2018-0753621I7 Subsection 247(12)

Principal Issues: (1) whether a deemed dividend under subsection 247(12) is a dividend for purposes of Article X; (2) whether paragraphs IV(6) and (7) of the Canada-US Income Tax Convention would apply to a deemed dividend under subsection 247(12).

Position: (1) Yes; (2) Yes.

Reasons: Analysis in the letter.

Author: Moreno, Yves
Section: 247(12), 212(2)

                                                                                             April 18, 2019

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                                                                                              Yves Moreno
                                                                                              (613)858-9338

                                                                                               2018-075362

XXXXXXXXXX 247(12) Deemed Dividend

XXXXXXXXXX (“Parentco”) is the only member of XXXXXXXXXX (“Parentco LLC”), which in turn is the only member of XXXXXXXXXX (“Sisterco LLC”).  Parentco LLC also owns all the shares of XXXXXXXXXX (“Canco”).  Canco resides in Canada for purposes of the Canada-US Income Tax Treaty (“the Treaty”).  Parentco is incorporated in the United States and is a resident of the United States under the Treaty.  Parentco LLC and Sisterco LLC are formed in the United States and have their mind and management in the United States.  Parentco LLC and Sisterco LLC are limited liability corporations and are disregarded entities, hence transparent for US tax purposes to the extent that their income is reported by their respective members and such members are liable for the payment of the related taxes in the US.  Since the only member of Sisterco LLC is Parentco LLC, all the income earned by the two entities is derived by Parentco for US tax purposes.

Sisterco LLC purchased property from Canco.  The CRA proposed an inclusion in the income of Canco under subsection 247(2) of the Income Tax Act (the “Act”) on the basis that the acquisition price paid by Sisterco LLC did not meet the arm’s length principle of that provision (i.e., the purchase price was too low).  More specifically, the CRA included an amount equal to the difference between the amount dictated by that principle and the consideration paid by Sisterco LLC to Canco for such transfers.  The CRA also proposed a secondary adjustment under subsection 247(12) on the basis that a benefit was conferred on Sisterco LLC and that such benefit was deemed to be a dividend that was paid by Canco and to be received by Sisterco LLC for purposes of Part XIII of the Act.

QUERIES

1)    Is the deemed dividend under subsection 247(12) considered a dividend for purposes of subsection 212(2)?

2)    Is the deemed dividend under subsection 247(12) a dividend for purposes of Article X of the Treaty? How should the deemed dividend under subsection 247(12) be treated with respect to Article IV(6) of the Treaty?

CONCLUSION

In our view, paragraph IV(6) of the Treaty applies to the deemed payment of the dividend by Canco to Sisterco LLC under subsection 247(12), such that the withholding rate that is applicable under Part XIII is 5%.

ANALYSIS

1)    Subsection 212(2)

Subsection 247(12) applies to transactions that occurred after March 28, 2012.  We understand that the transaction described above occurred after that date.

Subsection 247(12) provides that a corporation resident in Canada that undertakes a transaction with a non-arm’s length non-resident that results in a transfer pricing capital or income adjustment is deemed to pay a dividend.  The provision also deems the dividend to have been received by the non-resident corporation.

247(12) Deemed dividends to non-residents — For the purposes of Part XIII, if a particular corporation that is a resident of Canada for the purposes of Part XIII would have a transfer pricing capital adjustment or a transfer pricing income adjustment for a taxation year, if the particular corporation, or a partnership of which the particular corporation is a member, had undertaken no transactions or series of transactions other than those in which a particular non-resident person, or a partnership of which the particular non-resident person is a member, that does not deal at arm's length with the particular corporation (other than a corporation that was for the purposes of section 17 a controlled foreign affiliate of the particular corporation throughout the period during which the transaction or series of transactions occurred) was a participant,

(a)   a dividend is deemed to have been paid by the particular corporation and received by the particular non-resident person immediately before the end of the taxation year; and…

The application of 247(12) is predicated on the application of 247(2) as its application requires the existence of a transfer pricing capital or income adjustment as defined in 247(1).

“transfer pricing income adjustment” of a taxpayer for a taxation year means the total of all amounts each of which is the amount, if any, by which an adjustment made under subsection (2) (other than an adjustment included in determining a transfer pricing capital adjustment of the taxpayer for a taxation year) would result in an increase in the taxpayer's income for the year or a decrease in a loss of the taxpayer for the year from a source if that adjustment were the only adjustment made under subsection (2).

