Resource Capital Fund III: A Canadian Perspective on Applying a Treaty to a Hybrid Partnership

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1 Volume 70, Number 13 June 24, 2013 Resource Capital Fund III: A Canadian Perspective on Applying a Treaty to a Hybrid Partnership by Michael N. Kandev and Matias Milet Reprinted from Tax Notes Int l, June 24, 2013, p. 1313

2 Resource Capital Fund III: A Canadian Perspective on Applying a Treaty to a Hybrid Partnership by Michael N. Kandev and Matias Milet Michael N. Kandev is a partner with Davies Ward Phillips & Vineberg LLP in Montreal, and Matias Milet is a partner with Osler, Hoskin & Harcourt LLP in Toronto. The authors would like to thank Prashanth Kainthaje, a partner with Johnson Winter & Slattery in Sydney, for his helpful input on Australian law. Any errors or omissions remain those of the authors. On April 26, 2013, the Australian Federal Court handed down its decision in Resource Capital Fund III LP v. Commissioner of Taxation (RCF). 1 This case, which involved a private equity fund realizing a gain on the sale of shares of an Australian mining company, was eagerly expected as, among other things, it raises important issues of tax treaty law that are of interest to international tax practitioners in Australia and abroad. This article provides a Canadian perspective on the tax treaty matters discussed in RCF. In particular it discusses the following four questions: Can a tax treaty settle a procedural or administrative issue? What is the relevance of OECD commentaries in interpreting a tax treaty? When is a hybrid partnership a treaty resident? When is it appropriate to look through a hybrid partnership in applying a tax treaty? gold mining operations in Australia. During its tax year ended June 30, 2008, RCF sold its shares in SBM in two blocks, realizing an aggregate gross gain of $58.25 million. In 2010 the Australian government assessed RCF, which under Australian tax law is viewed as a nonresident corporation formed in the Cayman Islands, 2 for tax on the net capital gain from the sale of the SBM shares and penalties. RCF objected to the assessment and ultimately appealed to the Federal Court of Australia. Significantly, more than 97 percent of RCF s contributed capital was held by U.S. residents, and for U.S. tax purposes RCF was viewed as fiscally transparent. 3 The court was asked to rule on two questions: Was the commissioner able to properly issue an assessment to RCF or did the Australia-U.S. income tax treaty 4 preclude him from doing so? To the extent that the commissioner was able to issue the assessment, was the gain realized by Background Facts of the Case The facts of RCF are straightforward. In 2006 Resource Capital Fund III LP, a private equity fund organized as a Cayman Islands exempt limited partnership, bought shares in the capital of St Barbara Mines Ltd. (SBM), an Australian company that conducted 1 [2013] FCA 363 (RCF). 2 RCF, supra note 1, at paras Id. at paras The Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income, signed in Sydney on August 6, 1982, as amended by the Protocol Amending the Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income (Sept. 27, 2001). TAX NOTES INTERNATIONAL JUNE 24,

3 RCF subject to tax in Australia under its taxable Australian real property (TARP) domestic provisions? Justice Richard Edmonds, writing for the court, decided the case in favor of RCF on the basis that the commissioner was prevented by the treaty from assessing RCF under Australian domestic law as a nontransparent company. The court also found that the shares in SBM were not TARP assets and that therefore Australia could not tax the gain under its domestic law. On the main issue, the commissioner argued that RCF is a U.S. treaty resident on the basis of article 4(1)(b)(iii) of the treaty. 5 Therefore, article 13 of the treaty did not limit Australia s right to tax the capital gain. RCF argued, to the contrary, that it is not a U.S. treaty resident. The court agreed with RCF and ruled that since RCF is not a U.S. treaty resident, article 13 does not authorize Australia to tax the gain to RCF. Further, the court agreed with RCF s submissions that the gain had to be regarded as realized by the limited partners of RCF based on the treaty as interpreted in light of the commentaries to article 1 of the OECD Model Convention on Income and Capital dealing with partnerships. Finally, the court ruled that since there was an inconsistency between the application of the domestic provisions (RCF being the taxpayer for Australian tax purposes) and the treaty (RCF s limited partners being the taxpayers deriving the gain for treaty purposes), the inconsistency must be resolved in favor of the treaty. 5 Article 4(1)(b) of the treaty states: For the purposes of this Convention:...(b)aperson is a resident of the United States if the person is: (i) a United States corporation; (ii) a United States citizen, other than a United States citizen who is a resident of a State other than Australia for the purposes of a double tax agreement between that State and Australia; or (iii) any other person (except a corporation or unincorporated entity treated as a corporation for United States tax purposes) resident in the United States for purposes of its tax, provided that, in relation to any income derived by a partnership, an estate of a deceased individual or a trust, such person shall not be treated as a resident of the United States except to the extent that the income is subject to United States tax as the income of a resident, either in its hands or in the hands of a partner or beneficiary, or, if that income is exempt from United States tax, is exempt other than because such person, partner or beneficiary is not a United States person according to United States law relating to United States tax. It was not necessary for the court to rule on the secondary TARP issue. Nevertheless, it agreed to rule on it for the benefit of an appellate court, since it considered that the commissioner would likely appeal the decision. The court considered extensive valuation evidence presented by both parties and ultimately found that the shares disposed by RCF were not a TARP asset a gain on which would be taxable in Australia. Significant in this regard was the finding that valuable mining information is an intangible non-tarp asset. The decision of Justice Edmonds of the Federal Court of Australia has now been appealed to the Full Court of the Federal Court of Australia. 