Limitation on Benefits: Canadian Interpretation

Abstract

The Fifth Protocol to the Canada-US Income Tax Convention ("the Treaty") introduced Canada's first comprehensive Limitation on Benefits (LOB) clause, making access to Treaty benefits exclusive to those residents of the US that meet one or more of the LOB conditions. This article discusses Canada's interpretation of the LOB rules in the context of a US resident seeking benefits from Canada under the Treaty. The Treaty LOB represents a major change in Canada's approach to preventing abusive treaty shopping. Although Canada does not intend to pursue similar LOB rules in other treaties (relying instead primarily on Canada's domestic general anti-avoidance rule), the LOB clause in the Treaty is very important in determining the tax consequences of many Canada-US cross-border payments. While Article XXIX-A (7) allows the possibility of applying anti-abuse rules, the existence of a comprehensive LOB may make it difficult to establish that a policy is being misused or abused where the LOB conditions are otherwise satisfied.

The Fifth Protocol to the Canada-U.S. Income Tax Convention ("the Treaty")1 introduced Canada's first comprehensive Limitation on Benefits (LOB) clause,2 making access to Treaty benefits exclusive to those residents of the United States that meet one or more of the LOB conditions. While Canada has LOB clauses in about half of its 87 tax treaties, most of them are limited to denying treaty benefits to entities formed under certain tax preferential regimes.3 The introduction of a comprehensive LOB rule is a marked departure from Canada's existing treaty policy, and officials from the Canadian Department of Finance have suggested that Canada will not seek similar LOB clauses in other treaties. It appears that Canada's introduction of the LOB clause in the Treaty was in response to the Fifth Protocol's ehminating withholding tax on most interest payments (which Canada has not done in any other treaty). Canada is expected to continue its reliance on the domestic general anti-avoidance rule (GAAR) to restrict perceived abusive treaty-shopping arrangements.4

Although the new LOB clause in the Treaty is substantially similar to the LOB clauses in the U.S. Model Income Tax Treaty and most other recent U.S. income tax treaties, its interpretation remains uncertain in many aspects - especially from a Canadian perspective. The principal source of guidance on interpreting the LOB clause is the U.S. Treasury Department's Technical Explanation ("TE"),5 which was accepted by the Canadian government.6 In addition, the Canadian tax authorities have made a number of statements regarding the interpretation of the LOB clause, including:

* various technical interpretations issued by the Canada Revenue Agency (CRA);7

* statements made by officials from the CRA and the Department of Finance at the May 12, 2008, and May 21-22, 2009, meetings of the Canadian Branch of the International Fiscal Association ("the 2008 IFA Meeting" and "the 2009 IFA Meeting," respectively);

* statements made by a CRA official at a seminar on June 4, 2009, organized by the Toronto Centre CRA and Tax Professionals Group ("the June 4 Seminar"); and

* materials released by the CRA in May and June 2009 relating to the LOB clause and the claiming of treaty benefits generally.

The CRA indicated at the June 4 Seminar that it would interpret the LOB rules in a purposive manner with reference to their underlying objectives, namely, to prevent abusive treaty shopping. This is in line with the manner in which tax treaties are generally interpreted in Canada.8 Various interpretative issues remain under active consideration by the CRA, with additional guidance expected later this year - likely in the form of the CRA's Income Tax Technical News publication.

This article discusses Canada's interpretation of the LOB rules in the context of a U.S. resident seeking benefits from Canada under the Treaty. The LOB rules follow the coming into force of the Fifth Protocol to the Treaty: generally applying to taxation years that begin after 2008, and in respect of withholding taxes for amounts paid or credited on or after February 1, 2009. As the LOB clause does not have a "purpose" test, it could apply to structures established in earlier tax periods (even if initially formed for non-tax purposes). An exception to this is paragraph 6, discussed below, for which a specific determination must be made by the relevant tax authorities.