We understand that Audit proposed to proceed with a transfer pricing income adjustment that would result in an increase of Canco’s income.

Subsection 247(12) is specifically applicable for purposes of Part XIII, hence the dividend deemed paid by Canco under that provision would result in the application of subsection 212(2):

212(2) Tax on dividends — Every non-resident person shall pay an income tax of 25% on every amount that a corporation resident in Canada pays or credits, or is deemed by Part I or Part XIV [Branch Tax] to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of,

(a)   a taxable dividend (other than a capital gains dividend within the meaning assigned by subsection 130.1(4), 131(1) or 133(7.1)); or

(b)   a capital dividend.

The presumption in 247(12) makes the payment a dividend but 212(2) applies to a taxable dividend.  The definition of “taxable dividend” at subsections 248(1) and 89(1) of the Act and of “dividend” at subsection 248(1) of the Act bridge that gap by providing that a taxable dividend is a dividend on which no election was made under certain provisions:

89(1) taxable dividend means a dividend other than

(a)   a dividend in respect of which the corporation paying the dividend has elected in accordance with subsection 83(1) as it read prior to 1979 or in accordance with subsection 83(2), and

(b)   a qualifying dividend paid by a public corporation to shareholders of a prescribed class of tax-deferred preferred shares of the corporation within the meaning of subsection 83(1).

248(1) dividend includes a stock dividend (other than a stock dividend that is paid to a corporation or to a mutual fund trust by a non-resident corporation);

Annex 4 of the 2012 budget (Tax Measures: Supplementary Information, Notices of Ways and Means Motions and Draft Amendments to Various GST/HST Regulations) stated that the purpose of subsection 247(12) is to clarify the application of Part XIII to a secondary adjustment:

Transfer Pricing Secondary Adjustments:

Budget 2012 proposes to amend section 247 of the Income Tax Act to confirm that secondary adjustments will be treated as dividends for Part XIII tax purposes. A Canadian corporation subject to a primary adjustment will also be deemed to have paid a dividend to each non-arm's length non-resident participant in the transaction or series of transactions in proportion to the amount of the primary adjustment that relates to the non‑resident, regardless of whether the non-resident is a shareholder of the Canadian corporation.

The Finance technical notes (footnote 1) on subsection 247(12) echo that:

New subsection 247(12) of the Act is introduced to clarify the treatment of “secondary adjustments” as dividends for purposes of Part XIII…. In general terms, subsection 247(12) provides that a corporation that is resident in Canada for the purposes of Part XIII and that is subject to a primary adjustment will be deemed to have paid a dividend to each non-arm's length non-resident participant in the transaction or series of transactions equal to the benefit conferred on the non-resident. This is commonly referred to as a "secondary adjustment".

2)    Existence of a dividend for purposes of Article X of the Treaty

This segment of the letter deals with whether an amount deemed to be a dividend under 247(12) is a dividend for purposes of Article X of the Treaty, more particularly for purposes of the paragraph X(2) which reserves Canada’s right to tax it and at what rate.

For the purposes of Article X, paragraph X(3) provides a definition that extends the meaning of “dividend” to amounts that are “subject to the same taxation treatment” as income from shares:

3. For the purposes of this Article, the term "dividends" means income from shares or other rights, not being debt-claims, participating in profits, as well as income that is subjected to the same taxation treatment as income from shares under the laws of the State of which the payer is a resident.

The commentary (the "OECD Commentary") to the OECD Model Tax Convention on Income and on Capital (the "OECD Model Convention") (footnote 2) in Article 10, paragraph 3 suggests that one of the objectives of the extended definition is to capture different types of distribution of profits to the stakeholders of an entity that is different from the traditional model: (footnote 3)

Article X of the Model Tax Convention on Income and Capital

1.    By "dividends" is generally meant the distribution of profits to the shareholders by companies limited by shares, limited partnerships with share capital, limited liability companies or other joint stock companies. Under the laws of the OECD member countries, such joint stock companies are legal entities with a separate juridical personality distinct from all their shareholders. On this point, they differ from partnerships insofar as the latter do not have juridical personality in most countries.
2.    […]
3.    The position is different for the shareholder; he is not a trader and the company's profits are not his; so they cannot be attributed to him. He is personally taxable only on those profits which are distributed by the company…

