Preparing Canadian structures for 2010.

• Author: Felten, Brent E.

Limited liability companies (LLCs) have become a very popular tax planning tool for U.S. taxpayers that desire the tax transparency of a partnership with the limited liability protections of a corporation. The LLC provided a simple means of achieving those objectives. When thrown into the context of international operations, however, the LLC possessed the potential to gum up the works as U.S. treaty partners determined how to treat this new entity.

Canada initially adopted an adverse position on LLCs not opting out of partnership treatment under the check-the-box rules. Canada characterized an LLC as a corporate vehicle in essence and determined that it was not eligible for treaty benefits because it was not a U.S. taxpayer when treated as a transparent entity for U.S. tax purposes. This characterization distinguished it from true partnerships in which Canada provided treaty benefits to the partners and S corporations, which were also (for some reason) afforded treaty protection.

For years, both U.S. and Canadian taxpayers urged Canada to rethink its position on treaty eligibility for U.S. LLCs. Canada responded favorably in the fifth protocol (the protocol) to the U.S.-Canada tax treaty (the treaty). Effective January 1, 2010, Canada will look through tax-transparent U.S. LLCs and determine treaty eligibility at the member level. Appropriately heralded as great news by the tax community, the excitement of LLC treaty eligibility overshadowed some significantly unfavorable changes for existing treaty beneficiaries.

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Protocol Residency Provisions

The protocol provided the relief for LLCs via the treaty's residency provisions, specifically the addition of Article IV, paragraph 6. At the same time, however, the protocol also added Article IV, paragraph 7, which may eliminate as much or more relief than that granted by paragraph 6. Specifically, paragraph 7(a) provides that a U.S. taxpayer will not be considered a U.S. resident under the treaty when receiving income from Canadian sources through a non-U.S, reverse hybrid. Paragraph 7(a) really represents nothing more than the incorporation of the provisions of Sec. 894(c), already applicable to U.S.-source payments, into the treaty so that Canadian-source payments are treated similarly.

Paragraph 7(b) contains an even broader disallowance, providing that a U.S. taxpayer will not be considered a U.S. resident under the treaty when receiving income from a Canadian hybrid. The...