Canada: Fourth Protocol To Canada-UK Treaty Eliminates Withholding Tax On Arm’s Length Interest, But Preserves Tax Exemption For Gains On Disposition Of Shares And Interests Deriving Value From Canadian Real Property

On July 21, 2014, the governments of Canada and the United Kingdom signed the fourth protocol (Protocol) amending the Convention between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains (Canada-UK Treaty). The Protocol amends fifteen articles of the Canada-UK Treaty and includes provisions eliminating withholding tax on cross-border interest paid to a person with whom the payer deals at arm's length and imposing deadlines for certain transfer pricing adjustments. An Interpretive Protocol provides guidance on the application of the Canada-UK Treaty to UK limited liability partnerships (UK LLPs) and defines certain other terms. Many provisions of the Protocol are consistent with those included in other treaties recently negotiated by the Canadian government. However, as discussed below, it is noteworthy that Article 13 (Capital Gains) was not amended to permit a Contracting State to impose tax on a gain realized on the disposition of a partnership interest, interest in a trust or unlisted share that derives its value, or the greater part of its value, directly or indirectly from immoveable property situated in that State in which a business is carried on by the partnership, trust or company.

This article reviews several of the significant amendments to the Canada-UK Treaty contained in the Protocol.


The Protocol and Interpretive Protocol contain two changes that expand and clarify the application of the Canada-UK Treaty to partnerships.

First, the Protocol amends Article 3(1)(c) of the Canada-UK Treaty to provide that the term "person" includes a partnership. Partnerships were formerly expressly excluded from the definition. As a result of this amendment, a partnership that is liable to entity-level tax in either Canada or the UK could qualify as a resident of a Contracting State based on the test set out in Article 4(1). In Canada, the only partnerships that are liable to tax at the partnership level are "SIFT partnerships". However, as a SIFT partnership is liable to tax only on income and gains from non-portfolio property, it is not clear that such a partnership would be a resident of Canada for the purposes of the Canada-UK Treaty.

Second, the Interpretive Protocol provides that an item of income or gain that is derived by a UK LLP that has its place of effective management in the UK and that is fiscally transparent for UK tax purposes will be considered to be the income or gain of its members to the extent that such members are residents of the UK. This provision is presumably intended to ensure that a UK LLP that is fiscally transparent for UK tax purposes will be afforded look-through treatment in applying the Canada-UK Treaty to partners that are residents of the UK, regardless of whether the UK LLP is considered a partnership under Canadian tax principles.

Business Profits and Transfer Pricing

In general terms, Article 7 (Business Profits) of the Canada-UK Treaty provides that the business profits of an enterprise of a Contracting State are to be taxed only by that State, except where the enterprise carries on business in the other State through a permanent establishment situated therein. In the latter case, the other State is entitled to tax the profits of the enterprise that are attributable to the permanent establishment in that State. Articles 7(2) to (4) set out certain principles that apply to determine the extent to which the profits of an enterprise are attributable to a permanent establishment.

The Protocol amends Article 7 in order to conform to Article 7 of the OECD Model Tax Convention on Income and Capital (OECD Model Convention).1 Both the current and amended versions of Article 7(2) provide that the amount of profit attributable to a particular permanent establishment of an enterprise is to be determined as though the permanent establishment were a separate enterprise engaged in "the same or similar activities under the same or similar conditions". The amended version, however, adopts the language of Article 7(2) of the OECD Model Convention and states that the foregoing determination is to be made "taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through other parts of the enterprise".

The Protocol also introduces new Article 7(3), which provides that, where a Contracting State makes an upward adjustment with respect to the portion of the profits of an enterprise that are attributable to a permanent establishment situated in that State, the other State must make a corresponding downward adjustment to the extent required to eliminate double taxation. The competent authorities of each State are required to consult with each other if necessary to align their assessments of the enterprise. This provision is included in the OECD Model Convention.

