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Tax & Trusts

TD Securities (USA) LLC v. The Queen – Canada Revenue Agency Loses on Denying Treaty Benefits to a LLC

Published: 04/19/2010

By Ken Snider, Janice Vohrah

The Tax Court of Canada recently released its judgment in TD Securities (USA) LLC v. The Queen. The issue in this case is whether the taxpayer, a limited liability company (the "LLC") established under the laws of the United States, was entitled to enjoy the benefits of the Canada-US Income Tax Convention (the "US Treaty") in respect of Canadian-source income for the 2005 and 2006 taxation year. The specific issue was whether the LLC was a resident of the US for purposes of the US Treaty. The Fifth Protocol entered into between Canada and the US which amended the US Treaty to add specific rules to apply to LLCs was adopted and came into force after the periods in question. It has been a long-standing administrative position of the Canada Revenue Agency ("CRA") that a fiscally transparent LLC is not a resident of the US for purposes of the US Treaty. The Tax Court of Canada rejected CRA’s position and allowed the appeal.

Facts

The facts are straightforward. The appellant is an LLC governed by the Limited Liability Company Act of the State of Delaware. The sole member is a Delaware corporation, TD Holdings II Inc. ("Holdings II") that is not a resident of Canada for purposes of the Income Tax Act (Canada) (the "ITA") and is a resident of the US for purposes of the US Treaty. The parties agreed that a US LLC is recognized as a distinct legal entity separate from its members under Canadian law. The LLC did not contest that it should be treated as a corporation under Canadian law. The Court was not invited by either party to revisit the characterization question (i.e. whether an LLC is a partnership).

The LLC is a registered US broker dealer that provides financial services in the capital markets sector. It is based in New York and has over 500 employees. The LLC has a branch operation in Canada for purposes of serving its US customers.

The LLC’s Canadian branch profits for 2005 and 2006 were reported by it in its Canadian tax return. Non-residents of Canada that carry on business in Canada are subject to mainstream Canadian income tax under the ITA on their income from their Canadian business, subject to treaty protection. The US Treaty provides that a US resident that carries on business in Canada is only subject to Canadian income tax if the business is carried on through a permanent establishment ("PE") in Canada. It was agreed that the LLC’s branch satisfied the definition of a PE. The ITA provides that non-resident corporations that carry on business in Canada will be liable for an additional "branch" tax of 25% of its Canadian net after-tax income, which may be reduced under an applicable tax treaty. This tax is a proxy for the non-resident withholding tax on dividends that would have been payable if the non-resident had instead used a Canadian subsidiary to carry on business and the subsidiary paid a dividend to the non-resident.

The US Treaty provides that the rate of branch tax is reduced to 5%. Accordingly, the LLC claimed a reduced rate of Canadian branch tax of 5% under the US Treaty. CRA assessed the LLC to deny the benefit of the 5% US Treaty rate and assessed the branch tax at the statutory rate of 25%.

The LLC did not file an election under the "check the box" regulations. Consequently, under the Internal Revenue Code (the "US Code"), the LLC is a disregarded entity and it is not itself subject to tax on its income. All of its income was included in the income of its sole member, Holdings II. The income of Holdings II was consolidated with the income of its direct parent, TD USA, which paid the tax. TD USA was unable to claim a full foreign tax credit in respect of the Canadian branch tax in its consolidated return. The assessments therefore increased the combined US and Canadian tax imposed on the Canadian-source income of the LLC.

Issue and Positions Taken by the Parties 

The fundamental issue was whether the expression "resident of a Contracting State" in Article IV of the US Treaty included the LLC. The Respondent took the position that the meaning of the phrase "resident of a Contracting State" is clear and unambiguous and that the evidence was clear that that the LLC was not itself liable to tax in the US. It argued the US Treaty should be interpreted liberally and purposively but effect must be given to the words chosen. Furthermore, the Respondent argued that even if the LLC was considered to be liable to tax in the US by virtue of its income being taxed to Holdings II, the tax is not by reason of the LLC’s domicile, residence, place of management, citizenship, place of incorporation or any other criterion of a similar nature, as required by the US Treaty. It was argued that if the LLC was successful, LLCs would in the future be able to claim treaty benefits on the same basis, rather than on the basis of the Fifth Protocol. The Fifth Protocol has specific conditions that must be met to claim relief, which would be rendered meaningless if an LLC could claim relief, otherwise than by reason of the Fifth Protocol.

The LLC had two distinct arguments to support its claim for treaty relief. First, the phrase "liable to tax" is a phrase not defined in the US Treaty and therefore must be defined by reference to Canadian law. Determining whether an entity is "liable to tax" under the US Treaty is different from the mere determination of whether a person is required to pay tax on its income under the US Code. On this basis, it was argued that a Court can conclude that the LLC was liable to tax in the US and was a resident of the US for purposes of the US Treaty. The LLC’s alternative argument was that, consistent with the commentaries in the Model Tax Convention on Income and Capital of the Organisation for Economic Co-operation and Development ("OECD" and the "OECD Model Treaty"), a liberal interpretation and application of the US Treaty designed to achieve its purpose must give a meaning to the phrase “resident of Contracting State” that includes the LLC. Furthermore, the LLC relied on the 1999 OECD Partnership Report.