   […]

24. The notion of dividends basically concerns distributions by companies within the meaning of subparagraph b) of paragraph 1 of Article 3. Therefore the definition relates, in the first instance, to distributions of profits the title to which is constituted by shares that is holdings in a company limited by shares (joint stock company). The definition assimilates to shares all securities issued by companies which carry a right to participate in the companies' profits without being debt-claims; such are, for example, "jouissance" shares or ''jouissance" rights, founders' shares or other rights participating in profits. In bilateral conventions, of course, this enumeration may be adapted to the legal situation in the Contracting States concerned. This may be necessary in particular, as regards income from "jouissance" shares and founders' shares. On the other hand, debt-claims participating inprofits do not come into this category (see paragraph 19 of the Commentary on Article 11); likewise interest on convertible debentures is not a dividend.

[…]

The OECD Commentary goes further and indicates that the extended definition of “dividend” in paragraph X(3) captures economic benefits that would not generally be viewed as distributions of profit in the traditional sense :

28. Payments regarded as dividends may include not only distributions of profits decided by annual general meetings of shareholders, but also other benefits in money or money's worth, such as bonus shares, bonuses, profits on a liquidation or redemption of shares (see paragraph 31 of the Commentary on Article 13) and disguised distributions of profits. The reliefs provided in the Article apply so long as the State of which the paying company is a resident taxes such benefits as dividends….

That view also received judicial support in Canada in RMM Canadian Enterprises Inc. and Equilease Corporation v. The Queen, 97 DTC 302 where the Court concluded that a deemed dividend under subsections 84(2) and 212.1 of the Act would be a dividend within the meaning of Article X(3) of the Treaty.

Glaxosmithkline Inc. v The Queen, 2008 TCC 324 involved a Canadian company (Glaxo Canada) that paid amounts that were in excess of the fair market value for a chemical to its sister corporation.  On the secondary adjustment, the minister assessed Glaxo Canada for withholding tax under Part XIII of the Act on the excess amount on the basis that it was deemed by subsection 56(2) to have paid a dividend to its shareholder and not to its sister corporation on the basis that its shareholder had directed or concurred with the payment or transfer of the excess amount to as a benefit that it desired to confer to Glaxo Canada’s sister corporation.

Consistent with those comments, the CRA has opined that the deemed dividend resulting from the application of the following provisions would be considered a dividend for Article X: (i) subsection 84(1) (2009-0341681R3, 2009-0348581R3, 2010-0364531R3, 2011-0430761R3, 2012-0471921R3); (ii) subsection 84(3) (2011-0424211R3); (iii) paragraph 214(3)(a) (2012‑0434311E5); and (iv) subsection 219(5.3) (2001-0106695).  The CRA also confirmed that a dividend that was deemed to be paid under subsections 15(1) and 214(3) of the Act would qualify as a dividend for the purposes of the Canada-Switzerland Tax Convention (see 2007‑024199 and 2008-028004).

In this file, subsection 247(12) applies to deem the difference between the sales price that would have been agreed on between persons dealing at arm’s length and the sales price agreed on by Canco and Sisterco LLC to be deemed to be a dividend.

The OECD Commentary also provides guidance on whether a recipient who is not a shareholder can receive a “dividend” for purposes of Article X in light of the definition in paragraph X(3):

29. The benefits to which a holding in a company confer entitlement are, as a general rule, available solely to the shareholders themselves. Should, however, certain of such benefits be made available to persons who are not shareholders within the meaning of company law, they may constitute dividends if:

- the legal relations between such persons and the company are assimilated to a holding in a company ("concealed holdings"); and

- the persons receiving such benefits are closely connected with a shareholder; this is the case, for example, where the recipient is a relative of the shareholder or is a company belonging to the same group as the company owning the shares.

Although Sisterco LLC is not a shareholder of Canco, the transfer pricing income adjustment made under subsection 247(2) results from the fact that they are not dealing at arm’s length (or to paraphrase paragraph 29 of the OECD Commentary, that “the persons receiving such benefits are closely connected with a shareholder; this is the case, for example, where the recipient is a relative of the shareholder or is a company belonging to the same group as the company owning the shares”).