Overview of the LOB Rules in Article XXIX-A of the Treaty

Paragraph 1 contains a general rule limiting Treaty benefits to "qualifying persons," which is defined in paragraph 2. Paragraphs 3 and 4 allow benefits under the Treaty for certain income earned by a Treaty resident that is not a qualifying person under exceptions for an "active trade or business" and "derivative benefits," respectively. Paragraph 5 contains certain definitions. Paragraph 6 contains a residual exception allowing Treaty benefits where the Competent Authority determines that either: (1) the Treaty resident's creation and existence did not have as a principal purpose the obtaining of Treaty benefits not otherwise available; or (2) it would be inappropriate to deny Treaty benefits to that Treaty resident. Paragraph 7 contains a general anti-abuse override, allowing either country to deny Treaty benefits where it can reasonably be concluded that to do otherwise would result in an abuse of the provisions of the Treaty. This last rule could allow the CRA to apply Canada's GAAR to deny Treaty benefits in certain circumstances.

Article XXIX-A(1): Qualifying Persons

The "qualifying persons" test allows a resident of Canada or the United States to obtain Treaty benefits from the other country. The term "qualifying person" is defined to include natural persons, governmental entities, estates, certain not-for-profits, and charitable or pension-related entities. A "qualifying person" also includes a company or trust that is resident in Canada or the United States for purposes of the Treaty and meets at least one of three other conditions: (1) its principal class of shares or units is primarily and regularly traded9 on a "recognized stock exchange";10 (2) more than 50% of the company's shares (by vote and value) is directly or indirectly owned by five or fewer persons described in condition (I),11 provided each person in the chain of ownership is a qualifying person; or (3) 50% or more of the company's shares (by vote and value) or the trust's beneficial interests are not owned (directly or indirectly) by persons who are not qualifying persons, and a specified base erosion test is met.12

The TE suggests that in applying tests (2) and (3) of the "qualifying persons" condition, the lookthrough rules in Article IV(6) should be incorporated such that entities that are fiscally transparent under the laws of their country of residence - such as certain LLCs and partnerships - should be "looked through" in testing the application of the LOB rules.13

Article XXIX-A (3): Active Trade or Business Exception

Even if a person is not a qualifying person, it may still qualify for treaty benefits under the active trade or business (ATB) exception. The ATB exception applies, from a Canadian perspective, where the following conditions are met: (1) either USCo or a related person is engaged in the active conduct of a trade or business in the United States ("the U.S. Business"), other than certain activities that involve making or managing investments; (2) USCo derives income from Canada ("the Canadian Income") in connection with or incidental to the U.S. Business, either directly or indirectly through one or more other Canadian residents; and (3) the U.S. Business is substantial in relation to the Canadian activity that generates the Canadian Income.

Regarding condition (1), a trade or business of making or managing investments is not eligible under the ATB exception, unless those activities are carried on with customers in the ordinary course of business by a bank, insurance company, registered securities dealer, or deposit-taking financial institution. At the June 4 Seminar, the CRA indicated that "customers" could include related parties, although the situation where all customers were non-arm's-length persons had not been specifically considered. The CRA's position appears consistent with the text of the provision, which does not refer to "customers" as being arm'slength or otherwise (unlike the approach used in some other U.S. treaties). However, the "ordinary course of business" element of the test must also be satisfied, suggesting that related-party customers may need to deal with the financial institution on arm's-length terms.

The CRA has indicated that it would interpret "registered securities dealer" more broadly than its meaning under the Income Tax Act (Canada) ("ITA"), acknowledging that the term should apply to persons that come within either the ITA definition of that term or the definition of a "dealer in securities" under IRC §475 (and whose dealings as such are regulated under U.S. federal or state securities legislation). 14 Accordingly, a U.S. dealer that is not licensed in Canada may qualify.

