The Canada U.S. Tax Treaty Protocol: Impact and Planning Opportunities Todd A. Miller, Partner McMillan LLP Michael Domanski, Partner Honigman Miller Schwartz and Cohn LLP Presented at: Federated Press: Tax Planning for Migration to or from Canada November 8, 2010
Overview I. Fifth Treaty Protocol - Important dates & Interpretive Tools II. Cross-Border Migration A. Tax Basis Step-Up Relief on Migration B. Corporate Residency changes III. Cross-Border Investment A. Fiscally Transparent Entity Rules (1) Limited Liability Companies (2) Canadian Hybrid / Reverse Hybrid Entities B. Interest Payments IV. Cross-Border Services / Employment A. New Permanent Establishment Rules for Service Providers B. Allocation of Stock Option Benefits C. Pension / Other Employment Provisions 2
I. Fifth Treaty Protocol - Important dates & Interpretive Tools 3
I. Fifth Protocol Important Dates & Interpretive Tools The Fifth Protocol (the Protocol ) was signed on September 21, 2007 and came into force on December 15, 2008. However, not all of the Protocol s measures came into effect at the same time (more relevant at this point for historical purposes as all measures are now in force). Material Interpretive Sources include Diplomatic Notes, U.S. Technical Explanation, and OECD Model Convention & Commentary. Treaty changes are substantial and present a number of planning opportunities and potential pitfalls in the context of cross-border services, migration and investment. 4
II. Cross-Border Migration A. Tax Basis Step-Up Relief on Migration B. Corporate Residency Changes 5
II. Cross-Border Migration - U.S. Tax Residency for Individuals Under U.S. domestic law, individuals are considered to be U.S. tax residents if they: are U.S. citizens for U.S. immigration law purposes are permanent residents / green card holders for U.S. immigration law purposes satisfy the day count test make the appropriate election are not students, teachers or trainees otherwise eligible for non-resident status 6
II. Cross-Border Migration - U.S. Tax Residency for Individuals Under U.S. domestic law, individuals are considered to cease being U.S. tax residents if they: Terminate their U.S. citizenship / green card status for U.S. immigration law purposes No longer satisfy the day count test Revoke the residency election with IRS consent Are eligible for treaty relief and file an IRS Form 8833 (treaty-based position) 7
II. Cross-Border Migration - U.S. Tax Residency for Individuals Notable day count test issues: Current year days are counted as 1 full day while days present during the first and second preceding years are counted as one-third and one-sixth days, respectively Physical presence generally based upon a snapshot in time The following situations do not generally apply: Inability to leave the U.S. due to a medical condition Commuters involving Canada and Mexico In transit between two foreign points and present in the U.S. for less than 24 hours 8
II. Cross-Border Migration - U.S. Tax Residency for Individuals For individuals who are considered to be residents of both countries, the Treaty tie-breaker rules will determine residency based upon their: permanent home centre of vital interests / closer personal and economic relations habitual abode citizenship 9
II. Cross-Border Migration - U.S. Tax Residency for Individuals New U.S. tax residents are entitled to a carry-over / cost tax basis rather than a fair market value basis in their assets, unlike the Canadian tax treatment of new residents Accordingly, non-u.s. residents (including Canadian residents) who are subject to departure tax could experience double tax when the subject assets are eventually sold IRS Rev. Proc 2010-19 provides guidance regarding the election to apply Treaty relief and cause the individual to be deemed to have sold and reacquired the asset for purposes of achieving a step up in the tax basis of the asset from a U.S. perspective 10
II. Cross-Border Migration Canadian Domestic Rules Departure Tax on Emigration Brief review of Canadian residency definitions Subsection 128.1(4)(iii) of the Income Tax Act (Canada) (the Tax Act ) provides that an individual taxpayer, when ceasing to be resident in Canada, is deemed to have disposed of all property owned by that individual taxpayer, other than, amongst other things, an excluded right or interest of the taxpayer. Subsection 128.1(10) of the Tax Act defines an excluded right or interest of an individual taxpayer to include: A registered retirement savings plan, A registered education savings plan, A registered disability savings plan, A tax free savings account, and A superannuation or pension fund or plan 11