6 General Observations First, in its budget tabled shortly after the RCF decision was handed down, on May 14, 2013, the Australian government proposed to effectively overrule the court s decision on the TARP issue. The budget proposes that for events occurring after the budget date, in determining the value of TARP assets of an entity, intangible assets connected to the rights to mine, quarry, or prospect for natural resources (that is, mining, quarrying, or prospecting information, rights to such information, and goodwill) will be treated as part of the rights to which they relate. Second, the Australian TARP regime is similar in many regards to the taxable Canadian property (TCP) regime under the Income Tax Act (Canada) 7 which in essence ensures that a nonresident of Canada is subject to Canadian mainstream tax on a disposition of Canadian real property, Canadian resource property, and entity interests that derive more than 50 percent of their value from such properties. Third, to ensure the collection of the tax on the disposition of TCP by nonresidents, section 116 of the ITA provides a set of notification, advance tax, and certification requirements that currently do not have an equivalent in Australia. However, in its May 14, 2013, budget, the Australian government proposed a 10 percent advance withholding tax on gross proceeds. It is beyond the scope of this article to discuss the TARP issue any further, although the analysis is potentially significant in a Canadian context. 8 This article 6 The commissioner of taxation filed the appeal on May 17 (available at NSD842/2013/actions). An unsuccessful party may further appeal from the Full Court of the Federal Court of Australia to the High Court of Australia, subject to the High Court of Australia granting leave to appeal. The High Court of Australia is the ultimate appellate court in Australia. If the commissioner of taxation loses before the Full Court of the Federal Court of Australia, it is likely that the commissioner of taxation will seek leave to appeal to the High Court of Australia and in all probability will be granted special leave to appeal. 7 R.S.C (5th Supp.) c. 1 (ITA). Unless otherwise specified, all statutory references are to the provisions of the ITA. 8 Note that in the ITA s definition of TCP, eligible capital property such as seismic, drilling, or other resource-related information is itself TCP if it is held regarding a business carried on in Canada. However, such information is not included in the definition of Canadian resource property and is certainly not real property for purposes of the ITA. Thus, although a direct sale of such eligible capital property would be a disposition of TCP, it is less clear how to categorize such an asset when held by an entity whose equity is being tested for possible TCP status. Specifically, (Footnote continued on next page.) 1314 JUNE 24, 2013 TAX NOTES INTERNATIONAL

4 now proceeds to discuss tax treaty issues raised by RCF that are of broad application and fundamental importance. Discussion Can a Tax Treaty Settle a Procedural or Administrative Issue? The RCF case is surprising from a Canadian perspective. Normally the analysis of a situation such as the one in RCF would start by determining the proper tax treatment under domestic law (which would make the TARP issue the main issue in the RCF case), and only if the capital gain on the disposition of the SBM shares were properly taxable in Australia under its domestic law would the availability of substantive treaty benefits become relevant. It is unusual from a Canadian perspective that RCF was decided based on a treaty determination of what appears to be a purely domestic procedural issue, namely, whether the correct taxpayer had been assessed. 9 This, in itself, raises a fundamental tax treaty law issue: Can a tax treaty settle a procedural or administrative issue? This question came before Canadian courts in 2009 in RCI Trust. 10 The fundamental issue in this case was whether a treaty can override not only domestic substantive rules, such as mainstream and final withholding tax, but also procedural rules, such as non-final withholding requirements. The taxpayer in RCI Trust was a trust settled under the laws of Barbados. In 2006 the RCI Trust disposed of some shares of taxable Canadian corporation RCI Environnement Inc. (the RCI shares) for proceeds of disposition of $145 million, resulting in a capital gain when an entity s assets include both Canadian real or resource property and ancillary eligible capital property, such as seismic or drilling information relating to such real or resource property, it is unclear whether the eligible capital property would be assimilated to or subsumed within the Canadian real or resource property for purposes of determining whether the equity interests derive their value primarily from Canadian real or resource property. 