TE for New Canada-U.S. Protocol Should Eliminate an Old
Uncertainty
By Philip D. Morrison,
Esq.
Deloitte Tax LLP, Washington, DC
Treasury's Technical Explanations (TEs) to the tax treaties and
protocols it negotiates and sends to the Senate for ratification,
while designated “official guidance,” are never amended or
updated. As pointed out in a prior
commentary,1 they are more in
the nature of legislative history, locked in stone once written and
released, and not susceptible of amendment.
Every so often, however, Treasury has the opportunity for a
“do-over.” When a new protocol amends an old treaty
article but preserves language from (or uses very similar language to)
the old article, the TE for the new protocol provides a chance for
Treasury to clear up any ambiguities or uncertainties that have arisen
with respect to the old language. One such opportunity that Treasury
should grasp when it prepares its TE for the fifth Protocol to the
Canada-U.S. Treaty2 (the
“new Protocol”) is to clarify the meaning of
“substantial and regular trading” and “primarily and
regularly traded” as those terms are used in Article XXIXA
(Limitation on Benefits) (LOB).
The third Protocol to the Canada-U.S.
Treaty3 added a unilateral
LOB, aimed at preventing non-qualifying persons from enjoying
U.S. benefits. Like all U.S. treaty LOBs at that time and
since, that LOB provided that a publicly-traded Canadian corporation
could be a qualified person. Also like LOBs of the same era, to be
publicly-traded a corporation had to have “substantial and
regular trading” of its shares on a recognized stock exchange.
Unlike virtually every other treaty of that era, however, no guidance
was provided with respect to the meaning of “substantial and
regular trading.” Neither the third Protocol itself nor any of
the accompanying documents, including the TE, defined what
“substantial and regular trading” of a public company's
shares means.
Like most other treaties, the Canada-U.S. Treaty provides a
catch-all provision for undefined terms. Under Article III(2), unless
the context otherwise requires (or the Competent Authorities otherwise
agree), an undefined term is generally defined by reference to the tax
law of the source country. Thus, for purposes of defining
“substantial and regular trading” for purposes of the LOB
added by the third Protocol (applicable to U.S.-source income), one
must look to U.S. tax law.
The most sensible place to look for such a definition is in Regs.
§1.884-5. That section provides the anti-treaty shopping rules
implementing and interpreting the anti-treaty shopping rule of
§884(e), the branch tax's self-contained LOB. That provision is
designed to do precisely the same thing that the treaty LOB is
intended to do -- prevent treaty shopping.
While “substantial and regular trading” with respect to
a public corporation's stock is not defined in Regs. §1.884-5,
“regularly traded” is. Under Regs. §1.884-5(d)(4),
stock is generally considered to be regularly traded if: (A) stock
representing 80% or more of the vote and value is listed on an
established securities market; and (B)(1) there are trades on more
than 60 days in a year; and (B)(2) there is 10% turnover during the
year. Classes of stock that are listed on a U.S. exchange are deemed
to meet the 10% annual turnover requirement if the stock is regularly
quoted by brokers or dealers making a market in the stock. These rules
are similar, but for the market maker presumption to satisfy the
turnover requirement, to rules spelled out in other treaties or their
accompanying documents or TEs enacted both before and after the third
Protocol.4
Unlike treaties, however, Regs. §1.884-5(d)(4)(iii) provides
that closely held classes of stock cannot ever be treated as meeting
the trading requirements of (B)(1) and (B)(2), above, whether, as a
factual matter, they do or not. “Closely held” generally
means that non-qualifying shareholders, each of whom owns 5% or more
of the value of a class of stock (after applying a related person
rule), own 50% or more of the class for more than 30 days during a
taxable year.
It is not entirely clear whether this closely-held rule of the
branch tax regulation should apply as part of the domestic law one
should apply under Article III(2) to define the third Protocol's term
“substantial and regular trading.” On the one hand, while
most other U.S. treaties' LOB provisions use some variation of the
branch tax's method for computing “regular trading,” no
other U.S. treaty LOB provision defines “substantial and regular
trading” to include the branch tax's closely-held rule. In
addition, the 1996 and 2006 U.S. Model Treaty TEs both provide that
“regularly traded” as used in the LOB provision for public
companies shall, pursuant to Article 3(2), have the meaning ascribed
by the branch tax regulations, with the exception of the
closely-held rule. If, consistently from 1996 to at least 2006,
Treasury interprets the words “regularly traded” to
include the branch tax rules generally but without reference to the
closely-held rule, it might be strained for the government to maintain
that the very same words in 1995 (the third Protocol to the
Canada-U.S. Treaty) meant something different (i.e., the branch tax
rules including the closely-held rule).
On the other hand, it is evident from treaties both before and
after the third Protocol to the Canada-U.S. Treaty, and from the Model
TEs, that Treasury and its treaty partners knew how to define
“regularly traded” to not include the branch tax rules, or
at least the branch tax closely-held rule, when they wanted to. Normal
precepts of statutory interpretation would indicate that, if they
neglected to say something in one case that in multiple other cases
they clearly said, perhaps it is because they intended the omission in
that one case. Further, as a policy matter, it is easy to construct an
argument as to why Treasury might have wished the closely-held rule to
apply. If a Saudi prince (the archetype of a treaty shopper) owns 80%
of a public Canadian company that meets the trading test by lots of
turnover in the remaining 20% of its shares, is that a sympathetic,
non-treaty-shopping case?
However one resolves this debate, it is difficult to say there is
an inarguably correct answer. Unfortunately, the new Protocol, if
adopted, will insert into the Canada-U.S. Treaty a new LOB article
that, so far, has the same lack of clarity. Indeed, because the terms
used in the new Protocol are “primarily and regularly
traded,” the identical words in the branch tax, it could be
argued that there is even a slightly greater need than before for
clarity. It is imperative, therefore, that the TE being written for
the new Protocol make clear, as the Model TEs do, that the branch tax
closely-held rule does not apply. While an explanation in the TE for
the new Protocol would not entirely eliminate any question regarding
the meaning of “regular trading” for years controlled by
the third Protocol, if Treasury took the opportunity in the TE to note
that having no closely-held rule has been a consistent policy since at
least the 1992 signing of the Netherlands-U.S. treaty, it would be
very helpful in resolving such a question regarding the application of
the third Protocol.
This commentary also will appear in the February 8, 2008, issue
of the Tax Management International Journal. For more
information, in the Tax Management Portfolios, see Levine and Miller,
936 T.M., U.S. Income Tax Treaties -- The Limitation on Benefits
Article, and in Tax Practice Series, see ¶7140, U.S. Income
Tax Treaties.
1
Morrison, “When a Helpful TE Provision Arguably Conflicts with a Treaty,” 35 Tax Mgmt. Int'l J. 310 (June 9, 2006).
2
Signed September 21, 2007.
3
Signed March 17, 1995.
4
See, e.g., Netherlands-U.S. Treaty, signed December 18, 1992, and Luxembourg-U.S. Treaty, signed April 3, 1996.
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