With respect to condition (2), in many cases it will be difficult to determine whether the Canadian Income is sufficiently connected with the U.S. Business to meet this test.15 The TE indicates that "derived in connection with an active trade or business" includes income-generating activities that are "upstream," "downstream," or parallel to that conducted in the other country. The TE suggests a vertical or horizontal integration approach to allowing income to be colored as derived from an active business. There has been very utile guidance to date from the CRA as to what degree of linkage must exist between the income received by the U.S. resident (i.e., the person seeking Treaty benefits) and the Canadian Income being earned (i.e., by a Canadian operating company) such that the U.S. resident may be deriving the income "indirectly."16

Although the TE does not make reference to "complementary" activities as being "connected" with the U.S. Business, the CRA confirmed at the June 4 Seminar that it will consider "complementary" activities described in the Technical Explanation to the U.S. Model Income Tax Treaty 17 to come within the scope of the "in connection with" test in the ATB exception.

At the June 4 Seminar, the CRA indicated that capital gains realized by a U.S. resident on the sale of shares of a Canadian corporation where only part of the value of those shares is attributable to an activity that is connected with the U.S. Business should be apportioned between the connected activity (in respect of which the ATB exception could apply) and the remainder. No specific approach for apportioning the capital gain has been developed. The CRA noted that the portion of the gain that is not eligible for the ATB exception might be entitled to Treaty benefits under the residual rule in paragraph 6 (discussed below). The CRA suggested that apportionment may also be necessary in similar circumstances involving interest and dividend payments.

Regarding condition (3), the TE offers little guidance for interpreting the meaning of "substantial," providing only a single example in which the party claiming Treaty benefits operates a single outlet selling "a few" of the goods manufactured in the source country. At the June 4 Seminar, the CRA rejected the relevance of safe harbor tests in other U.S. treaties (such as Article 30(2)(b) of the U.S.-France Income Tax Treaty) in interpreting the substantiality requirement of the Treaty, which contains no references to safe harbors. The CRA also remarked, citing the TE, that the U.S. Business need not be as large as the activity generating the Canadian Income, but it "cannot represent only a very small percentage" of that Canadian activity.18

Article XXIX-A (4): Derivative Benefits

In order to qualify for the "derivative benefits" exception, a company must meet the following four conditions:19 (1) it must be resident in the United States or Canada for Treaty purposes; (2) at least 90% of its shares must be owned, directly or indirectly, by qualifying persons or eligible third-country shareholders;20 (3) its eligible third-country shareholders must be entitled to a Canadian or U.S. withholding tax rate on the relevant income as low as or lower than the corresponding rate under the Treaty;21 and (4) it must meet the base erosion test (i.e., deductible expenses payable to non-qualifying persons must be less than 50% of gross income).

"Eligible third-country shareholders" must be persons that would be qualifying persons if they were residents of the United States (or Canada). With respect to foreign public companies that are shareholders of U.S. companies, the TE indicates that the public company can meet the test if its shares are traded on a recognized stock exchange under the Treaty, or under the treaty between the source country (i.e., Canada) and the third country.22 However, as Canada has no other treaties with a comprehensive LOB, it has no other recognized stock exchanges beyond those in the Treaty. This would restrict the application of the rule to third-country public companies that "primarily and regularly" trade a principal class of shares on certain Canadian and U.S. exchanges. At the June 4 Seminar the CRA said it may be appropriate to take administrative action to extend derivative benefits to a U.S. company that would be eligible if "recognized stock exchange" included a stock exchange that is both (1) located in a country that has a tax treaty with Canada and (2) a "designated stock exchange" for purposes of the ITA.23

The base erosion test in the derivative benefits exception is somewhat onerous relative to many other U.S. treaties. To pass the base erosion test, deductible expenses payable by a U.S. or Canadian company to persons other than qualifying persons cannot exceed 50% of the company's gross income. Expenses payable to persons in countries other than Canada or the United States will therefore always be treated as baseeroding payments.24