II. Cross-Border Migration Departure Tax - Excluded right example Tax Free Savings Account ( TFSA ): Listed as an excluded right or interest under subsection 128.1(10) of the Tax Act. Pursuant to subsection 128.1(4)(iii) of the Tax Act, an individual taxpayer is not deemed to have disposed of her/his TFSA upon emigration. However, despite no deemed disposition, income earned in the TFSA may be taxed under U.S. tax law with the result that proactive steps should be taken (i.e., withdrawal of TFSA funds pre-emigration). 12
II. Cross-Border Migration Canadian Domestic Rules Step-up on Immigration Subsection 128.1(1) deemed disposition and reacquisition at FMV of all property other than, in the case of individuals (inter alia), property that is taxable Canadian property or an excluded right or interest. 13
A. New Treaty Tax Basis Step-Up Provision The Protocol introduces a replacement paragraph 7 of Article XIII, aimed at further facilitating the elimination of double taxation and/or potential timing mismatches associated with pre-emigration gains on property held by an emigrant (e.g. Canadian migrating to U.S. or in respect of certain gifts that the U.S. does not recognize as being immediately taxable). Election results in a deemed sale and reacquisition of the subject property at FMV (facilitating access to foreign tax credits). 14
A. New Treaty Tax Basis Step-Up Provision (con d) Impact: Gains subjected to tax in the emigrant s original jurisdiction of residence are not subject to double taxation in the new jurisdiction of residence (e.g., results in FMV ACB for U.S. tax purposes if non-u.s. citizen becomes U.S. resident and accelerated U.S. tax in case of U.S. citizens). However, post-emigration gains remain taxable in the new country of residence. 15
II. Cross-Border Migration - U.S. Tax Residency for Companies Under U.S. domestic law, companies / partnerships are considered to be residents according to the following criterion: Corporations are residents of the country where they are incorporated Partnerships are not residents of any country, but their activities are typically attributed to their owners for purposes of determining whether the partners have a U.S. trade or business or permanent establishment Partners in the partnership may be eligible for treaty benefits 16
B. Corporate Residency Changes Article IV(1) of the Treaty provides, the term resident of a Contracting State means any person that, under the laws of that State, is liable to tax therein by reason of that person s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature 17
B. Corporate Residency Changes (cont d) The Protocol introduced revised paragraph 3 to Article IV of the Treaty. It provides that if, pursuant to paragraph 1 of Article IV, a corporation is considered resident of both Contracting States (e.g., incorporated in one state with management in the other), then that corporation s status is determined in the following manner: If it is created under the laws of only one Contracting State, it will be deemed resident of that Contracting State (paragraph (a)); and If the above does not apply (e.g., dual incorporation), the competent authorities may decide the question of residence by mutual agreement. If no agreement is reached (none to date), the subject company shall not be considered a resident of either country for purposes of claiming any of the benefits available under the Treaty (paragraph (b)). Effective September 18, 2000 (per prior agreement between the countries) Future uses of dually-incorporated companies? 18
III. Cross-Border Investment A. Fiscally Transparent Entity (FTE) Rules (1) Limited Liability Companies (2) Anti - Hybrid Entity Measures B. Interest Payments C. Dividend Payments 19
A. Fiscally Transparent Entities U.S. Entity Classification Rules Default Rules for U.S. Companies U.S. LLCs, U.S. partnerships are considered to be fiscally transparent U.S. corporations are not fiscally transparent Default Rules for Non-U.S. Companies An entity providing limited liability for all of its owners is generally considered to be a corporation (e.g., Canadian corporations) In all other cases, entities are (in the absence of an election) generally considered to be fiscally transparent (e.g., Canadian ULCs) 20