Consistent with the views and precedents described above, we are of the view that the deemed dividend resulting from the application of subsection 247(12) in this file is a dividend as defined by paragraph X(3) of the Treaty for purposes of Article X of the Treaty.

3)    Paragraphs IV(6) of the Treaty

In the absence of paragraph IV(6), an entity such as a LCC that is not liable for tax in the US because it is disregarded for tax purposes cannot get the benefit of Article X of the Treaty because that entity is not a US “resident” as defined in Article IV of the Treaty.

The segment of Article X that informs this discussion reads as follows:

1.    Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

2.    However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of such dividends, the tax so charged shall not exceed:

(a)   5 percent of the gross amount of the dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends (for this purpose, a company that is a resident of a Contracting State shall be considered to own the voting stock owned by an entity that is considered fiscally transparent under the laws of that State and that is not a resident of the Contracting State of which the company paying the dividends is a resident, in proportion to the company's ownership interest in that entity);

(b)   15 per cent of the gross amount of the dividends in all other cases.

This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.

The entity that is disregarded in the US cannot claim treaty benefits since it is not a resident of the US under paragraph IV(1) of the Treaty. As such, there would be no dividends paid by a corporation resident in Canada to a corporation residing in the US under paragraph X(1) and no “such dividends” to which the reduced rates under paragraph X(2) could be applied.  The ownership presumption rule in subparagraph X(2)(a) is also not relevant for the entity that is disregarded in the US since it only applies to a beneficial owner that is a resident of the United States.

Paragraph IV(6) was introduced, amongst others, to grant the benefit of Article X in situations where dividends are paid or credited to a disregarded entity that is not liable to tax such as a LLC on or after February 1, 2009.  The application of IV(6) in this file would determine if Parentco, as the member of Parentco LLC which in turn is the member of Sisterco LLC, can be viewed as having derived the amount recharacterized as a dividend under subsection 247(12).

It is helpful to read paragraph (IV)(6) with the names of the entities inserted to identify where the potential ambiguities and uncertainties lie:

6. An amount of income [presumably the deemed dividend resulting from the application of 247(12)], profit or gain shall be considered to be derived by a person [Parentco] who is a resident of a Contracting State [the US] where:

(a)   The person [Parentco] is considered under the taxation law of that State [the US] to have derived the amount through an entity (other than an entity that is a resident of the other Contracting State) [Sisterco LLC and Parentco LLC don’t reside in Canada]; and

(b)   By reason of the entity [Sisterco LLC and Parentco LLC] being treated as fiscally transparent under the laws of the first-mentioned State [the US], the treatment of the amount under the taxation law of that State [the US] is the same as its treatment would be if that amount had been derived directly by that person [Parentco].

The uncertainties and ambiguities can be listed as follows:

1)    In the preamble, what amount of income is tested under this provision?  The answer informs whether the different conditions of application are met.

2)    In IV(6)(a), can it be said that [Parentco] is considered under the taxation law of the US to have derived the deemed dividend resulting from the application of 247(12) through Sisterco LLC and Parentco LLC?

3)    In paragraph IV(6)(b), can it be said that the treatment of the amount of the deemed dividend resulting from the application of 247(12) under the taxation laws of the US is the same as its treatment would be if that amount had been derived directly by Parentco?

It seems inescapable that the amount of income that is tested under IV(6) is the deemed dividend resulting from the application of 247(12) since the application of IV(6) informs the rate of withholding applicable to that amount under Part XIII in light of Article X.

The deemed dividend resulting from the transfer pricing adjustment results from a presumption in Canadian legislation (subsection 247(12)).  Paragraph IV(6) only determines whether the “indirect recipient” (from a US perspective in this case) of an income is entitled to the treaty benefit where the other conditions of application of a provision of the Treaty are otherwise met (one of such conditions being the nature of the income).  For instance, had Canco paid to Sisterco LLC an amount that is a dividend at law, the application of paragraph IV(6) of the Treaty would give to Parentco the benefit of Article X.

The positions on paragraph IV(6) that were announced at the CRA round tables presented as part of the 2009 and 2017 Canadian Tax Foundation annual Conferences inform the application of paragraph IV(6) in this file.