Article XXIX-A (6): Residual Claim to Benefits

Where Treaty benefits are not otherwise available to a Treaty resident under one of the other elements of the LOB rules, Article XXEX-A (6) requires the relevant Canadian or U.S. Competent Authority (upon request from the Treaty resident)25 to grant Treaty benefits if:26 (1) the Treaty resident's creation and existence did not have as a principal purpose the obtaining of Treaty benefits that would otherwise not be available; or (2) it would not be appropriate to deny Treaty benefits to the Treaty resident, having regard to the purpose of Article XXIX-A. At the June 4 Seminar the CRA acknowledged that the grant of benefits is mandatory, not discretionary, where one of the two tests is met. The CRA also stated at the June 4 Seminar that if numerous requests for relief on the same topic are made, the Canadian Competent Authority could grant relief on an omnibus basis rather than to specific taxpayers only. The TE confirms that relief under paragraph 6 may be granted retroactively. However, the CRA's guidelines indicate that a grant of treaty benefits under paragraph 6 expires at the earlier of three years from the date of the determination letter or immediately before the occurrence of a material change in facts or circumstances. The CRA encourages taxpayers to apply for renewed relief under paragraph 6 not later than six months before the expiration of existing benefits.

Conclusion

The Treaty LOB represents a major change in Canada's approach to preventing abusive treaty shopping. Although Canada does not intend to pursue similar LOB rules in other treaties (relying instead primarily on Canada's domestic GAAR), the LOB clause in the Treaty is very important in determining the tax consequences of many Canada-U.S. crossborder payments. Also, the existence of the LOB clause in the Treaty may reduce the likelihood of GAAR applying to deny benefits under the While Article XXIX-A (7) allows the possibility applying anti-abuse rules, the existence of a hensive LOB may make it difficult to establish that a policy is being misused or abused where the conditions are otherwise satisfied. Although the ited Canadian guidance to date assists in the LOB provision, many uncertainties remain. The CRA expects to develop a coherent and consistent approach to administering the LOB over time. Until then, U.S. taxpayers seeking to obtain Treaty benefits with respect to Canadian.source income should care. fully momtor developments in this area.

Footnote

1 Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital signed on Sept. 26, 1980, as Amended by the Protocols signed on June 14, 1983, Mar. 28, 1984, Mar. 17, 1995, July 29, 1997, and Sept. 21, 2007. The Fifth Protocol entered into force on Dec. 15, 2008.

2 Article XXDC-A of the Treaty. Before the Fifth Protocol, Article XXIX-A of the Treaty applied only from the U.S. perspective, restricting benefits otherwise available to certain Canadian residents.

3 The Canada-Germany treaty contains a general anti-abuse LOB, but is not as comprehensive as the LOB under the Treaty.

4 Canada's general anti-avoidance rule (GAAR) was amended retroactively in 2005 to explicitly apply to tax treaties. Canada has also attempted, albeit unsuccessfully, to restrict treaty benefits through an implicit anti-abuse rule in tax treaties see MIL Investments S.A. v. The Queen, 2007 FCA 236), and through the use of the term "beneficial owner" see Prévost Car Inc. v. The Queen, 2009 FCA 57).

5 Available at http://www.treas.gov/press/releases/reports/tecanada08.pdf.

6 See Department of Finance release 2008-052, dated July 10, 2008, available at http://www.fin.gc.ca/n08/08-052-eng.asp.

7 See CRA document no. 2009-03 1943 1C6, dated Aug. 5, 2009; CRA document no. 2007-0262 141E5, dated Apr. 15, 2009; CRA document no. 2008-0272371C6, dated Apr. 8, 2009; CRA document no. 2007-0261911C6, dated July 18, 2008; CRA document no. 2007-025702 1E5, dated July 16, 2008.

8 See Gladden Estate, [1985] 1 C.T.C. 163 (FCTD), approved in Crown Forest Industries, [1995] 2 C.T.C. 64 (SCC), and Allchin, [2004] 4 C.T.C. 1 (FCA).