A. Fiscally Transparent Entities U.S. Entity Classification Rules Check-the-Box Rules Entities can elect their classification unless considered to be per se corporations (e.g., U.S. and Canadian corporations) All other entities are typically eligible to elect status (e.g., U.S. LLCs, U.S. and Canadian partnerships, Canadian ULCs) 21
A. Fiscally Transparent Entity Rules - Definitions The CRA has provided commentary on the interpretation of the term fiscally transparent as found in paragraph 6(b) of Article IV: An entity is considered fiscally transparent if the income it earns is taxed at the beneficiary, member or participant level. Entities that are subject to tax, but with respect to which tax may be relieved under an integrated system, are not considered fiscally transparent. Examples of fiscally transparent entities under U.S. tax law LLCs that do not check the box Grantor trusts Common Investment trusts under Internal Revenue Code 584 Partnerships S Corporations* Example of fiscally transparent entities under Canadian tax law Partnerships bare trusts 22
A. Fiscally Transparent Entity Rules - Changes U.S. Limited Liability Companies ( LLCs ) Pre-Protocol, most LLCs did not qualify as residents for Treaty purposes (CRA viewed an LLC as a corporation, but not as a U.S. resident, since the LLC was not itself liable to comprehensive taxation per principles enunciated by SCC in Crown Forest; however, the recent TCC decision in TD Securities casts doubt on this view). Pursuant to new paragraph 6 of Article IV, income, profit or gain derived by such LLCs are attributed to U.S. resident members of the LLC (as applicable) with Treaty benefits (as applicable) accorded at the member level. Key requirement is that income amount be subject to the same treatment for U.S. tax purposes as would have resulted had the U.S. resident LLC member derived the income profit or gain directly. Implications and compliance requirements for U.S. investment into Canada using LLCs. 23
A. Fiscally Transparent Entity Rules Continuing Problems with Canadian Resident use of LLCs Stems from Canada s traditional view of LLCs as separate taxpayers Ineligible for 5% Treaty rate on branch profits (where Canadian corporate LLC members are concerned) (Article 7(a)) Ineligible for Treaty rates of withholding tax on interest, dividends and royalties However, lower tier LLCs (e.g., subsidiaries of U.S. C corporations) are not problematic 24
Hybrid Entities New Paragraph IV(7)(a) Protocol adds paragraph 7 of Article IV, which operates to deny treaty benefits for income received from or derived through certain hybrid entities (generally, entities treated as transparent by one jurisdiction (e.g., disregarded or partnership) but as a regarded entity (e.g., a corporation) by the other) (the Hybrid Clause ). The Hybrid Clause takes effect on January 1, 2010 Paragraph 7(a) can deny treaty benefits to U.S. owners of reverse hybrids (i.e., FTE for Canadian purposes, corporation for U.S. purposes) Specifically, income, profit or gain in the source state shall not be considered to have been paid to or derived by a person resident in the other state if: That person is considered under the laws of the source state to have derived the amount through an entity that is not a resident of the residence state; and By reason of that entity not being treated as fiscally transparent by the residence state, the treatment of the amount under the laws of the residence state is not the same as its treatment would be if that amount had been derived directly by the person. 25
Hybrid Entities New Paragraph IV(7)(b) Paragraph 7(b) may deny treaty benefits to U.S. owners of certain hybrid entities. Paragraph 7(b) is targeted at, among other things, amounts paid to a U.S. resident from a Canadian hybrid entity. Specifically, income, profit or gain shall be considered not to be paid to or derived by a resident if: That person is considered under the laws of the source state to have received the amount from an entity that is a resident of the source state, and By reason of that entity being treated as fiscally transparent by the residence state, the treatment of the amount under the laws of the residence state is not the same as its treatment would be if that entity was not fiscally transparent under the laws of the residence state (the Same Treatment Test ). EXAMPLE U.S. Resident NSULC Dividend Canada treats U.S. resident as having received a dividend. However, because the U.S. treats the distribution differently were NSULC not disregarded, the Same Treatment Test is not satisfied. 26
