Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

The Chief Counsel’s Office just released an advisory, CCA 201106007, which ruled that the sale of software products by a controlled foreign corporation to end-users situated in the United States was not an investment in the U.S. under section 956(c)(1)(D) requiring that the amount so invested be included in the U.S. shareholders’ gross income under section 951(a)(1)(B) based on the underlying facts.

The taxpayer is a U.S. entity involved in the distribution of information technology and services, including the development of software in the U.S. under a cost sharing arrangement with its wholly-owned foreign subsidiary, S (also CFC). Under the cost sharing arrangement, S acquired the rights to market the acquired copyrights in the U.S. When the taxpayer finishes the development of a software product intended for sale to end-user customers, the final version of the software “code” is transferred to a “gold master” disk and delivered to S. The wholly owned subsidiary then reproduces and sells copies of the software to unrelated, end-user customers in the United States.

Background

Under the CFC provisions, a U.S. shareholder is required to include in gross income her pro rata share of the CFC’s subpart F income and the increase in the CFC’s investment in U.S. property See §951(a)(1)(B). The underlying rationale for the investment in U.S. property provision is that such reinvestment is substantially equivalent to a dividend. See Sen. Rep. No. 1881, 87th Cong., 2d Sess., 1962-3 CB 703, 704. The term U.S. property is defined in section 956(c) (1) as a rule of inclusion and section 956(c)(2) as a rule of exclusion. (and excluded from the definition of the term in section 956(c)(2). U.S. property includes tangible property in the U.S., stocks and debt obligations of related domestic corporations, and patents, copyrights and other intangibles acquired or developed for use in the U.S. A CFC’s stock in a U.S. subsidiary is also U.S. property. See Tobin, “Double Taxing Sandwiches”, 39 Tax Mgmt. Int’l 273 (2010).

There are exceptions to U.S. property set forth in section 956(c)(2) which attempt to apply to property held temporarily in the United States as part of a “normal commercial transactions”. A U.S. shareholder claiming the benefit of any exception must file a statement with its return identifying the property covered by the exception. Treas. Reg. § 1.956-2(b)(2). Portfolio investments in stock and debt of unrelated U.S. companies are also excluded from the definition of U.S. property.

In addition to the myriad of rules of inclusion and exclusion contained in section 956(c) and the underlying regulations, property held by a foreign corporation controlled by the CFC is treated as owned by the CFC if avoidance of section 956 is “one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation.” The latter rule is intended to prevent taxpayers from circumventing section 956 by using a CFC with no earnings and profits to hold U.S. property that is effectively acquired with the earnings of a related CFC. Treas. Reg. § 1.956-1T(b)(4)(i). See, e.g., The Limited, Inc. v. Comm’r, 113 TC 169, 192 (1999) , rev'd on another issue, 286 F3d 324 (6th Cir. 2002).

Intangibles as U.S. Property

The CCA starts its analysis by noting “United States property” per section 956(a)(1)(D) includes any right to use intangible property in the U.S. that is acquired or developed by a CFC for use in the U.S. The operative word here is “right” to use in the U.S. Whether such right has been acquired or developed for use in the U.S. is based on examining all facts present. Treas. Reg. § 1.956- 2(a)(iv)(d). However, a right actually used principally in the U.S. will generally be considered to have been acquired or developed for use in the U.S. unless affirmative evidence shows the contrary.

Thus, both the statute and regulations to section 956 define U.S. property in relation to whether a CFC develops intangible property intended for use in the U.S. or acquires the right to use intangible property in the U.S.—not whether such right is actually exercised.

Resolution of the Issue in CCA 201106007

Here, S, a CFC, invested in U.S. property per section 956 when it acquired or developed the rights to use copyright rights in the U.S. pursuant to the cost sharing arrangement. However, the actual sales of the computer software copies from S to end-user customers in the U.S. do not in and of themselves constitute an investment in U.S. property within the scope of section 956(c)(1)(D). Furthermore, the actual transfer of copies of the software by S to the end-user U.S. customers does not affect the calculation of the inclusion amount, if any, under section 956 attributable to S’s original investment in U.S. property, because S did not acquire or develop additional rights (or relinquish any rights) to use the software in the U.S. merely as a result of the sale of copies to a U.S. person.