Footnote

9 The TE suggests that Canada will adopt the U.S. interpreta- tion of "regularly traded" and "primarily traded" taken from the branch tax provisions of the Internal Revenue Code (IRC), sub- ject to reserving the right to adopt different definitions. An addi- tional trading test must be met if the company has a class of shares entitling a holder resident in one country to a dispropor- tionately higher share of earnings generated in the other country.

10 The term "recognized stock exchange" includes the NASDAQ and any stock exchange registered with the U.S. Securities and Exchange Commission as a national stock exchange, and (in Canada) the Toronto and Montreal exchanges and Tiers 1 and 2 of the TSX Venture Exchange.

11 This allows subsidiaries of public companies covered in the first condition to qualify.

12 The base erosion test requires the amount of expenses deductible from the company's gross income and payable (directly or indirectly) to persons who are not qualifying persons for the preceding fiscal period to be less than 50% of such gross income for that period.

13 This was confirmed by the CRA at the June 4 Seminar. See also CRA documents nos. 2008-0272361C6 and 2007-0261901C6, dated July 17, 2008, memorializing comments made by the CRA at the 2008 IFA Meeting. Note also that the hybrid entity rules in Article IV(7) could apply to deny treaty benefits to certain fiscally transparent entities after 2009, independent of the application of the LOB rules.

Footnote

14 CRA document no. 2009-031916117, dated June 30, 2009.

15 The TE is the primary source of guidance on this rule to date.

16 CRA technical interpretation 2007-0257021E5, dated July 16, 2008, deals with a case of indirect earnings. However, the facts of that case were straightforward and very favorable for reaching a positive conclusion: there were actual back-to-back dividend payments up a chain of companies, the underlying income (from which the Canadian- source dividends were being paid) was generated by the U.S. business itself, and there appear to have been no intervening expenses. However, the CRA was willing to look through not only Canadian residents in the "income derived indirectly" analysis but also U.S. residents.

17 Technical Explanation accompanying the U.S. Model Income Tax Treaty of November 15, 2006, Article 22, paragraph 3, available at http://www.teeas.gov/offices/taxpolicy/library/TEMod006.pdf

18 The TE uses "income, assets, or other similar measures" as a basis for measurement.

19 A Department of Finance official confirmed at the 2008 IFA Meeting that the derivative benefits exception works on an "all or nothing" basis.

Footnote

20 An eligible third-country shareholder is a resident of a third country entitled to benefits under a treaty between Canada or the United States and that third country, and who (if resident in the United States or Canada, respectively) would be either a qualifying person under the Treaty or eligible for Treaty benefits under the "active trade or business" test (if it was assumed that the shareholder carried on in the United States the same business that it carries on in the third country).

21 Because the Treaty is the only Canadian tax treaty with a zero withholding rate on most forms of interest payments, derivative benefits are currently relevant from a Canadian perspective only for dividends and royalties.

22 The text of the Treaty does not refer to stock exchanges recognized in the treaty between Canada and the third country, so the TE appears to expand on the Treaty language.

23 The current list of designated stock exchanges is at http:// www.fin.gc.ca/act/fim-imf/dse-bvd-eng.asp.

24 In contrast, Article 26(3) of the U. S. -Netherlands Income Tax Treaty tests whether the payment is made to a person that is not an "equivalent beneficiary," a term that includes residents of various third countries.

25 Guidelines for Taxpayers Requesting Treaty Benefits Pursuant to Paragraph 6 of Article XXIX-A of the Canada-U.S. Tax Convention, May 22, 2009, available at http://www.cra-arc.gc.ca/ tx/nnrsdnts/rtcl29-eng.html; CRA document no. 2009-031 943 1C6, published Aug. 5,2009.

26 Based on all factors, including the history, structure, ownership, and operations of the Treaty resident.