9 Though conceptually the identity of the person liable for taxation is a substantive matter, in this particular case, the court s decision on the main issue did not finally decide whether the capital gain is taxable in Australia. Implicit in this case is that if the Australian government was still within the time limitations to assess and if the SBM shares were a TARP asset, the Australian government could issue assessments to RCF s limited partners and rightfully claim its tax. 10 Robert M.O. Morris and Neville Leroy Smith, Trustees of the RCI Trust v. Minister of National Revenue, 2009 FC 434 (Apr. 29, 2009), rev d, 2009 FCA 373 (RCI Trust). For commentary on this case, see Nathan Boidman and Michael Kandev, Can a Treaty Override Domestic Backup Withholding Rules? The Canadian Decision in RCI, Tax Notes Int l, June 8, 2009, p. 867; and Boidman and Kandev, RCI Trust: Canada s Backup Withholding Trumps Treaties, Tax Notes Int l, Jan. 18, 2010, p See also Boidman and Kandev, The Canadian Decision in RCI Trust and Treaty Residence, Tax Notes Int l, July 27, 2009, p of $144,999,800. The purchaser was reportedly Les Investissements Historia Inc. (Historia), a Canadian corporation. On May 4, 2006, the RCI Trust applied to the Canada Revenue Agency under the pre-2009 version of section 116 of the ITA, 11 for a certificate that would have the effect of relieving Historia of its obligation under subsection 116(5) to deduct part of the proceeds of disposition and remit the withheld amount on behalf of the RCI Trust to the government. The RCI Trust did not remit to the CRA the amount required as non-final withholding tax in section 116, being 25 percent of the capital gain of $144,999,800, nor did it provide security for it, but claimed that the capital gain on the sale of the RCI shares was exempt from Canadian tax under the Barbados-Canada tax treaty. The CRA apparently considered the request of RCI Trust for a section 116 certificate and asked for further information about the RCI Trust and the relevant transactions. Some information was provided, but the CRA was not satisfied that a certificate should be issued. Hence, the CRA declined to issue a certificate without receiving the payment or security required by subsection 116(2). As a result of the CRA s refusal, the RCI Trust commenced an application in the Canadian Federal Court for judicial review of the CRA s delay in granting the certificate. The taxpayer argued that the CRA does not have the discretion to refuse to provide it with the subsection 116(2) certificate, because under the Barbados-Canada tax treaty, Canada cannot impose tax on the capital gain realized by the RCI Trust on the disposition of the RCI shares. The trustees, Mr. Morris and Mr. Smith, relied on the treaty exemption that would apply if the RCI Trust were a treaty resident of Barbados, that is, if the RCI Trust were a person who, under the laws of Barbados, is liable to taxation in Barbados by reason of its domicile, residence, place of management or any other criterion of a similar nature, and is not liable to taxation in Canada by reason of any of those criteria. At trial, the Canadian Federal Court somewhat surprisingly sided with the taxpayer, ordering the CRA to make a binding ruling...about whether the RCI shares are treaty exempt property based on the the court s reasons (at paragraph 43). The court in essence held that the Barbados-Canada tax treaty may limit the Canadian advance non-final withholding tax under section 116. The decision was based on its finding that the RCI Trust is a Barbados treaty resident. 11 Under this version of the rules, shares in a private Canadian corporation were TCP, whether or not their value was derived from Canadian real property or resource property. TAX NOTES INTERNATIONAL JUNE 24,

5 Predictably, the Federal Court of Appeal (FCA) reversed the trial court s decision by dismissing the taxpayer s application for judicial review. The court explained that nothing in the ITA relieves a person of the obligation to make a payment or provide security in order to obtain a section 116 certificate. Although the outcome of RCI Trust was that the Barbados-Canada tax treaty may not override Canada s procedural section 116 requirements, the FCA did not explicitly discuss this interesting issue of the relationship between a tax treaty and source state procedural or administrative requirements. Certainly, before the trial decision the common wisdom had been that, absent rare, specific treaty provisions to the contrary, 12 a tax treaty may not limit domestic non-final withholding taxes. Yet there is no direct Canadian authority on this matter and the 1975 Tax Appeal Board decision in National Indian Brotherhood v. MNR, which held that non-final employment income withholding tax was not applicable on domestically exempt salary, could be seen as supporting the RCI Trust s position. 13 Now, the decision in RCF seems to point precisely in the opposite direction to the final outcome in RCI Trust: that is, that a tax treaty may determine a procedural or administrative matter, such as the proper subject for assessment under domestic law. To the extent that Australian tax collected from a limited partnership (treated as a corporation for Australian tax purposes) can be refunded to its partners claiming the benefits of a tax treaty on income derived by them under the tax laws of their country, then as in RCI Trust, there seemingly could be a subsequent opportunity for the substantive question of treaty benefits to be considered and if necessary adjudicated. In this regard, even if the court felt that the treaty ought to have some bearing on the final question of tax liability it may not have been necessary for it to use the treaty to settle a procedural issue. It will be seen whether on appeal the Australian courts will follow in the footsteps of Canada s FCA and reverse Justice Edmonds s