At the 2009 Canadian Tax Foundation roundtable (2009-034535), one of the questions raised the issue of amounts that are deemed in Canada to be dividends and treated differently for US tax purposes in the context of Article IV(6) of the Treaty.  The segment of the question that is relevant to this discussion reads as follows:

… would treaty benefits be available with respect to an amount paid by a Canadian corporation (other than a corporation that is disregarded under the taxation laws of the US) to a LLC after 2009 if the amount is not disregarded but the treatment of the amount under the taxation laws of the US differs from the treatment of that amount under the taxation laws of Canada?  This could occur, for example, if the corporation pays a cash dividend on shares held by the LLC and all or a portion of that dividend is treated as a return of capital under the taxation laws of the US.

The CRA responded that although the words in IV(6) track specific income, it would be willing to consider that the conditions are met where the income is treated differently in both countries (our emphasis):

The CRA believes that the better view is that Article IV(6) does not apply to treat a particular amount of Canadian-source income, profit or gain as being derived by the US resident member(s) of a LLC if that amount is "disregarded" under the taxation laws of the US.  However, the CRA recognizes that there is substantial uncertainty regarding the scope and intended application of Article IV(6) of the Treaty, particularly as it applies to an amount of income, profit, or gain that is subject to different tax treatment under the taxation laws of the US than under the taxation laws of Canada.  Given this uncertainty, the CRA will not take the position that an amount that was paid or credited before 2010 by a Canadian corporation to a fiscally transparent LLC was not "derived" by the member(s) of the LLC within the meaning of Article IV(6)(a) of the Treaty.  However, the CRA will not accept a claim for treaty benefits made by a LLC to the extent that the claim relates to a "disregarded" amount that is paid or credited after 2009.

With respect to an amount of income, profit or gain that is not "disregarded" under the taxation laws of the US but is treated differently under those laws than under the taxation laws of Canada, the CRA is willing to consider, for the purposes of applying Article IV(6), that the amount has been derived under the taxation laws of the US.  For example, assume that a fiscally transparent single-member LLC holds shares of a Canadian corporation that is not disregarded under the taxation laws of the US.  Assume also that the corporation redeems some of the shares held by the LLC. In this situation, the CRA is willing to consider, for the purposes of applying Article IV(6), any Canadian-source deemed dividend which arises on the redemption of the shares to be derived by the US-resident member of the LLC even though the amount paid by the corporation to redeem the shares may be treated, under the taxation laws of the US, as proceeds of disposition or a return of capital.  In addition, if the Canadian corporation pays a cash dividend to the LLC, the CRA is willing to consider, for the purposes of applying Article IV(6), that the Canadian-source dividend has been derived by the US‑resident member of the LLC even though, under the taxation laws of the US, the dividend may be treated partly as a dividend and partly as a return of capital.

The CRA reiterated that position at the 2017 Canadian Tax Foundation roundtable.

In determining whether those positions extend to the amount of the income adjustment under subsection 247(2) and the consequential secondary adjustment under subsection 247(12) discussed in this letter, it is useful to explore the way those provisions operate and their underlying economic rationale in this context.

Subsection 247(12) deems a Canadian resident to have paid a deemed dividend where there is an income adjustment under 247(2) resulting from a purchase for consideration that exceeds the amount that would meet the arm’s length principle or from a sale for consideration that is lower than such amount.  The purpose of subsection 247(12) is basically to put Canco and the non‑resident on the same footing as if the amount were a distribution of cash in the form of a deemed dividend (purchase by the Canadian resident for more than the arm’s length amount) or a transfer of property in the form of a deemed dividend (excess of the arm’s length amount over the consideration paid by the non-resident).

The economic position of the Canadian resident and the non-resident is substantively identical whether the Canadian resident sells for insufficient consideration or buys for excessive consideration.  The application of subsection 247(12) would also be identical when applied as a consequence of the application of subsection 247(2) in either scenario to the extent that the Canadian resident will be deemed to have paid a dividend and the non-resident will be deemed to have received such dividend.

From the perspective of the non-resident, the economic form of the amount of such deemed dividend depends on the circumstances.  Where the non-resident sells for more than the amount that meets the arm’s length principle, the deemed dividend takes the form of an additional profit resulting from the additional consideration that it received in excess of such amount.  Where the non-resident purchases for consideration that is lower than the amount that meets the arm’s length principle, the deemed dividend takes the form of the excess of such amount over the consideration that it paid for the property or in other words, of the excess of the value of the property acquired over the consideration paid for it.