Article 9(2) of the Canada-UK Treaty provides that where a Contracting State makes a transfer pricing adjustment that it is entitled to make, the other State is required to make an appropriate adjustment to the amount of tax charged by it on the relevant profits of the associated enterprise in that State. However, in general, Article 9(3) provides that the other State is only required to make such adjustment if, within six years from the end of the taxation year (in Canada) or the chargeable period (in the United Kingdom) to which the original adjustment relates, the competent authority of the other State has been notified that the original adjustment has been made or proposed. The Protocol replaces Article 9(3) and provides that a Contracting State cannot make a "primary adjustment" (an undefined term) to the income of an enterprise after the earlier of: (i) the expiry of the limitation period under domestic law, and (ii) eight years after the end of the taxation year to which the relevant income relates.

Dividends Received by Pension Organizations

The Protocol amends Article 10 (Dividends) to add two new provisions, Articles 10(3) and (4), to eliminate withholding tax on dividends paid by a resident of a Contracting State to organizations that are constituted and operated exclusively to administer or provide benefits under one or more recognized pension plans. The new withholding tax exemption will apply to any dividend paid by a resident of a Contracting State to such an organization constituted and operated in the other State provided that: (i) the organization is the beneficial owner of the dividend, holds the shares on which the dividend was paid as an investment and is generally exempt from tax in its residence State, (ii) the organization does not directly or indirectly own shares representing more than 10% of the voting power or value of all of the shares of the dividend payer, and (iii) each recognized pension plan provides benefits primarily to individuals who are residents of the other State.


One of the most significant changes to be implemented by the Protocol is the introduction of new Article 11(3)(c), which eliminates withholding tax on interest paid by a resident of a Contracting State to a resident of the other State. However, the nil rate of withholding tax does not apply if the beneficial owner of the interest does not deal at arm's length with the payer (unlike the Canada-United States Income Tax Convention (1980)) or if the interest is "contingent or dependent on the use of or production from property or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a company" (commonly referred to as "participating debt interest"). The Interpretive Protocol provides that the determination of whether an interest payer and recipient deal at arm's length generally is to be made in accordance with domestic law.

The amendments to Article 11 correspond to recent amendments to the Income Tax Act (Canada) (Tax Act) that generally eliminate Canadian withholding tax on interest (other than participating debt interest) paid to a non-resident with whom the payer deals at arm's length. Clause 212(1)(b)(i)(B) of the Tax Act, however, provides that interest paid by a resident of Canada to a non-resident "in respect of" a debt obligation owing to a person with whom the payer does not deal at arm's length remains subject to Canadian withholding tax even if the non-resident who receives the interest deals at arm's length with the payer. This provision was enacted in response to the decision in Lehigh Cement Ltd. v. R.,2 in which a corporation loaned money to a borrower with whom it did not deal at arm's length and subsequently sold the interest coupon to a person with whom the borrower dealt at arm's length. The Federal Court of Appeal concluded that interest paid by the borrower to the purchaser of the coupon should be considered to be paid to a person with whom the borrower dealt at arm's length, even though the principal amount of the obligation was owed by the borrower to a person with whom it did not deal at arm's length. The withholding tax exemption in Article 11(3)(c) requires only that the "beneficial owner of the interest" deal at arm's length with the payer so that the Canada-UK Treaty might eliminate any withholding tax that would otherwise arise pursuant to clause 212(1)(b)(i)(B) in a scenario similar to Lehigh in which a Canadian resident pays interest to a resident of the UK with whom it deals at arm's length but the principal amount of the obligation is owed to a non-arm's length person. However, new Article 11(9) provides that the provisions of Article 11 shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the debt-claim in respect of which the interest is paid to take advantage of Article 11 by means of that creation or assignment. Presumably this provision will limit such planning.

