Robert Hogan is a partner at law firm Stikeman Elliott in Montréal, Canada. He can be reached at +1 514 397 3238 and at firstname.lastname@example.org.
On September 21, 2007, after nearly ten years of negotiations, the United States and Canada signed the fifth protocol (?Protocol?) amending the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital (?Convention?). The Protocol introduces wide-ranging changes to the Convention, including source-country withholding tax exemptions on some cross-border interest payments, mandatory arbitration of double tax issues, extension of treaty benefits to limited liability companies (?LLCs?) and clarifications affecting the taxation of stock options.
Once effective1, the Protocol will have significant impacts on the choice of investment vehicles and structures for acquisition strategies in Canada. In this new environment, US private equity investors investing in Canada will need to address the new opportunities and challenges which result from the new Protocol.
This article reviews the principal consequences of the tax treatment of LLCs and cross-border debt structures. Despite the new opportunities offered by the Protocol, there remain many pitfalls for US private equity investments in Canada that may utilize LLCs.
Former tax treatment
Management groups of US private equity funds often structure their management operations and carried interest investments through LLCs. The historical background is tied to the fact that limited liability can be lost under limited partnership arrangements where the limited partners are active in the management of the business. A LLC offers the benefits of limited liability without the risk of forfeiture if the members are actively involved in its operations. It remains a flow-through for US tax purposes, unless a check-the-box election is filed to treat it as a corporation.
However, for purposes of the Convention, the Canada Revenue Agency (?CRA?) has traditionally been of the view that US LLCs which are treated under US tax law as partnerships, and which are therefore not liable to tax in the United States, are not residents of the United States notwithstanding that such companies may be residents in the United States under the common law tests of residency. Accordingly, because LLCs are disregarded for Canadian tax purposes in the application of the Convention, they do not qualify for reduced rates of Canadian tax on Canadian source income which would otherwise be granted to other types of corporations, such as C-corporations and Scorporations. Nor would the LLC members benefit from the Convention.
Management and transaction fees derived from services rendered in Canada by a private equity sponsor are subject to a 15 percent withholding tax2. However, if the sponsor is structured as an LLC, such withholding may not be refunded as the result of filing a Canadian income tax return and claiming a treaty exemption on the basis that the sponsor has no permanent establishment in Canada, since Canada does not accept that an ?unchecked? LLC is a treaty-resident of the United States. Similarly, sponsors structured as LLCs will not be entitled to claim exemptions with respect to capital gains sourced in Canada which are attributed to the LLCs as a result of their carried interests in private equity funds. Thus, Canadian tax would be payable on any capital gains allocated to the sponsors on a sale of Canadian investments by the funds.
The historical treatment of LLCs and resulting tax leakage have fueled the use of partnerships and S-corporations for structuring US private equity sponsors, reliance on US C-corporations under LLCs (blockers) and the establishment of complex offshore partnership structures to invest in Canada. While at first blush, the new Protocol appears to offer interesting opportunities for reducing the complexity and costs associated with those solutions, a closer review shows that many obstacles still exist which can expose the unwary to significant tax risks.
New tax treatment
Under the Protocol, income that US residents earn through a hybrid entity such as an LLC will be treated by Canada (the source country) as having been earned by a resident of the United States. The LLC is hybrid because it is treated as a partnership for US tax purposes if it has more than one member and as a corporation in Canada for tax purposes. A corollary rule provides that if the LLC's income is not taxed directly in the hands of its investors, it will be treated as not having been earned by a US resident. Thus, an LLC with only US investors which earns Canadian-source investment income will treat such income as having been paid to the US investors (provided the US investors are taxed in the US on the income in the same way as if they had earned it directly). The reduced withholding tax rates provided in the Convention would therefore apply.