decision on this point. What Is the Relevance of OECD Commentaries in Interpreting a Tax Treaty? The conclusion on the main issue in RCF, to the effect that the treaty prevented Australia from assessing RCF as a nontransparent corporation, was reached on the basis of the commentaries to article 1 of the OECD model. Justice Edmonds applied the treaty in light of the OECD commentaries as follows: 12 See, e.g., Article XVII of the pre-fifth-protocol Canada-U.S. tax treaty dealing with reg. 105 non-final withholding tax on independent personal services D.T.C. 110 (TAB), rev d, 78 D.T.C (FC-TD). The Federal Court Trial Division reversed on the basis that the salaries at issue were not exempt and hence it was unnecessary to consider the withholding tax matter. [65] RCF is fiscally transparent for US tax purposes and the limited partners are subject to US tax on RCF s income. The OECD Commentary on Art 1 of the OECD Model (which, as noted in [38] above, substantially corresponds with Article 1(1) of the Convention) provides that when partners are liable to tax in the country of their residence on their share of partnership income it is expected that the source country, (in this case, Australia) will apply the provisions of a convention... as if the partners had earned the income directly so that the classification of the income for purposes of the allocative rules of Articles 6 to 21 will not be modified by the fact that the income flows through the partnership. (OECD Commentary on Art 1, para 6.6). [66] Thus, the requirement, imposed by Art 13 of the Convention, that income or gains derived by a resident of one of the Contracting States (US) from the alienation or disposition of real property situated in the other Contracting State (Australia) may be taxed in the other State, is met in the circumstances of the present case by treating the gain as having been derived not by RCF but by its limited partners who or which are residents of the US for the purposes of the Convention. This interpretation avoids denying the benefits of tax Conventions to a partnership s income on the basis that neither the partnership, because it is not a resident, nor the partners, because the income is not directly paid to them or derived by them, can claim the benefits of the Convention with respect to that income. Following from the principle discussed in paragraph 6.3, the conditions that the income be paid to, or derived by, a resident should be considered to be satisfied even where, as a matter of the domestic law of the State of source, the partnership would not be regarded as transparent for tax purposes, provided that the partnership is not actually considered as a resident of the State of source. (OECD Commentary on Art 1, para 6.4). [67] Here, RCF was not a resident of Australia for the purposes of the Convention in the year of income and while the Assessment Acts regarded RCF as not being transparent, the OECD Commentary on Art 1 of the OECD Model...is founded upon the principle that the State of source (Australia) should take into account, as part of the factual context in which the Convention is to be applied, the way in which an item of income, arising in its jurisdiction, is treated in the jurisdiction of the person claiming the benefits of the Convention as a resident. (OECD Commentary on Art 1, para 6.3) JUNE 24, 2013 TAX NOTES INTERNATIONAL

6 In support of the above conclusions, Justice Edmonds noted at paragraph 70 that the OECD commentary on article 1 of the OECD model had been incorporated from the 1999 OECD partnership report 14 by the time of the signing of the 2001 protocol to the treaty and that neither the U.S. nor Australia expressed any reservation regarding the 2000 changes to the commentaries, which incorporated the conclusions of the partnership report. Moreover, at paragraph 31, Justice Edmonds observed that according to the U.S. Treasury Department s technical explanation of the 2001 protocol, negotiations took into account Treasury s current tax treaty policy, the then-current (1996) U.S. model, the Australian model tax convention, and, significantly, the 2000 version of the OECD model. The court s approach in RCF raises the perennial, fundamental question: What is the proper function of the OECD model, commentaries, and other materials (such as reports) in the process of interpreting tax treaties? 15 A particularly important subissue that is highlighted by the decision in RCF is whether the mere fact that a country has not filed any observations to particular OECD commentaries automatically means that the country has adopted and follows the conclusions of the OECD expressed in such commentaries. In RCF, because the U.S. and Australia had amended their treaty while taking into account 16 the 2000 OECD commentaries and because neither the U.S. nor Australia filed observations on the partnership report changes to the commentaries, Justice Edmonds seems to have assumed that Australia unreservedly follows such commentaries and effectively saw them as determinative in applying the treaty in the case. Arguably however, such presumption should not exist. From a Canadian perspective, in the absence of specific positive statements by Canada s Department of Finance, 17 it should not automatically be presumed 14 OECD, The Application of the OECD Model Tax Convention to Partnerships (Paris: Jan. 20, 1999) (the partnership report). 15 See generally Kandev and M. Peters, Treaty Interpretation: The Concept of Beneficial Owner in Canadian Tax Treaty Theory and Practice, in Report of Proceedings of the Sixty Third Tax Conference, 2011 Tax Conference (Toronto: Canadian Tax Foundation, 2012) at 26:23ff. 16 Significantly, the expression took into account in the technical explanation does not indicate that either or both country agreed to follow any of the OECD commentaries. 