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Mergers and Acquisitions in Canada

The Treaty provides relief from Canadian income taxes only to residents of the U.S., as defined in Article IV of the Treaty. A “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.”

In The Queen v. Crown Forest Industries Limited,[[95 D.T.C. 5389 at 5395.]] the Supreme Court of Canada established that the concept of residence for the purpose of the Treaty entails “being subject to as comprehensive a tax liability as is imposed by a state,” and that such comprehensive taxation is taxation on worldwide income. Accordingly, the CRA has applied these indicia in determining whether certain special types of non-resident entities are residents of the U.S., and thus eligible for Treaty benefits.

“S” Corporation

A corporation that files an election under Subchapter S of the Internal Revenue Code[[Title 26 of the United States Code (26 U.S.C.).]] is commonly referred to as an “S” Corporation. This type of corporation may be treated as a flow-through entity for U.S. federal income tax purposes. However, administratively, the CRA considers an “S” Corporation to be a resident of the U.S. for the purposes of the Treaty.

U.S. Limited Liability Company

A U.S. limited liability company (“LLC”) that is treated as a flow-through entity for U.S. income tax purposes will not generally be subject to U.S. income tax on its worldwide income. The CRA previously took the position that an LLC was not liable to tax and was thus not a resident of the U.S. for purposes of the Treaty, and would not qualify for the benefits offered by the Treaty. Without the relief granted by the Treaty, dividends payable by a Canadian corporation to the U.S. LLC would be subject to withholding tax at a rate of 25%. The relief for capital gains, the rules governing the allocation of business profits, and the reduction in the Canadian branch tax, would also not be available. It should be noted that the CRA’s position may be incorrect (see TD Securities (USA) LLC, a decision of the Tax Court of Canada in April 2010).[[2010 D.T.C. 1137. This case held that an LLC was liable to tax in the U.S. and therefore a resident in the U.S. under the Treaty. Although the CRA did not appeal this decision it has publically stated that it disagrees with the decision.]]

However, the Treaty was amended effective January 1, 2009 and it now enables Canada to “look-through” U.S. entities that are fiscally transparent to determine their entitlement to Treaty benefits. Although an LLC itself is not entitled to Treaty benefits, under the Treaty, it can claim the benefits that are available to its U.S. resident members as a result of the look-through provisions.

Limitation on Benefits Provision

The Treaty has been recently amended to include a limitation of benefits (“LOB”) provision which deals with entities that are not ultimately owned by U.S. entities or by public corporations, the principal class of shares of which are primarily and regularly traded on recognized U.S. or Canadian stock exchanges. The LOB rules are aimed at countering “treaty shopping” by non-residents. This is the first LOB provision utilized by Canada and, accordingly, there is only limited guidance in Canada on such rules. In general terms, the rules operate to deny Treaty benefits to any U.S. entity which otherwise meets the requirements under the Treaty, unless certain tests are met.

Generally, a U.S. or Canadian public company whose shares regularly trade on a recognized Canadian or U.S. stock exchange can benefit from the Treaty. A U.S. company controlled by five or less U.S. individuals who own at least 50% of the votes and value of the company can also benefit from the Treaty. In addition, U.S. residents may qualify for Treaty benefits under the LOB provision if the income in question is earned in Canada in connection with, or incidental to, a trade or business carried on in the U.S., and the trade or business in the U.S. is substantial in relation to the activity carried on in Canada. In certain situations, the U.S. resident may qualify for certain Treaty benefits if the ultimate owner of the U.S. resident is a resident of a country with which Canada has entered into a comprehensive tax convention, which provides similar treaty benefits as those set out in the Treaty, and certain other tests are satisfied. Alternatively, a U.S. resident may apply to the Canadian Competent Authority for a determination of the applicability of Treaty benefits on the basis of all relevant factors. In this regard, it will be necessary to show that the principle purpose of the creation and existence of the U.S. resident was not to obtain benefits under the Treaty that would otherwise not be available, and that it would be appropriate, having regard to the purposes of the LOB rules, to not deny Treaty benefits. If the CRA determines that either test applies, the U.S. resident will be granted the benefits of the Treaty.

It should be noted that at present, the Treaty is the only one which includes a LOB provision which is applicable to Canadian taxes.In 2013, the Canadian government announced its intention adopt new legislation to counter treaty shopping. In 2014, the Federal Budget proposed certain treaty shopping rules to counter the abuse of Canada’s tax treaties. However, these proposed rules are not likely be enacted until formal recommendations from the OECD on the Base Erosion and Profit Shifting (BEPS) Project are released.

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