Tax Court of Canada Decision

Based on the fact that the income of the LLC was fully taxed in the US, the Court held that the income of the LLC should enjoy the benefits of the US Treaty. The LLC was a resident and was "liable to tax" in the US on a comprehensive basis, albeit at the member level. The Court adopted a purposive approach and concluded that the object and purpose of the US Treaty would be frustrated if the Canadian-source income that was fully taxed did not enjoy treaty benefits. The Court applied an interpretive approach taken by the OECD countries, the OECD Model Treaty and related commentaries. As summarized below, Mr. Justice Boyle, a former Toronto tax lawyer, based his interpretation on a thorough and discursive review of the definition of "a resident of a Contracting State" in Article IV, past amendments to Article IV, the Fifth Protocol, principles of treaty interpretation, the OECD Model Treaty, CRA administrative practices, and US interpretation and administration.

The Court first reviewed the history of Article IV and noted that its interpretation was consistent with the approach taken by Canada and the US with respect to the interpretation and application of the US Treaty to government entities and not-for-profit entities prior to the Third Protocol. The Court noted that the Third Protocol in 1995 added to the definition of "resident" not-for-profit organizations and pension funds constituted in a Contracting State and generally exempt from tax in that state by reason of their status. This change was a clarification that confirmed interpretations adopted by both Canada and the US that not-for-profit organizations and pension funds needed to be residents to claim treaty relief. Also, the Third Protocol added a clause that deemed the government of one of the countries (and other extensions thereof) to be a resident. The Court noted that both countries applied the pre-amendment US Treaty to treat such persons as residents because the "context required or because it was implicit."

The judge then reviewed the relieving language in respect of LLCs in the Fifth Protocol. This provision is not retroactive and did not apply to the taxation years in question. He found it noteworthy that, based on a literal application, the Fifth Protocol amendments would not solve the problem faced by the LLC because they do not deal with why the LLC would be able to claim the treaty reduction in its Canadian income tax return, which it is required to file and not its member. He noted that the deficiency is dealt with in the Technical Explanation. He cites this as an example of tax administrators interpreting the US Treaty, like the Third Protocol, to achieve a result that is consistent with its purpose and context, and not applying a strict meaning or result of the words.

In reviewing the case law on treaty interpretation, the judge cited the commentary on the OECD Model Treaty as a widely-accepted guide to the interpretation of treaties. He then proceeded to review the OECD Model Treaty and the OECD Partnership Report in support of a broad interpretation.

After quoting various provisions of the OECD Partnership Report, he stated:

…the OECD wants to be able to maintain that a partnership that is treated as a flow-through in its country of establishment will not be considered liable to tax therein for purposes of the OECD Model Treaty. However, the OECD makes it equally clear that, the OECD Model Treaty is intended to, and should be interpreted and applied in a manner that nonetheless extends the benefits of the Convention to the income of such a partnership notwithstanding that it is not, strictly speaking, a resident of its home country. In the case of partnerships this is to be done at the partner level notwithstanding that the partnership is not liable to tax in its home country and its partners are not considered to have earned the income in the source country. 

He concluded that the Court sees no reason that the foregoing conclusions should be any different in the case of a fiscally transparent LLC.

The judge paid special attention to the published views of CRA regarding LLCs and noted that with the exception of LLCs, CRA had been consistent in its interpretation of Article IV in determining treaty residence. He concluded that the treatment of partnerships and LLCs should be analogous.

He then reviewed the US interpretation of the US Treaty, which he observed was instructive and provided evidence of intentions, objects and purpose of the US Treaty. He concluded that the US intended that the entitlement to treaty benefits of income earned by a fiscally transparent entity, such as a partnership or LLC, be determined at the member level using a look-through approach.

Based on the object and purpose of the US Treaty and the interpretive approach taken by OECD countries, the OECD Model Treaty and commentary, he concluded the LLC must be considered a resident of the US for purposes of the US Treaty, it must be considered to be liable to tax in the US by virtue of all of its income being taxed at the member level, and it must be considered to be subject to full and comprehensive tax under the US Code by reason of a criterion similar to the enumerated grounds in Article IV.

Finally, the Court responded to the Respondent’s concerns of potential abuse. The judge gave little weight to this concern. He stated:

Further, this decision cannot be said to stand for the simple proposition that every US LLC is a resident of the US for the purposes of the US Treaty. On the facts of this case, as put before this Court, and the applicable law and authorities advanced and argued by the parties, the requirements of new paragraphs 6 and 7 of Article IV would be satisfied by TD LLC and Holdings II if the Fifth Protocol Amendments were applicable to the years in question. For that reason the decision in this case does not constitute a materially different gate to access the US Treaty by US LLCs, much less a potential flood gate.

Conclusion

This decision represents a major taxpayer victory and a vindication of the widely-held view that CRA’s position on LLCs was incorrect. In addition, the judgment will serve as a common sense and practical approach to interpreting treaties. Taxpayers in similar circumstances to this case who were adversely affected by the CRA policy in respect of LLCs and were denied treaty benefits should consider applying for refunds subject to the strict limitation periods in the ITA. We expect that an appeal will be filed by the government which could affect the processing of refund applications.