The CCA did find, as mentioned, that S made an investment in U.S. property for purposes of section 956(c)(1)(D) as a result of its acquisition or development of rights to use copyright rights in the U.S. under the cost sharing agreement. Still, the amount invested in the U.S. is based on S’s adjusted basis in the copyright rights. Where S’s costs were properly deducted in computed taxable income, it may have a $0 basis in U.S. property. The CCA then opined that further factual development is needed to determine whether and to what extent other aspects of Sub's activities with respect to the copyright rights constitute an investment in U.S. property within section 956.

CCA Conclusion

The CCA concluded, based on the preceding analysis, that the sale of software products by S (a CFC) to end-user customers in the U.S. did not constitute an investment in U.S. property under section 956(c)(1)(D) so as to require an income inclusion for its U.S. parent corporation. S, however, was viewed in the CCA as having made an investment in U.S. property when it acquired or developed rights to use copyrights in the U.S. under the cost sharing agreement. Still, the actual sales of the computer software copies from S to the U.S. end-user (customers) did not, per se, constitute an investment in the U.S.

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In Gudmundsson v. U.S., 107 AFTR 2d 107 AFTR2d ¶2011-456 (2nd Cir. 2011) the Court of Appeals for the Second Circuit has affirmed a district court decision which dismissed the taxpayers’ claim for refund in tax based on an alleged overvaluation of stock one of the spouse’s received under an incentive (employee) stock option plan where the stock subsequently precipitously fell in value. The lower court found that since the stock received had "vested" for purposes of §83, i.e., the stock was transferable and not subject to a substantial risk of forfeiture on the date of receipt, there was no rule in §83 that would permit the taxpayer to defer the recognition date or the proper time for valuing the stock until a later date.

The taxpayer was an office of a Midwest food concern and was a participant in an incentive stock plan. Under the plan he received the right to the distribution of approximately 73,000 shares of employer stock as part of an IPO of the company. The IPO was effectuated in July, 1998. Under the terms of the plan, the taxpayer was issued and received the shares of stock on July 1, 1999. The taxpayers 1999 return, consistent with the Form W-2, reported that the taxpayer, Olafur Gudmundson, received stock worth $1.3M. This is due to the rules underlying §83 that vested stock received for services is valued for federal income tax purposes on the date of receipt. re not subject to a substantial risk of forfeiture. The stock received was still subject to certain resale restrictions imposed by securities laws and internal agreements.

By the end of 1999, the value of the publicly traded shares fell by over 26%. A further drop in value to 50% of the IPO value occurred in February 2000. Claims of alleged mismanagement of the Company resulted in the filing of indictments in early 2001 against the former officers of the Company who eventually entered guilty please for securities fraud and related charges.

The taxpayers filed an amended return within the 3 year period for filing a claim for refund the taxpayer claimed was due for an alleged overpayment of tax of approximately $300,000 plus statutory interest for 1999. The argument made by the taxpayer that the stock he received on July 1, 1999 should have valued at the market price at the end of the year instead of based on the stock price on date received. The IRS rejected the claim and the taxpayers filed a refund suit in Federal District Court. 104 AFTR 2d 2009-7093.

The District Court rendered a summary judgment and stated that the taxpayer failed to show that the stock was not "vested" for §83 purposes as of July 1, 1999. The Court of Appeals for the Second Circuit examined the timing and valuation issues involved in the case. First it rejected the argument made that the risk that the taxpayer could lose his job did not defer or postpone the proper date for including the value of the stock received in gross income. Such possibility did not constitute under the facts of the case a "substantial risk of forfeiture". What the taxpayer failed to prove was that the stock would be forfeited, not simply the taxpayer’s job. The Court further held that the taxpayer’ claim that he was potentially running the risk of a fraud action filed by the SEC constituted a a substantial risk of forfeiture. However, §83(c)(3) blocked this approach since its application is limited to civil suits other than those brought under §16(b) of the 1934 Securities Act. The Court found that the stock received was transferable under §83.