In our view, the application of paragraph IV(6) would also have to be identical and informed by the positions expressed at the 2009 and 2017 round tables, whether there is an income adjustment under 247(2) resulting from a purchase for consideration that exceeds the amount that would meet the arm’s length principle or a sale for consideration that is lower than that amount.

The existence of a remedy in the form of a determination by the respective Competent Authorities is consistent with the underlying economic logic of subsections 247(2) and 247(12) and to that extent, it also informs the application of the positions expressed by the CRA at the 2009 and 2017 round tables.

4)    Competent Authority

If the assessment were issued to Canco claiming Part XIII tax on the 247(12) deemed dividend at a rate of 25%, Canco and Sisterco LLC would likely make a request to their respective Competent Authorities to eliminate the double taxation resulting from the inclusion in Canco’s income and from the additional profit realized by Sisterco LLC on the sale of the inventory acquired on that transaction.  In addition, the taxpayer would request a reduction of the amount assessed Part XIII.

On the one hand, there is the option of repatriation under subsection 247(13).  An exchange published in the following article suggests that if the taxpayers go to Competent Authority and all the parties agree on an adjusted price for the transaction that was assessed, Sisterco LLC might decide to pay an amount to Canco equal to the adjusted amount accepted by the parties:  Jeffrey Shafer and Daryl Boychuk, "Understanding the Competent Authority Process," Report of the Proceedings of the Sixty-Eighth Tax Conference, 2016 Conference Report (Toronto: Canadian Tax Foundation, 2017), 20:1-15.

The process was described as follows by Daryl Boychuk in that article:

Repatriation is about rebalancing the accounts between the related parties after a transfer‑pricing case has been resolved. It is relevant when the transfer-pricing adjustment gives rise to a secondary adjustment in the form of a deemed dividend. For example, assume that a Canadian subsidiary paid an amount in excess of an arm's-length amount for services rendered to it by its non-resident parent, and that the amount in excess of an arm's-length amount was deemed to be a dividend paid by the subsidiary. In this case, the CRA would normally issue an assessment against the Canadian subsidiary for the failure to withhold the part XIII tax on the deemed dividend.

That comment is made in respect of an overpayment of the Canadian corporation for services rendered by its non-resident parent corporation.  That situation is comparable to the one we are dealing with: an overpayment for services results in a benefit being conferred the same way a sale of property for insufficient consideration would and Part XIII tax is payable on the conferral of that benefit.

The discussion then suggests that the non-resident parent would offer to pay the shortcoming to its Canadian subsidiary, which would result in the cancellation of the failure-to-withhold assessment.  The response indicated that this outcome is consistent with the approach described in paragraphs 56 to 58 of Information Circular 71-17R5 and that the same would hold true for transfer-pricing adjustments that relate to transactions that occurred after March 29, 2012 and governed by subsections 247(12) to (15).  The corresponding tax adjustment made by the tax authority of the other country is not described in that discussion but the economic and tax consequences would likely be levelled and identical to what would have happened had the transaction respected the arm’s length principle in the first place.

Alternatively, Canco’s representative indicated that “upon final resolution by the Canadian and U.S. Competent Authorities the adjustment would also give rise to a dividend for U.S. tax purposes”.  We presume that this suggests that Sisterco LLC would not offer to pay the shortcoming to Canco.  One possibility is that the US Competent Authority will increase the cost to Sisterco LLC of the property bought from Canco to the amount agreed with the Canadian Competent Authority to be the amount that meets the arm’s length principle.  The US Competent Authority might also include the amount of a dividend in the income of Parentco under section 482 of the Internal Revenue Code (a “corresponding adjustment”) in its quality of shareholder of Parentco LLC (a disregarded entity) along with a contribution to the capital of Sisterco LLC (a disregarded entity).

On the face of IV(6), the question is whether the amount of the deemed dividend resulting in Canada from the application of 247(12) and deemed received by Sisterco but inexistent in the US is the same as the amount of the “corresponding adjustment” considered to have been received by Parentco LLC.