A. Fiscally Transparent Entity Rules - Hybrids The Technical Explanation provides a number of examples re: the application of Article IV(7)(b) including: U.S. corporation is the sole owner of a Canadian unlimited liability company ( ULC ). The ULC is disregarded for U.S. tax purposes but is a taxable entity for Canadian tax purposes. If the U.S. corporation loaned funds to the ULC, interest payments from the ULC to the U.S. corporation would be treated as a nonexistent event pursuant to U.S. tax laws. Under Article IV(7)(b) of the Treaty, as introduced by the Protocol, the U.S. corporation would not be entitled to any treaty benefits for the interest payment (i.e., the statutory withholding rate of 25% would apply). 27
A. Fiscally Transparent Entity Rules Other Examples USco USco Dividends US LLC CanCO Dividends Ontario LP CanCO USco entitled to 5% dividend withholding tax rate (Article IV(6)) USco not entitled to the 5% Treaty rate on dividends because Same Treatment Test is not satisfied(article IV(7)(a)) 28
A. Fiscally Transparent Entity Rules - ULCs Possible Workaround in case of Dividends: Step one: Sole member ULC increases the stated capital and thus the paid-up capital (PUC) of its shares. Canadian withholding tax applies on the resulting deemed dividend (of particular significance, the U.S. generally treats such increase as a nothing, regardless of whether the ULC is a FTE (thus, the Same Treatment Test is satisfied)). Step two: The stated capital of the ULC s shares is decreased by the same amount and distributed to U.S. Shareholders (generally, PUC returns are not subject to Canadian withholding tax (thus no need for release on the Treaty)). The CRA has taken the position that neither paragraph 7(b) of Article IV nor GAAR would apply to this arrangement provided the ULC is distributing what can reasonably be viewed as active business earnings. 29
B. Interest Payments Unrelated Parties: Withholding tax on interest paid to unrelated parties eliminated by new Article XI(1). Compliments Canadian domestic changes (effective January 1, 2008). Related Parties: Withholding tax on interest payments between related parties eliminated for payments after January 1, 2010. Exceptions: Participating debt / contingent interest. 30
IV. Cross-Border Services A. New Permanent Establishment Rules for Service Providers B. Allocation of Stock Option Benefits C. Pension and Other Employment Provisions 31
IV. Cross-Border Services - U.S. Tax Liability of Non- Resident Individuals Under U.S. domestic law: Only subject to tax on U.S. source income rather than on worldwide income as in the case of U.S. residents No U.S. tax on compensation not exceeding $3,000 and received by employees of non-u.s. companies working in the U.S. for less than 90 days U.S. source income includes amounts effectively connected to a U.S. trade or business Non-residents individuals who are partners in a partnership (or members of a U.S. LLC) that is engaged in a U.S. business will be considered to be so engaged 32
IV. Cross-Border Services - U.S. Tax Liability of Non-Resident Individuals For Treaty purposes: No U.S. tax on compensation less than $10,000 and received by employees of non-u.s. companies or U.S. branch offices working in the U.S. for less than 183 days U.S. source income includes amounts attributable to a U.S. permanent establishment 33
A. New Permanent Establishment Rules for Service Providers Pre-Protocol Rules / Case law: Traditional permanent establishment (Art.V) ( PE ) and fixed base (Art.XIV) concepts A U.S. resident service provider s income from independent contractor services provided in Canada is taxed only to the extent that income is attributable to a fixed base in Canada that is regularly available to the U.S. resident and through which the U.S. resident carries on his/her/its business Dudney (FCA) decision did not sit favourably with CRA. 34
A. New Permanent Establishment Rules for Service Providers (cont d) Protocol: Fixed Base concept eliminated (merged with PE definition and Article VII business profits provisions, consistent with OECD Model Convention s recognition that there is no practical distinction between the two concepts ), such that PE provisions now apply to individuals Definition of PE is expanded to include a deeming rule with respect to certain service providers who do not otherwise have a fixed place of business in the country where the services are provided/performed 35