On the stock value, the taxpayer was held to have failed to offer any legal basis for not valuing the stock received on July 1, 1992 and not some later date. For purposes of §83(a), property received [for services] is valued at its "fair market value (determined without regard to any restriction other than a restriction which by its terms will never lapse)". The taxpayer failed in his effort to convince the appellate court that the trial failed in determining fair market value by not reducing the IPO value by restrictions imposed on him with respect to transferring the shares and lack of marketability. Here such issues were limited in duration and thus were property rejected.

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In Canal Corp., supra, the Tax Court recently held that a corporation's 1999 transfer of a wholly owned subsidiary to a joint venture was a disguised sale that required the company to include in capital gain the amount realized in the year of sale on its consolidated federal income tax return. An accuracy related penalty under §6662 for a substantial understatement of income tax was imposed notwithstanding the fact the PricewaterhouseCoopers (PwC) had issued a favorable opinion letter on the transaction. The Court, per the majority opinion written by Judge Kroupa,  held that the “should” level of comfort  opinion was nothing more than a “quid pro quo” between the taxpayer and the accounting firm which its board of directors insisted upon in order to engage in the tax motivated transaction.

FACTS
In 1985, the taxpayer, Chesapeake Corp. (Chesapeake), the predecessor to Canal Corp. (and subsidiaries), acquired Wisconsin Tissue Mills, Inc., (WISCO) its largest subsidiary. Chesapeake restructured 12 years later focusing on specialty packaging but WISCO did not fall within the new strategy. Chesapeake’s basis in WISCO was small relative to its value and therefore Chesapeake preferred to not engage in a direct taxable sale to an interested buyer, Georgia-Pacific (GP). 
An investment banking firm selected to advise Chesapeake recommended a leveraged partnership structure. The leveraged partnership involved WISCO and Georgia-Pacific contributing their respective tissue-business assets to a joint venture. The joint venture would borrow money from a third party and distribute it to Chesapeake, which would guarantee the debt, resulting in WISCO having a minority interest in the joint venture and Georgia-Pacific having the majority interest. The intended result would be that Chesapeake would receive a large sum of cash but would not recognize gain for tax purposes under the disguised sales rules under §707(a)(2)(B). It would still book the transaction as a sale for financial accounting purposes.
PwC, the outside auditor and tax return preparer for Chesapeake, assisted in structuring the transaction and helped in the drafting of an indemnity agreement whereby WISCO served as the indemnitor of the joint venture's debt. In its opinion letter, PwC expressed its highest level of comfort that the company would succeed on the merits and would avoid gain treatment on the distribution of the cash. Chesapeake's board, in approving the transaction, made clear to PWC and its investment banker that the asset transfer and special distribution had to be nontaxable for it to approve the transaction. The planned tax deferral enabled Chesapeake to accept a lower price for WISCO.
The planned joint venture was effectuated, i.e., formation of Georgia-Pacific Tissue LLC, and a subsidiary of Georgia-Pacific loaned money to the LLC to help repay the original return. Chesapeake did not report any gain on the transaction although, as mentioned,  the transaction was treated as a sale for accounting purposes. The companies carried out the transaction, creating Georgia-Pacific/WISCO LLC. The joint venture operated for a year, with WISCO selling its minority interest to Georgia-Pacific in 2001.

