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In a recent Tax Court Memorandum decision (Dynamo Holdings LP et. al. v. Commissioner; T.C. Memo 2018-61) the Tax Court held that certain transfers from a Canadian based real estate company’s U.S. subsidiaries to related U.S.-based entities were made for less than adequate consideration, and thus constituted constructive distributions subject to withholding tax – along with penalties for failure to file the requisite returns and deposit the taxes.
In Dynamo, a successful Canadian real estate development company decided to create a separate U.S. based organizational structure as part of a plan to deal with tax inefficiencies stemming from existing Canadian based operations with U.S. subsidiaries. To implement this plan, the company transferred assets from the Canadian based structure to the U.S. based structure over a period of several years. These transfers included both advances of cash to fund the U.S. structure’s operations, as well as the sale of several income-producing assets to the U.S. based entities.
When analyzing these transfers the Tax Court ruled that, despite their initial characterization as loans and sales, the transfers were instead, in portion, constructive distributions to a Canadian corporation – treated in part as dividends and in part as non-dividend distributions.
For more information on the court’s analysis regarding constructive distributions, see our tax alert here.
When a dividend is paid to a foreign corporation – as it was in Dynamo – the dividend may trigger a gross basis withholding tax obligation. In general a 30 percent withholding tax applies to U.S. source dividends paid to foreign corporations subject to reduction under a treaty. In addition, non-dividend distributions may be subject to withholding tax if the distributing entity is a U.S. real property holding corporation. In these cases, the U.S. payer of the dividend (or the withholding agent) is required to deduct and withhold the necessary tax. The U.S.-Canada tax treaty reduces the rate that applies to cross-border dividend payments
Having already ruled that the transfers in question resulted in constructive distributions, the court also held that the U.S. withholding agent was required to withhold tax, at a rate of 5 percent as required under the U.S.-Canada treaty, on the portion of the constructive distribution that was a dividend, i.e., the portion treated as coming from the earnings and profits of the U.S. corporation that paid the dividend.
The court next turned to withholding tax due on those distributions paid in excess of the U.S. payer’s earnings and profits. Generally, a U.S. real property holding corporation is defined as any corporation in which the fair market value of its U.S. real property holdings exceeds 50 percent of the fair market value of its combine U.S. and non-U.S. real property interests, plus any other assets used or held for sale in a trade or business. In general, non-dividend distributions from a U.S. real property holding company to a foreign person were subject to a 10 percent withholding tax during the years at issue.
The taxpayers in Dynamo argued that, despite the fact that a majority of the U.S. payer corporation’s assets were U.S. real property interests, the corporation was not a U.S. real property holding corporation. To prove this, they relied on an alternative test for determining U.S. real property holding corporation status, in which they excluded the fair market value of property held for sale in the ordinary course of business from total U.S. real property holdings. The court, however, disagreed with this approach. Finding that the taxpayers offered no compelling evidence as to why property held for sale should be excluded from the analysis, the court held that the U.S. payer corporation was indeed a U.S. real property holding corporation, and that as such, the non-dividend distributions – those in excess of the U.S. payer corporations earnings and profits – were subject to the 10 percent withholding tax.
Taxpayers commonly transfer assets between members of a global related group. Thus, this ruling underscores the importance of both properly characterizing related party transactions (e.g., as debt or equity or as a sale vs. gift) and developing strong evidencing supporting the transfer price used to value transactions between related parties. Thus, taxpayers should make sure to consult their tax advisors regarding transfers of property between related entities, especially in cases involving cross border transfers.