LLC, it felt that the amendments to the Fifth Protocol would have otherwise applied to it, so no abuse could have existed.
Implications of Findings
As stated by the Crown, Article IV(6) was put in place to limit to a certain extent when an LLC can have access to the treaty benefits. If the CRA follows the opinion in TD Securities, reliance on this article may not be required. (Attention may still be required to the application of the limitation of benefits provisions added by Article XXIX-A of the treaty under the Fifth Protocol amendments.)
Although Article IV(6) of the treaty was included to allow fiscally transparent entities to benefit from the treaty, Article IV(7) was put in place to disallow the treaty benefits. Article IV(7) has the effect of considering an “amount of income, profit, or gain to not have been paid by a resident of a Contracting State.” This deeming provision is referred to as the “anti-hybrid” rule and applies where, from the perspective of the United States, a U.S. resident entity would itself own an interest in a Canadian entity that would not be fiscally transparent under Canadian laws but would be fiscally transparent for U.S. laws.
Articles IV(6) and IV(7) have been subject to a large volume of technical interpretations following their coming into force. Unlike the decision in TD Securities, where the courts have accepted the view that a treaty need be “interpreted liberally and purposively,” the interpretations have tended to be very technical in nature and similar to an analysis of domestic law, where greater weight is provided to the meanings of the word utilized. It will be interesting to see if this case reverses or somewhat calms the waters with respect to the interpretation of these articles of the treaty. In the interim, it will be necessary to monitor and review transactions with entities, including LLCs, that are affected by these two treaty articles and weigh the CRA’s perspective as to their meaning and application.
An obvious implication for LLCs that the CRA has denied treaty benefits in the past is whether there is now a possibility of recovering taxes. The answer may depend on the fiscal year for which the CRA denied the benefits. Depending on the nature of the benefits denied, a taxpayer may wish to take action to recover taxes. This is a matter that may be discussed with a Canadian income tax adviser based on a taxpayer’s specific facts and circumstances.
Editor: Anthony S. Bakale, CPA, M. Tax.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.