Notice of Deficiency Issued by IRS
The IRS issued Chesapeake a notice of deficiency, attributing $524 million in capital gains to the company from the transaction, finding that it was a disguised sale, and imposing a $36 million accuracy-related penalty.
In its opinion, the Tax Court stressed that when a partner receives a distribution shortly after making a contribution of property, the transaction may be deemed a sale. Under Treas. Reg. §1.707-3(c)(1), “contributions and distribution transactions” within 2 years are presumed to effect a sale unless the facts and circumstances clearly establish otherwise. The court concluded that a disguised sale occurred under the rules.
The taxpayer’s reliance on Treas. Reg. §1.707-5(b), the so-called “debt-financed transfer” exception was rejected. It found instead that WISCO's indemnity agreement should be disregarded under the partnership anti-abuse regulation pertaining to the allocation of partnership debt. Treas. Reg. §1.752-2(j)(4).

Tax Court's Decision In Favor of Respondent-Commissioner
The court found that the agreement was designed to limit the risk to WISCO's assets. The court also found that an intercompany note between WISCO and Chesapeake only served the purpose of giving the appearance of economic risk, and it said the indemnity agreement lacked economic substance.
The court also rejected Chesapeake's argument that the 10% net worth requirement in Rev. Proc. 89-12 was  also inapplicable. The court found that the indemnity agreement should be disregarded and further found that WISCO sold its business assets to Georgia-Pacific in 1999 in accordance with §707(a)(2)(B), the year it contributed the assets to the LLC, not the year it liquidated its LLC interest.
Finally, the court sustained the IRS's determination that Chesapeake was liable for a §6662(a) accuracy-related penalty for 1999. It found that PwC lacked the independence necessary for Chesapeake to establish good-faith reliance and that Chesapeake did not act with reasonable cause or in good faith in relying on PwC's opinion.
The mathematics to the disguised sale resulted in a $755M recharacterization of the distribution as a receipt from the disguised sale resulting in a realized gain of approximately $524M. The deficiency in tax was approximately $183.5M and the penalty was 20% of such amount or approximately $36.7M.

Reliance on PwC Opinion Did Not Result in Abatement of Accuracy Related Penalty
Chesapeake’s Board not only accepted a lower price for WISCO based on the tax deferral but further conditioned entering into the transaction in exchange for PwC’s issuance of a “should” (approximately 70-75% favorable) tax opinion. The fee for the opinion was for an agreed price of $800,000.
PwC knew that the transaction’s favorable treatment depended on whether the leveraged debt would, under the indemnity agreement, be allocated solely to WISCO. While there was no direct authority on point, the PwC favorable opinion was based on the indemnification by WISCO of Georgia-Pacific’s guaranty be given substance for federal income tax purposes. PwC advised Chesapeake, therefore, that WISCO could defer gain until it sold its remaining assets, paid off the debt, or sold its partnership interest. Mr. Miller advised that WISCO maintain assets of at least 20% of its maximum exposure under the indemnity. Although there was no direct authority requiring this percentage such standard was sourced from Rev. Proc. 89-12, 1989-1 C.B. 798, obsoleted by Rev. Rul. 2003-99, 2003-2 C.B. 388. Moreover, Rev. Proc. 89-12, supra, made no reference to allocation of partnership liabilities.
The parties effected the transaction on the same day PWC issued the "should" opinion.

Termination of the Georgia-Pacific Joint Venture
One year after the establishment of the joint venture, the deal ended in 2001 when Georgia-Pacific set out to acquire the Fort James Corporation. The Department of Justice in order to approve of the acquisition, required Georgia Pacific to sell its LLC interest for antitrust purposes. As part of a sale to a Swedish concern, Georgia-Pacific  first offered to purchase and WISCO agreed to sell its minority interest in the LLC to Georgia-Pacific for $41 million, a gain of $21.2M from its initial valuation of $19.8M. Georgia-Pacific further agreed to pay Chesapeake $196M to compensate Chesapeake for any loss of tax deferral. Chesapeake reported a $524M capital gain on its consolidated Federal tax return for 2001. Chesapeake determined that the termination of the indemnity resulted in WISCO receiving a deemed distribution under §752. Chesapeake also reported the $196M tax cost make-up payment from GP as ordinary income on its consolidated Federal tax return for 2001.
Respondent issued Chesapeake a notice of deficiency for 1999 claiming that the alleged joint venture was instead a disguised sale that produced $524 million of capital gain includable in Chesapeake's consolidated income for 1999. Chesapeake timely filed a petition to the Tax Court. Respondent asserted in an amended answer a $36,691,796 accuracy-related penalty under section 6662 for substantial understatement of income tax.