As a result of the new rules, US private equity sponsors structured as LLCs which have only US resident investors will be able, in most circumstances, to avoid paying income tax in Canada. With respect to management and transaction fees, withholding will still apply at the 15 percent rate for fees paid in respect of services rendered in Canada, but such withholding taxes will be refunded if an income tax return is filed and a treaty exemption claimed on the basis that the sponsor has no Canadian permanent establishment. If the US sponsor has a Canadian permanent establishment from which it has provided services in Canada, any withholding tax will be refunded only if it exceeds the Canadian income taxes payable for the year by the sponsor. With respect to capital gains sourced in Canada, sponsors will also be allowed, in most circumstances, to claim a treaty exemption to the extent that they do not have permanent establishments to which the capital gain is attributable.3
Various problems could arise in situations where certain investors of an LLC are not residents of the United States because the new ?look-through? approach for LLCs under the Convention only applies with respect to US resident investors. For example, if 40 percent of Canadian sourced income earned by a sponsor is allocated to US residents, only 40 percent of such income will benefit from the Convention and the remaining portion will be fully taxable in Canada. Although there remains uncertainty as to whether the look-through approach will apply to LLCs having both US and non-US resident investors, this appears to be the intent under the Protocol. The language and the scope of the amendments are not as clear as tax practitioners would have liked. Situations of this nature will likely create administrative problems and, potentially, significant disputes when the time comes to determine the amount of tax payable on Canadian sourced income and where the tax costs should fall.
Those problems may be exacerbated in situations where an LLC is used as an aggregator by various investors which are themselves disregarded for US tax purposes (e.g., partnerships or trusts). For example, if capital gains are realized by an LLC on exit, it may be difficult to allocate the Canadian tax among the ultimate investors that do not reside in the United States. Indeed, the allocation may prove to be impossible in the case of investment structures involving multiple-tiered partnerships or trusts. The Canadian tax could then end up being borne by all investors. This would effectively prevent the US resident investors from benefiting from the Convention.
These potential issues demonstrate that the new Protocol will not resolve all concerns with the treatment of LLCs under the existing Convention. In fact, the Protocol may create new problems. For this reason, US private equity sponsors with non-US investors will have to continue to resort to various alternatives developed over the years to avoid the prejudicial effects of the current Canadian tax treatment of LLCs, such as the use of Luxembourg entities.
Cross-border debt structures and hybrid entities
Traditionally, debt structures implemented in Canada by US private equity funds have relied on unlimited liability companies (?ULCs?) under Nova Scotia or Alberta legislation. For US tax purposes, ULCs are disregarded if they have only one member and are treated as partnerships if they have more than one member. For Canadian tax purposes, ULCs are treated as regular corporations. The dual tax treatment of ULCs in Canada and the United States has allowed private equity investors to avail themselves of various benefits, such as the allocation of losses realized by the ULC to the US investors to be applied against their profits. In addition, loans made by a US private equity fund to a wholly-owned ULC will be disregarded for US tax purposes (because the entity does not exist for US tax purposes) but will be treated as debt for Canadian tax purposes. Under this structure, interest on the debt would be deductible for Canadian tax purposes but would not be recognized for US tax purposes.4
Once the provisions regarding the treatment of hybrid entities come into effect, it appears from the language in the Protocol that there could be adverse consequences for debt structures with US investors that rely on ULCs, stemming from the fact that ULCs which are disregarded for US tax purposes will lose the benefits of the Convention. As a result, amounts paid by an ULC to a US person which are subject to Canadian withholding (e.g., interest, dividends and royalties) will no longer qualify for the reduced rates of withholding tax and will be subject to the Canadian default rate of 25 percent. This would mean significant additional costs in any cross-border debt structures with US entities investing in Canadian ULCs. These new rules could come into effect as early as January 1, 2010 if the Protocol is ratified by both Canada and the United States in the course of 2008.
Two solutions may be envisaged to deal with these problems. First, US investments in ULCs could be made through countries other than the United States. A middle entity would be formed in a (Canadian) treaty jurisdiction between the US entity and the ULC. The middle entity could thus safeguard the benefits of the reduced withholding tax rates provided in the tax treaty between Canada and the entity's jurisdiction. Second, hybrid instruments such as synthetic debt could be used to benefit from the dual tax treatment of hybrid instruments as opposed to hybrid entities. The holder of hybrid instruments could then benefit from the absence of withholding on interest.
While the new Protocol addresses many of the frictional tax issues that arose between the two major trading partners over the last decade, when it comes to using LLCs, the amendments create numerous traps for the unwary. In many cases, private equity funds will still be required to use alternative investing and management structures to benefit from treaty exemptions or reductions in withholding taxes.