A. New Permanent Establishment Rules for Service Providers (cont d) Protocol: Pursuant to new paragraph 9 of Article V, an enterprise providing/performing services in the other state is deemed to have a PE in the other state if (and only if) one of the following conditions is met: a) the services are performed by an individual who is present in the other state for > 183 days during any 12 month period and more than 50% of the enterprise s gross active business revenues (i.e., revenues excluding investment activities) that the enterprise has charged or should have charged are derived from such services; or b) the services are provided in the other state for > 183 days during any 12 month period and the services relate to the same project or a connected project for a customer who is either a resident of the other state or who has a PE in the other state (to which the services can be attributed). If Article V(9) is applicable, income from the subject services will be taxed in accordance with Article VII (Business Profits). 36
A. New Permanent Establishment Rules for Service Providers (cont d) Protocol: U.S. Treasury Department Technical Explanation: 9(a) is intended to apply with reference to the presence of a single individual. Meaning of same or connected project (per new Article 9(b)). The Diplomatic Notes included in Annex B to the Protocol (the Diplomatic Notes ) provide that projects will be considered to be connected if they constitute a coherent whole, commercially and geographically from the service delivering enterprise s perspective. Factors per U.S. Technical Explanation for commercial coherence include: One contract absent tax considerations, similar work and same individuals. Geographical coherence example (multi-city bank auditing project) Article V(9) is subject to Article V(3), which provides that a building site or construction or installation project will only constitute a PE if it lasts for longer than 12 months. 37
A. New Permanent Establishment Rules for Service Providers (cont d) Article V(9) contains the phrase, enterprise of a contracting state. This phrase is not found elsewhere in the Protocol or the Treaty. The OECD Model Convention defines the term as an enterprise carried on by a resident of a contracting state. Published commentary from CRA defining the terms third party and enterprise : Third Party as used in paragraph 9 of Article V of the Treaty, should be interpreted to mean any person other than the person operating the enterprise in question. Enterprise, refers to, a resident of a contracting state but only in reference to a particular line of business carried on by such resident. Physical location of service delivery governs in terms of where the services are considered to have been performed or provided (examples: telephone/computer related services and home office services) 38
A. New Permanent Establishment Rules for Service Providers (cont d) Application of Article V(9) Example: CanCo hires a Canadian law firm to perform work in the U.S. The Canadian law firm sends a lawyer to work in the U.S. for greater than 183 days. CanCo pays the law firm an amount that does not exceed more than 50 % of the Canadian law firm s gross active business revenues during the days the lawyer is present in the U.S. The Canadian law firm would not be found to provide services through a PE in the U.S. for purposes of Article V(9)(a). If CanCo (as a customer of the Canadian law firm) is not resident in the U.S. and does not have a PE in the U.S., the Canadian law firm will likely not be found to be providing services through a PE in the U.S. for purposes of Article V(9)(b). Other Examples (see U.S. Technical Explanation) 39
A. New Permanent Establishment Rules for Service Providers (cont d) Tips: Cross-border service providers must carefully monitor the amount of time spent in the host state in order to avoid a PE and resulting tax liability Other 40
B. Allocation of Stock Option Benefits The Diplomatic Notes provide a new rule (for purposes of Article XV and XXIV) applicable to situations where an employee is granted a stock option while resident in one country but exercises it while resident in the other country (and with the same employer group). Paragraph 6 of the Diplomatic Notes provides that each country can only tax the amount of the option benefit that is equal to the number of days that the employee s principal place of employment was in that country, during the period between the day the option was granted and the day the option was exercised, divided by the number of days in that period. 41