Analysis of Accuracy Related Penalty

Most tax advisors are quite familiar with the particular rules surrounding the imposition of an accuracy related penalty under §6662(a) and §6662(b)(2) for a substantial understatement of income tax . The mathematical threshold was easily reached in this case, i.e., the greater of10% of the tax required to be shown on the return or $10,000. §6662(d)(1); Treas. Reg. §1.6662-4(b)(1). However the penalty does not apply with respect to any portion of an underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer acted in good faith with respect to that portion.  §6664(c)(1); Treas. Reg. §1.6664-4(a), Income Tax Regs. Among the relevant factors are the taxpayer’s efforts to determine its proper amount of taxes owed, its knowledge and experience and the reliance on the advice of a competent tax adviser. Treas. Reg. §1.6664-4(b)(1). See §6664(c); U.S. v. Boyle, 469 U.S. 241, 250-251 (1985).

However, the Tax Court opinion warned that reliance on the advice of a tax professional is not unlimited. Neither reliance on the advice of a professional tax adviser nor reliance on facts that, unknown to the taxpayer, are incorrect the required reasonable cause or good faith needed to avoid imposition of the penalty. Long Term Capital Holdings v. U.S., 330 F. Supp. 2d 122, 205-206 (D. Conn. 2004), affd. 150 Fed. Appx. 40 (2d Cir. 2005). Moreover, it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. See e.g., Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279; Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C. Memo. 1991-181; Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 F.2d 221 (3d Cir. 2002). A professional tax adviser with a stake in the outcome has such a conflict of interest.

In countering the taxpayer’s arguments of proper reliance and good faith, the Service argued that the taxpayer unreasonably relied on an opinion that made improper assumptions and was written by a tax advisor which had a conflict of interest.

The Court went on to criticize the manner in which the agreed fee was determined, the sloppiness of the written opinion itself and the amount of time actually spent on it, and concluded that PwC’s time spent in analyzing and writing the opinion was not relevant to the determination of the amount of the fee which was substantial. The opinion was found to be filled with questionable conclusions and unreasonable assumptions. There was, for example, a conclusion made by PwC that WISCO’s maintaining 20% of the LLC debt was a favorable factor in reaching its “should” opinion. The Court was highly critical of the work product and effort that went into the production of the “should” tax opinion. The Court was also upset about the number of times the draft opinion used the word “it appears” in the draft opinion. This language was used to support the author’s analysis under §752 regulations adopting an “all or nothing approach” which had no basis other than the author’s interpretation. The opinion failed to consider whether the indemnity agreement had substance. Factors indicating it did not was that neither the joint venture agreement nor the indemnity agreement included provisions requiring WISCO to maintain any minimum level of capital or assets. WISCO and Chesapeake could also remove WISCO's main asset, the intercompany note, from WISCO's books at any time and for any reason. The opinion was therefore not of reasonably quality and analysis and it was unreasonable for the taxpayer to rely on such an opinion. It did not act in good faith.