17 See, e.g., the 2007 technical explanation to Article XV(2) of Canada-U.S. treaty, which refers to paragraph 8 of the commentaries to article 15 of the OECD model. It is understood that the technical explanation of the Canada-U.S. treaty issued by the U.S. Treasury Department accurately reflects Canada s views of the meaning of the articles of that treaty; see Canada, Department of Finance, News Release (July 10, 2008). Otherwise, it is not the practice of the Department of Finance to publish travaux préparatoires or technical explanations to Canada s treaties. that any OECD commentaries actually reflect Canada s interpretation of the relevant treaty article. 18 Canada s attitude precisely regarding the partnership report and the corresponding changes made to the commentaries is particularly instructive and illustrates this argument. The issues addressed in the partnership report have been particularly relevant in the Canada-U.S. context. Contrary to the conclusions of the partnership report, the general consensus in Canada before the fifth protocol to the Canada-U.S. tax treaty had been that U.S.-owned fiscally transparent limited liability companies are not eligible for the benefits of the Canada-U.S. tax treaty 19 and, conversely, that the U.S. members of a Canadian reverse hybrid limited partnership are eligible for such treaty benefits. 20 In the latter case, the CRA seems to have struggled mightily with the inconsistency between its traditional position and the partnership report. In Technical Interpretation E5, the CRA observed the following regarding allowing treaty benefits to a reverse hybrid partnership: This position is currently under review, as it conflicts with the OECD Commentary relating to Article 1 of the OECD Model Convention... The [CRA] generally supports giving significant weight to the OECD Commentary for purposes of tax treaty interpretation except where Canada has specifically entered an observation... We note that Canada has not entered an observation for the Article 1 Commentary dealing with partnerships. The results of our review of this issue will be released in a future Income Tax Technical News. In the meantime, the [CRA] intends to maintain its long-standing position of allowing the reduced withholding rate (that is, 10 percent) on interest payments made by Canco to the Partnership in the circumstances described in your letter. In CRA document C6, containing CRA s answer to Question 2 at the government roundtable at the 2004 International Fiscal Association seminar, the CRA elaborated as follows: The Agency has three general concerns with maintaining the current position [on allowing treaty benefits to U.S.-owned reverse hybrid Canadian partnerships]. The first is that maintaining the position may be inconsistent with Agency practice in other areas; the Agency has followed 18 Of course, it is assumed that Canada has not recorded a reservation to that actual article in the OECD model. 19 See Technical Interpretations (Kentucky LLC); (Colorado LLC); and (Florida, Wyoming, Delaware, and Indiana). One could ask, of course, whether the conclusions of the partnership report should extend to corporate entities, such as LLCs. 20 See Technical Interpretation E5. TAX NOTES INTERNATIONAL JUNE 24,

7 or relied on OECD Commentary with respect to treaty interpretation for a number of other issues. While the weight to be given to Commentary on any particular subject will always depend in part on the overall Canadian tax context, the Agency should be consistent to the greatest extent possible on how Commentary is used in establishing interpretative positions. The second concern is with Canadian tax policy. Canada has not entered an Observation with respect to the particular OECD Commentary in question, which may indicate that Canada agrees with the OECD that treaty benefits should not be given to partners of a partnership where the partnership is treated as a transparent entity in the source state and as a separate legal entity by the partner s state of residence. Our third concern is that Canadian courts are taking notice of and applying OECD Commentary in a growing number of situations. At the same time, we recognize that the weight to be given to OECD Commentary remains in issue, especially where the Commentary in question has been adopted after Canada has entered into the relevant tax treaty. However, the Introduction to the OECD Commentary states that new Commentary should be taken into account when interpreting an existing tax treaty as long as the new Commentary is merely clarifying in nature. It is our understanding that new paragraphs 2-6 and 6.1 et seq. of the Article 1 Commentary are intended to be merely clarifying in nature, that is, these new comments were simply intended to say explicitly what had been understood implicitly before. In summary, we are revisiting the issue of whether a partner resident in a treaty country should receive the benefits of a tax treaty between Canada and that treaty country where the partner is not liable for tax on the particular income in the treaty country because the partnership is treated as a separate taxable entity by that country. Our review will focus specifically on this issue and not on general partnership issues. Our main concern is that our current position is directly contrary to specific, applicable OECD Commentary on which Canada has not entered an Observation. The results of our review will be announced in a future Income Tax Technical News. Significantly, the CRA never published a revised view. Then the 2008 fifth protocol introduced new Article IV(6) and IV(7)(a), respectively offering and denying treaty benefits in the above two situations (that is, extending treaty benefits to a U.S.