6. An amount of income [presumably the deemed dividend resulting from the application of 247(12)], profit or gain shall be considered to be derived by a person [Parentco] who is a resident of a Contracting State [the US] where:

(a)   The person [Parentco] is considered under the taxation law of that State [the US] to have derived the amount through an entity (other than an entity that is a resident of the other Contracting State) [Parentco LLC doesn’t reside in Canada]; and

(b)   By reason of the entity [Parentco LLC] being treated as fiscally transparent under the laws of the first-mentioned State [the US], the treatment of the amount under the taxation law of that State [the US] is the same as its treatment would be if that amount had been derived directly by that person [Parentco].

Two questions might arise :

a)    Would the amount of the corresponding adjustment be the same as the amount of the dividend deemed by 247(12) to exist in Canada for purposes of the preamble of IV(6)?

b)    Would IV(6) apply if the corresponding adjustment takes the form of a dividend deemed received by Parentco LLC (it is not clear that the corresponding adjustment in the form of a dividend would be made in the hands of Sisterco LLC because it is not a shareholder of Canco).

On the first question, the position of the 2017 Canadian Tax Foundation round table would extend to the corresponding adjustment.

On the second question, it is possible that the connection between the corresponding adjustment and the 247(12) deemed dividend might be sufficient to conclude favorably because they both emanate from the transfer pricing primary adjustments negotiated by both Competent Authorities.

On that basis, it is our understanding that the Canadian Competent Authority would give the benefit of Article X to Parentco and reduce the Part XIII assessment on the basis that the conditions of application of paragraph IV(6) would be met.

Conclusion

We are of the view that the positions expressed by the CRA at the 2009 and 2017 round tables and described above would extend to the acquisition by Sisterco LLC of assets that form part of its inventory from Canco for less than the amount that would meet the arm’s length principle.

In the absence of a corresponding adjustment by the US Competent Authority, the economic benefit deemed under subsection 247(12) to be a dividend exists in the US in the form of latent profit that will be realized by Sisterco LLC once it sells the property and the additional profit would then be taxed in the hands of Parentco.  Such economic profit would result in double taxation considering that Canco would have to include the same amount in its income under subsection 247(2).

In order to eliminate such double taxation, we would expect the parties to refer the matter to their respective Competent Authority.  As discussed above, we would expect that an amount equivalent to the amount that will be agreed by the Competent Authorities to meet the arm’s length principle will be added to the cost of the inventory of Sisterco LLC (thus eliminating the latent profit) and added in the income of Parentco in the form of a dividend.

If a corresponding adjustment is made in the U.S. to consider that Canco has paid a dividend that is derived by Parentco through Parentco LLC, the conditions of paragraph IV(6) should be met since Parentco would be considered to have derived a dividend through Parentco LLC.

Before a corresponding adjustment is made or even if no corresponding adjustment is made, we are of the view that the conditions of paragraph IV(6) should still be met since Parentco is considered to have derived an amount (that is not disregarded) through US Sisterco LLC. More specifically, we understand that, from a US tax perspective, Parentco, will have a reduced cost of inventory that is derived through the purchases of Sisterco LLC from Canco.  The application of paragraph IV(6) would result in the amount deemed to be a dividend under subsection 247(12) to be derived by Parentco for purposes of paragraphs X(1) and (2) and the presumption of ownership of the shares of Canco by Parentco in subparagraph X(2)(a) would apply to determine the applicable rate of withholding.

Either way, we would not view that amount as being “disregarded” for US tax purposes and we therefore consider that the application of the positions described above in respect of paragraph IV(6) to the transactions do not depend upon the terms of the agreement between the Competent Authorities on the secondary adjustment.

CAVEAT

Except as expressly stated, this opinion does not imply acceptance, approval or confirmation of any other income tax implications of the facts or proposed transactions described herein.  For greater certainty, we assumed and are not in a position to confirm in respect of:

(a)   whether Canco is fiscally transparent under the taxation laws of the United States; and

(b)   whether the deemed dividend resulting from the transaction referred to above is disregarded under the taxation laws of the United States.

Yours truly,

Yves Moreno
Manager, International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  October 2012 [S.C. 2012, c. 31 (Bill C-45)]
2  Model Tax Convention on Income and on Capital: Condensed Version 2017, OECD Publishing, Paris.
3  IBID, commentary on Article 10, paragraph 1, page 231.

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