Finally, the PwC opinion was inflicted or tainted with an inherent conflict of interest. The party issuing the opinion not only researched and drafted the tax opinion he also "audited" WISCO's and the LLC's assets to make the assumptions in the tax opinion. He made legal assumptions separate from the tax assumptions in the opinion. He reviewed State law to make sure the assumptions were valid regarding whether a partnership was formed. In addition, he was intricately involved in drafting the joint venture agreement, the operating agreement and the indemnity agreement. 
As the court stated: “In essence, Mr. Miller issued an opinion on a transaction he helped plan without the normal give-and-take in negotiating terms with an outside party. We are aware of no terms or conditions that GP required before it would close the transaction. We are aware only of the condition that Chesapeake's board would not close unless it received the "should" opinion. Chesapeake acted unreasonably in relying on the advice of PWC given the inherent and obvious conflict of interest. See New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 192-194 (2009) (reliance on opinion by law firm actively involved in developing, structuring and promoting transaction was unreasonable in face of conflict of interest); see also CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16 (reliance not reasonable as advice not furnished by disinterested, objective advisers); Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636, 714-715 (2008), affd. ___ Fed. 3d ___ (June 11, 2010).”
The Court therefore held that PWC lacked the independence necessary for Chesapeake to establish good faith reliance. It further found that the taxpayer did not act with reasonable cause or in good faith in relying on PWC's opinion.  The penalty was therefore properly imposed by the Service.
Comment
The Canal Corp., supra, case warns taxpayers that certain tax opinions and advise by tax advisers, including those who are highly compensated and work for high-powered accounting and law firms, will in various instances not avoid the imposition of an accuracy related penalty. For issues involving the alleged lack of economic substance, the presence of a favorable tax opinion is irrelevant. See §7701(o). See also, August, “Codification of Economic Substance Doctrine, Parts I and II”, Business Entities (Sept/Oct) and (Nov/Dec 2010).

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Canadians seeking to make investments in U.S. based private equity funds do face a challenging landscape attributable to the multitude of U.S. taxing authorities, federal, state and local governmental taxing authorities, as well as a somewhat counterintuitive home country tax regime, in reporting their U.S. operations back home in Canada. This is because U.S. private equity funds are frequently organized as limited partnerships which has the consequence that each non-resident U.S. partner is allocated his or its pro rata share of partnership income and is subject to U.S. income tax on such portion. More specifically, with respect to a non-resident investor who is a partner in the fund, its distributive share of partnership income is treated as income attributable to the conduct of a trade or business in the U.S. ("effectively connected income" or "ECI") if the equity fund is so engaged. §875(1). Treas. Reg. §1.875-1. Johnston v. Comm’r, 24 T.C. 920 (1955)(Canada-U.S. Income Tax Treaty: Unger v. U.S. 936 F.2d 1316 (CA-D.C., 1991); Rev. Rul. 90-80, 1990-2 C.B. 170.

The Canadian (or non-resident) partners sale of an interest in the partnership also generates ECI, at least that is the Service’s publicly stated position. See Rev. Rul. 91-32, 1991-1 CB 107 . Where the non-US. Investor in the fund is a foreign corporation, the branch tax is implicated but at a reduced treaty rate. §884 ; Canada-U.S. Tax Treaty, Article X, para. 6. Where the US limited partnership operative a private equity fund has ECI, it must withhold at a 35% rate on each non-resident’s share of ECI. §1446.

In order to mitigate these tax impacts, it is common for a foreign investor to own its interest in a private equity fund in the U.S. through a U.S. corporation. The insertion of such entity, frequently referred to as a "blocker" company , is either a de jure U.S. corporation or a de facto corporation for tax purposes which occurs, in the latter instance, through forming, for example, a single member LLC which makes a reverse default election under the CTB regulations to be treated as a corporation. This results in the blocker corporation being subject to U.S. tax on its share of the fund’s income and is the entity responsible for filing U.S. tax returns and payment of U.S. tax. Profits are distributed to the non-resident owner of the blocker as either dividends or a liquidating distribution. As to dividends, if no treaty is involved the withholding tax is 30% but a Canadian investor may qualify for an exemption or a reduced withholding rate under the Treaty. Canada -U.S. Tax Treaty, Article X, para. 2(b). If the Canadian owner holds 10% or more of the U.S. subsidiary’s voting stock, the rate on dividend withholding is reduced to 5%. A special relief rule applies to liquidating distributions.