-owned fiscally transparent LLC and denying benefits to a Canadian reverse hybrid partnership). Arguably, the clear implication of these provisions is that Canada and the U.S. did not believe the partnership report and resulting commentaries reflect a fair interpretation of the OECD model on which they could rely or with which they could agree. This is so even though Canada and the U.S. did not record observations to the partnership report or to the resulting commentaries, whereas other countries, such as the Netherlands, were very critical of them. 21 The surprising and ironic aspect of the above example, as discussed next, is that the Canadian decision in TD LLC, 22 similarly to the Australian RCF case, seems to have applied the partnership report precisely to offer treaty benefits to a disregarded LLC owned by a U.S. resident for years before the fifth protocol despite the seeming contrary consensus on this point. When Is a Hybrid Partnership a Treaty Resident? Having decided that the validity of the Australian tax assessment depended on the application of the treaty as interpreted by the OECD commentaries, rather than solely under domestic law, the court had to determine what limit, if any, the treaty imposed on the commissioner s right to assess RCF. The first issue in this regard was whether RCF was a resident of the United States for treaty purposes. Despite RCF being treated as a partnership for U.S. tax purposes, there was a genuine issue to consider due to the peculiar wording of the treaty. Article 4(1)(b)(iii) of the treaty defined a resident of the United States to include any person (other than a corporation or any unincorporated entity treated as a corporation for U.S. tax purposes) 23 that is resident in the United States for purposes of its tax, with the proviso that a partnership is not a U.S. resident except to the extent that income derived by the partnership is subject to U.S. tax as the income of a resident, either in the hands of the partnership or its partners. While the proviso in article 4(1)(b)(iii) was satisfied (substantially all of the income of the partnership was subject to tax in the hands of U.S. resident partners), the court held that the requirement that the partnership be resident in the United States for purposes of U.S. tax was not. One might have thought that the basis for the court s holding that RCF was not a U.S. resident for U.S. tax purposes would have been that RCF was not liable to tax (that is, was not a potentially taxable entity under U.S. law). However, article 4 of the treaty 21 The Netherlands, France, and Portugal all entered observations regarding the 2000 revisions to the commentaries based on the partnership report, each of them positing essentially that express language in a particular treaty would be required to render the treaty applicable. 22 TD Securities (USA) LLC v. Canada, 2010 D.T.C (TCC). 23 The carveout for fiscally nontransparent unincorporated entities makes one wonder what kinds of partnerships resident in the United States for purposes of its tax the treaty negotiators were referring to when they negotiated the wording of article 4(1)(b)(iii). The seeming internal contradictions of this treaty provision render somewhat more plausible the court s reasoning that suggests that a fiscally transparent partnership can be a treaty resident of the United States simply if it is formed under U.S. state law JUNE 24, 2013 TAX NOTES INTERNATIONAL

8 does not contain the general liable to tax standard found in other treaties based on the OECD or U.S. model treaties. Nor did the court seem inclined to give any kind of substantive meaning to what it means to be resident of a contracting state within the meaning of article 4(1)(b) of the treaty specifically. The court was instead content to rely on the following convoluted argument from the taxpayer as to why RCF was not a U.S. resident: Corporations are only U.S. residents for treaty purposes if they are formed under U.S. state law; by analogy, a partnership should only be resident if it is formed under U.S. state law; and, since RCF is formed under Cayman Islands law, it should not be considered a resident of the U.S. for tax purposes. The argument from analogy did not explain why a hallmark of a taxable entity (jurisdiction of formation) should be determinative in addressing whether a fiscally transparent entity was a U.S. treaty resident. One implication of this odd hollowing out of the concept of U.S. residence of an entity for treaty purposes, basing it solely on jurisdiction of formation and not on status of the entity under the check-the-box regulations, is that if RCF had been formed under, say, Delaware law, and still had been treated as a partnership for U.S. tax purposes, it would have by implication been found to be a resident of the United States for purposes of the treaty. The residence analysis in RCF may be contrasted with the reasoning applied by the Tax Court of Canada in TD LLC, in which a Delaware LLC was held to be a resident of the United States for purposes of the Canada-U.S. tax treaty. As in the Australian case, the source country (Canada) treated the foreign entity as a corporation and hence as the relevant taxpayer under domestic law, while the country in which the entity s members resided treated the entity as fiscally transparent the LLC in the Canadian case was a disregarded entity for U.S. tax purposes whose sole member was a U.S. C corporation. In accordance with its long-standing position, the CRA had denied the LLC a reduced treaty rate on Canadian branch profits tax on the assumption that the disregarded LLC was not liable to tax in the U.S. and thus not resident there for treaty purposes. The Tax Court of Canada concluded, however, that the LLC was resident in the United States because all of its income was liable to tax in the United States in the hands of the LLC s sole member, which itself was a taxable U.S. resident. The court had earlier in the judgment found that because the income of the LLC was fully liable to U.S. tax, this was a sufficient basis on which to decide the case in favor of the taxpayer. However, the court also added that it was required as a matter of law to reach a conclusion as to the U.S. treaty residence of the LLC. By reasoning thus, the Tax Court of Canada managed to arrive at a result that took into account the residence state treatment of the income while still respecting the source state s treatment of the hybrid entity as the taxable entity not just for domestic law but also treaty purposes. 