B. Allocation of Stock Option Benefits (cont d) Note that paragraph 6(a) of the Diplomatic Notes is subject to paragraph 6(b), which allows the competent authorities to agree to a different allocation method where the terms of the option were such that the grant of the option should be appropriately treated as a transfer of ownership of the underlying securities. 42
B. Allocation of Stock Option Benefits (cont d) CRA commentary on the definition of the phrase principal place of employment : the Contracting State in which the employee was physically present while exercising the employment on a particular day. Example provided by the CRA: January 1, 2009 employee granted option to acquire 1000 shares of capital stock of her employer. December 31, 2009 employee exercises the option and realizes a benefit of $100,000. During the year, the employee worked 100 days in Canada and 150 in the U.S. 43
B. Allocation of Stock Option Benefits (cont d) Example provided by the CRA (cont d): If paragraph 6(b) of the Diplomatic Note does not apply (no such cases so far), then: $40,000 of the stock option benefit would be determined to arise from the individual s employment in Canada $60,000 of the stock option benefit would be determined to arise from the individual s employment in the U.S. 44
IV. Cross-Border Services - U.S. Tax Non-Resident Individuals Under U.S. domestic law: U.S. source wages may be subject to U.S. FICA / SECA (social security) and FUTA (unemployment) taxes Non-qualified deferred income plans may be subject to U.S. tax 45
IV. Cross-Border Services - U.S. Tax Non-Resident Individuals For treaty purposes: U.S. Social security taxes on U.S. wages may be avoided if individual can provide a certificate of coverage establishing payment of Canadian social security taxes and is sent to the U.S. to work for 5 years or less Article XVIII and IRS Rev. Proc. 2002-23 allow individuals to elect the same deferral treatment in the U.S. as in Canada in connection with RRSPs / RRIFs / Canadian retirement plans 46
C. Pension and Employment Provisions Protocol measures apply to qualifying retirement plans (QRP) (which includes RRSPs under subsection 204.2(1.32) of the Tax Act). Individuals resident in one country but who work in the other country and contribute to a QRP in that country may now avail themselves of certain benefits (e.g. contribution deductibility). Illustrative example: Assume that a Canadian resident individual working in the U.S. contributes to his/her U.S. employer s pension plan. In such circumstances, the Canadian resident may be eligible to deduct such contributions for Canadian income tax purposes in the same manner as would have been available on a contribution to a RRSP. 47
C. Pension and Employment Provisions The Protocol amended Article XV of the Treaty by providing that an individual resident in one country and working in the other country will not be subject to tax in the source country if he/she is not present in the source country for more than 183 days in any 12- month period commencing or ending in the fiscal year concerned. Clarifies that payments in kind are included into income (consistent with OECD Model Convention) Previously, the Treaty had provided that a recipient of remuneration in that other country must not be present in that other country for more than 183 days in that taxation year. This provided greater flexibility, as a recipient could be present in that other country for greater than 183 days of employment, as long as the 183 days occurred over two taxation years. 48
Fifth Protocol Questions? 49
Notes / Disclosures These materials have been prepared for information purposes only. These materials do not constitute legal advice and cannot be relied upon for the purpose of avoiding federal tax penalties. ********************************************************************* IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed in this communication. ********************************************************************* 50
The Canada U.S. Tax Treaty Protocol: Impacts and Planning Opportunities Presented at: Federated Press: Tax Planning for Migration to or from Canada November 8, 2010 Todd A. Miller, Partner McMillan LLP 181 Bay Street Suite 4400 Toronto, ON M5J 2T3 todd.miller@mcmillan.ca d 416.865.7058 Michael Domanski, Partner Honigman Miller Schwartz and Cohn LLP 2290 First National Bldg. 660 Woodward Avenue Detroit, MI 48226-3506 mdomanski@honigman.com d 313.465.7352 51