Mutual Agreement Procedure

The Protocol repeals Article 23 (Mutual Agreement Procedure) (MAP) in its entirety and replaces it with a similar provision that imposes deadlines for certain actions undertaken pursuant to the Canada-UK Treaty. In particular:

  • Under new Article 23(1), a resident of a Contracting State who considers that the actions of one or both competent authorities will result in taxation that does not accord with the principles of the Canada-UK Treaty must request competent authority relief within three years "from the first notification of the action resulting in taxation not in accordance with" the Canada-UK Treaty.
  • New Article 23(3) provides that a Contracting State cannot make a "primary adjustment" to the income of a resident of a Contracting State that is subject to tax in the other State after the earlier of: (i) the expiry of the limitation period under domestic law, and (ii) eight years after the end of the taxation year to which the relevant income relates.

Exchange of Information and Assistance in Collection of Taxes

The Protocol proposes to add to the Canada-UK Treaty new Articles 24 (Exchange of Information) and 24A (Assistance in Collection of Taxes), which effectively adopt articles 26 and 27 of the OECD Model Convention. These provisions have become standard in Canada's tax treaties.

Taxation of Seconded Employees

The Canada-UK Treaty provides that remuneration from employment derived by a resident of a Contracting State may be taxed by the other State if the employment is exercised in the other State. However, such remuneration is taxable only in the residence State if (i) the recipient is present in the source State for a period or periods not exceeding in the aggregate 183 days in the calendar year concerned, (ii) the remuneration is paid by, or on behalf of, an employer who is not a resident of the source State, and (iii) the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the source State. The Protocol will amend the first condition such that the employee can only be present in the source State for a period or periods not exceeding in the aggregate 183 days in any 12 month period commencing or ending in the fiscal year concerned. This will affect numerous longer secondments that straddle a calendar year end.

Capital Gains

The Protocol does not amend Article 13 (Capital Gains) of the Treaty to delete Article 13(7)(b), which provides that, for purposes of determining whether a partnership interest, interest in a trust or unlisted share derives its value, or the greater part of its value, directly or indirectly from immovable property situated in a State, immovable property does not include real property (other than rental property) in which a business is carried on by the partnership, trust or company.

Canada imposes tax on capital gains realized by a non-resident on the disposition of "taxable Canadian property" which is defined to include certain shares, interests in trusts and partnership interests where, in general, at any particular time during the 60-month period that ends at the time of disposition, more than 50% of the fair market value of the share or interest was derived directly or indirectly from real or immovable property situated in Canada and/or Canadian resource property and/or timber resource property and/or options or rights in such property.

Article 13(5) of the Canada-UK Tax Treaty allows a Contracting State to impose tax on a gain realized by a resident of the other State on the disposition of a partnership interest, interest in a trust or unlisted share that derives its value, or the greater part of its value, directly or indirectly, from immovable property situated in the Contracting State. Article 13(6), however, provides that Article 13(5) does not apply if the alienator, or the alienator and persons related to or connected with him, owned less than 10% of each class of shares of the company or trust interests or partnership interests entitling them to less than 10% of the income and capital of the trust or partnership.

A UK resident that disposes of a share, interest in a trust or partnership interest that would otherwise be taxable Canadian property but which derives its value principally from Canadian real property in which a business is carried on (e.g., a mine or oil or gas well), can rely on Article 13(8) to exempt any gain arising on the disposition from Canadian tax.

Finance was reported to have previously stated that it no longer considered this broad "business property exemption" to align with its policy objectives and, accordingly, it would seek to ensure that the definitions of real or immovable property in Canada's tax treaties parallel the OECD Model Convention provisions and the "taxable Canadian property" definition in the Tax Act. The recent treaty with Hong Kong and (unratified) treaty with New Zealand, for example, are consistent with this policy. This objective was not realized in the Protocol but it is unclear whether this indicates a change in policy or is merely the result of "horse trading" in treaty negotiations.

Coming Into Force

The Protocol remains subject to ratification by both Canada and the UK before coming into force. In Canada, the withholding tax provisions will come into force on January 1 of the calendar year after the Protocol is ratified and the other provisions will apply to taxation years beginning after that date.3


1. As of July 22, 2010.

2. [2010] 5 C.T.C. 13 (F.C.A.).

3. Protocol, Article XVI(1)(a).

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