24 In RCF, once the court found that the assessed entity was not a U.S. resident for purposes of the treaty, the court might have concluded that therefore the treaty could offer the entity no protection against the Australian assessment. However, the court did not treat RCF s nonresidence in the United States for treaty purposes to be determinative, as it went on to apply the treaty to determine that the wrong taxpayers had been assessed. When Is It Appropriate to Look Through a Hybrid Partnership? The second and decisive issue under the treaty was, as framed by both the taxpayer and the court, whether the treaty authorized Australia to assess RCF. The court answered this question by identifying which taxpayer(s) derived the capital gain for treaty purposes. The court held that the largely U.S. resident partners derived the capital gain realized by RCF for treaty purposes. It did so by applying the 2000 OECD commentary to the treaty in particular the statements in the OECD commentary to the effect that even when a source country treats a partnership as fiscally nontransparent, if the partners residence state treats the partnership as transparent, the source state should take that into account so as to not deny treaty benefits. 25 The court noted that not following that approach would lead to double taxation, since the U.S. partners would be liable to U.S. tax on their share of RCF s gain with no U.S. foreign tax credit for Australia s tax on RCF Some might say the Tax Court of Canada achieved this balancing of considerations at the cost of applying a rather strained interpretation of the terms of Article IV (residence) of the Canada-U.S. tax treaty. See discussion in Matias Milet, Hybrid Foreign Entities, Uncertain Domestic Categories: Treaty Interpretation Beyond Familiar Boundaries, Can. Tax J. (2011), Vol. 59, No. 1, 25-57, at The holding of the court is less relevant under current law, since the Canada-U.S. tax treaty has since the tax years at issue in TD LLC been amended by the fifth protocol to require Canada to treat income derived for U.S. law purposes by U.S. resident members of an LLC as having been so derived for purposes of the Canada-U.S. tax treaty, thereby permitting the LLC to claim treaty benefits on the basis of the status of its members. It is thus no longer necessary to reach the conclusion that a fiscally transparent LLC is a resident of the United States in order to allow the LLC to claim the benefits of the Canada-U.S. tax treaty. 25 The FCA cited among others paragraphs 6.3 and 6.4 of the OECD commentary on article 1 of the OECD model income tax treaty. 26 We understand that the availability of a U.S. foreign tax credit may not be as straightforward as is suggested by the Australian judge, who had the benefit of U.S. tax expert witnesses. In particular, if Australia had been permitted to tax the capital gain at the level of the partnership, arguably the United States could still have been required to grant a foreign tax credit. See, e.g., article 27(1)(a) of the treaty ( income derived by a resident (Footnote continued on next page.) TAX NOTES INTERNATIONAL JUNE 24,

9 The court concluded that consistent with the OECD commentary, Australia should treat the capital gain realized by RCF as having been derived by its partners, and the court used that finding to settle the question of the validity of the tax assessment in favor of the taxpayer. It held that it follows from the derivation point that it is the limited partners of RCF, not RCF the limited partnership, that Australia is authorised to tax under Art 13(1) of the Convention. 27 Taking one additional step, the court said the treaty conclusion conflicted with domestic law as to the entity or entities to be taxed on the capital gain, and it therefore followed (based on the implementing legislation that caused the treaty to override domestic law to the extent of inconsistency) that the assessment of RCF was invalid. In reasoning in this manner, the court in effect treated the permission granted to Australia under the treaty to tax U.S. residents on some capital gains derived by them for treaty purposes into a prohibition on assessing any other person on such gains, even one treated as a Cayman Islands resident corporation that for Australian tax purposes had realized the gain, if the income of that other person was derived for treaty purposes by U.S. residents. On appeal of the RCF decision, this surprising use of the capital gains article in the treaty may be challenged. The court sought to bolster its conclusion regarding the application of the treaty by applying a mirror transaction mode of argument often found useful in determining unclear entitlements to treaty benefits. The court considered hypothetically what the result would be if a U.S. real property gain were realized by a partnership that was treated as a corporation for U.S. tax purposes and whose members were Australian residents. The court