A special concern for Canadian investors with use of a "corporate" blocker to hold its interest in a U.S. limited partnership is that that the partnership will still be treated as a pass through entity for Canadian tax purposes. Therefore, for Canadian investors, a problem arises when a U.S. fund uses as a blocker a U.S. limited partnership that elects to be treated as a corporation for U.S. tax purposes. The partnership still will be treated as a pass-through partnership for Canadian tax purposes. See §96 of the Canadian Income Tax Act .

The 2007 Protocol to the Canada-U.S. Tax Treaty, which addressed problems associated with the use of hybrid entities for investing in both Canada and the U.S., also impacts blocker structures for Canadians investing in the U.S. First problem pertains to tax reporting. The U.S. K-1 will go to the U.S. blocker entity (corporation) and not to the Canadian investors who will need the same information provided on a K-1 in order to fulfill their Canadian income tax reporting and tax payment obligations since the blocker is treated as fiscally transparent. More critical is the tax consequences in Canada attributable to the use of the blocker structure itself. Generally a dividend paid to a non-U.S. shareholder is subject to a U.S. 30% withholding tax, subject to applicable treaty reduction. Where a private equity limited partnership makes a distribution to a U.S. blocker taxable as a corporation, the corporation, already subject to income tax on ECI and other U.S. source income includible in taxable income, which them makes a distribution from its earnings and profits to its non-resident partners, is required to withhold 30% of the dividend subject to treaty override. A Canadian resident that otherwise qualifies for benefits under the U.S.-Canadian Treaty can reduce this rate to 15% and 5% if he or it owns 10% or more of the subsidiary’s voting stock. Qualified pensions in Canada are entitled to 0% withholding.

Under the 2007 U.S.-Canadian Treaty Protocol pertaining to hybrid entities, paragraph 7(b), Article IV states:

"An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State [Canada] where ...

"(b) The person is considered under the taxation law of the other Contracting State [U.S.] to have received the amount from an entity that is a resident of that other State [U.S.], but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State [Canada], the treatment of the amount under the taxation law of that State [Canada] is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State [Canada]."

Under this provision, for Canadian income tax purposes, a U.S. "blocker" corporation is still treated as a pass through entity and the income of the U.S. limited partnership is still allocated as ECI to the Canadian owner of shares in the blocker company. The transfer of funds by the "blocker" to Canadian residents is not taxable. (Were the U.S. blocker treated as a corporation for Canadian income tax purposes, then the payments by the blocker would be considered to be a dividend which is the U.S. treatment of the payment). Still, there would seem to be a withholding obligation of 30% by the U.S. blocker on cash funds distributed to the Canadians. In other words, treaty benefits presumably are to be denied to the Canadian investors on the dividends. See Technical Explanation of the 2007 Protocol. As a result, paragraph 7(b) of the 2007 Protocol would apply to provide that the dividends are not considered to be paid to or derived by either the Canadian corporation or the Canadian pension fund.

So direct investment by the Canadian in the U.S. limited partnership (private equity fund) results in ECI on its distributive share of the income and is subject to withholding subject to treaty reduction. Investment in a U.S. blocker corporation doesn’t change the result and perhaps could inspire another level of withholding on dividends paid by the blocker to its non-resident shareholders.

The potential solution to this "whipsaw" situation is the use of a U.S. limited liability company (instead of a limited partnership) to perform the role of the blocker, i.e., the use of a domestic LLC that elects to be treated as a corporation for U.S. income tax purposes. Canada views the LLC as a corporation. See, e.g., CRA Document Nos. 9729780 (11/14/97) and 9713120 (5/20/97); Income Tax Technical News No. 29 (10/30/02); CRA Interpretation Bulletin IT-343R, "Meaning of the Term ‘Corporation’" (9/26/77), at para. This offers the benefits of the U.S. blocker structure and reduction of withholding levels on distributions made by the LLC to Canadian residents.

Caution: This BLOG does not in any way render legal advice to persons reading the material contained in this or any other filing made on this site and may not be relied upon as legal advice. If you have this issue described in this submission to resolve you must consult with your tax counsel in reviewing the options that you may consider and their impacts.

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