accepted the taxpayer s argument that in such circumstances, a U.S. court would likely see it as determinative that for Australian tax purposes the Australian resident members derive the gain rather than the partnership. What the court failed to note, however, is that there are U.S. domestic law provisions (U.S. Treas. reg. section (d)(1) and (3)(iii)) that require that the U.S. defer to its treaty partner s characterization of the entity for treaty purposes in such circumstances, while Australian domestic law seemingly contains no similar provision. of the United States which, under this Convention, may be taxed in Australia shall for the purposes of the income tax law of Australia and of this Convention be deemed to be income from sources in Australia ), and article 22(1)(a) of the treaty, which on its terms does not require that the U.S. resident applying for U.S. foreign tax credit relief be the same entity taxed by Australia. 27 Article 13(1) of the treaty, in conjunction with article 13(2)(b)(ii), permits Australia to tax gains derived by a U.S. resident when the property disposed of is a share in a company whose assets consist wholly or principally of real property situated in Australia. The approach taken to the application of the treaty to a hybrid entity may be contrasted with the approach that the United States and Canada agreed to in the fifth protocol to the Canada-U.S. tax treaty. As noted, the fifth protocol introduced Article IV(6), which in effect requires Canada to treat income or gains of an LLC that is fiscally transparent for U.S. tax purposes as derived by the LLC s U.S. resident members. As noted in the U.S. Treasury Department s technical explanation of the fifth protocol, Canada will not disregard the LLC for treaty purposes simply because the U.S. treats the LLC as fiscally transparent; rather, Canada will allow the LLC to claim the benefit of the treaty on the basis of the derivation of the relevant income or gains by its U.S. resident members. While the LLC s nontransparent status under Canadian tax law can thus no longer be used to deny treaty benefits available to U.S. resident members, that status remains relevant for some purposes, such as identifying which entity is required to file a Canadian tax return (if necessary) on which treaty benefits would be claimed. 28 As non-australian lawyers, we do not know if a similar approach would have been available to the court in RCF under Australian law, but it strikes us that one way in which the court could have fulfilled its evident desire to avoid double taxation of RCF s capital gain would have been to accept that RCF as a corporate taxpayer for Australian purposes was the correct entity to be assessed under domestic law, a procedural result with which the treaty would not interfere, but that RCF could object to such assessment on the basis of derivation of 97 percent of the gain for treaty purposes by U.S. residents. That this would appear to be a preferable approach becomes evident if the facts in RCF are varied somewhat: If only 50 percent of the partners of RCF had been U.S. residents and the rest had been resident in non-treaty countries, the court s approach would have led to an all-or-nothing result either the assessment is invalidated on the basis of at least partial treaty benefits and then no tax is paid on any of the gain (even with the non-treaty residence of half the partners), or an arbitrary decision is made that there are not enough U.S. resident partners and then the assessment is allowed to stand in its entirety and no treaty benefits are granted (even with the treaty residence of the other half of the partners). In contrast, allowing the entity to be assessed but raise objections to the quantum of tax assessed to the extent that the underlying income or gain is treaty protected allows for a more calibrated response, one that moreover would seem to not run quite so roughshod over domestic procedural law. A final observation on the application of the treaty in RCF relates to timing: When the U.S. and Australia 28 See technical explanation of Article IV(6) under the heading, Application of paragraph 6 and related treaty provisions by Canada JUNE 24, 2013 TAX NOTES INTERNATIONAL

10 negotiated and signed the treaty in 1982, Australia s law taxing some limited partnerships as corporations did not yet exist. 29 Thus, the inconsistent tax treatment of partnerships that is now common as between the two countries seemingly was not yet envisaged and it is our understanding that both countries then treated partnerships as fiscally transparent. Accordingly, one argument that could have been made for the result in the case is that the court was simply requiring Australia to honor its original bargain of allowing treaty benefits to be available for income of a partnership with U.S. resident members a bargain as part of 29 RCF, supra note 1, at para. 16. which (as the terms of article 4(1)(b)(iii) showed) the source country treatment of the partnership does not figure. 30 Conclusion Some of the conclusions reached by the court in RCF may be surprising, particularly to tax experts outside Australia, but there is no denying the difficulty of the questions that were before the court. The decision has been appealed and may be overturned, but if it stands the judgment will remain a notable instance of a country s domestic law framework giving way as a result of the application of a tax treaty to evolving consensual, but by no means unanimous, international norms relating to hybrid entities. 30 This raises the question of whether under Australian law subsequent domestic law enactments can override treaties, and if so, whether the change in domestic law here was an implied treaty override. TAX NOTES INTERNATIONAL JUNE 24,