On Friday, September 21, 2007 Canada's Minister of Finance and the U.S. Secretary of the Treasury signed a protocol (the "New Protocol") updating the Canada-U.S. Tax Treaty (the "Treaty").
The New Protocol will:
- eliminate withholding taxes on cross-border interest payments;
- extend treaty benefits to U.S. limited liabilities companies (LLCs);
- eliminate double taxation on emigrants' capital gains;
- give mutual tax recognition of pension contributions;
- clarify how stock options are taxed; and
- allow taxpayers to require that certain key double tax issues, such as transfer pricing, be settled through arbitration.
The New Protocol also provides for the implementation of many technical changes to the Treaty.
Measures such as the elimination of withholding tax on interest payments and allowing LLCs to benefit from the Treaty were long awaited and are certainly welcome as they will facilitate cross-border transactions to the benefit of businesses of both countries.
To take effect, the New Protocol must be ratified in the House of Commons in Canada and the Senate in the United States. The New Protocol will enter into force on January 1, 2008 or the date both countries have exchanged notifications that their respective procedures for ratification have been satisfied, whichever is the later date.
Following is an overview of the principal provisions of the New Protocol.
Elimination of withholding tax on cross-border interest payments
Currently interest paid by a resident of Canada to a resident of the U.S. (or vice versa) is subject to withholding tax at a rate of 10%. While the U.S. has a broadly available exemption from such withholding tax, Canada has an exemption (the so-called "5/25 exemption") that is often highly impractical for borrowers to access. If applicable, this tax raises the cost of capital for Canadian borrowers as it almost invariably must be borne by the borrower. Once the New Protocol is ratified that withholding tax will be eliminated. Thus, Canadian businesses will benefit as they will be able to more easily access U.S. capital markets, their borrowing costs will be reduced, and cross-border investment will become more efficient.
The elimination of withholding tax on cross-border interest will be available as of the second month after the New Protocol comes into force for interest paid between unrelated or arm's length parties.
For interest paid between related parties, the elimination of cross-border withholding tax will be phased-in. For the first year after the New Protocol is in force the tax rate will be reduced to 7%. The tax rate will be further reduced to 4% in the second year after the Protocol comes into force, and will be fully eliminated as of the third year after the Protocol is in force.
Treaty benefits for Limited Liability Companies ("LLCs")
Certain entities may be treated as corporations in one country and partnerships in the other (generally referred to as "hybrid entities"). There is currently no accommodation for hybrid entities under the Treaty. In particular, the Canada Revenue Agency has taken the position that under the current terms of the Treaty U.S. LLCs that are treated as disregarded entities for U.S. tax purposes may not benefit from the terms of the Treaty as such LLCs are not resident in U.S. for the purposes of the Treaty because they are not subject to tax in the U.S. As a result, benefits such as reduced withholding tax may not be available.
Under the new rule introduced by the New Protocol, income earned by residents of one country (the "residency country") through a hybrid entity will in certain cases be treated in the other country (the "source country") as having been earned by a resident in the residency country. If, however, the income of the hybrid entity is not taxed directly in the hands of its investors it will be treated as not having been earned by a resident (the "Corollary Rule"). Consequently, if U.S. investors invest in Canada through a hybrid vehicle that is viewed as a corporation in Canada but as a flow-through entity in the U.S., and if the investors are taxed in the U.S. on income in the same way as if they had earned the income directly, Canada will treat the income as having been paid directly to the U.S. resident. Therefore, reduced withholding tax will apply to the payment of the income across the border.
The new rule applies as of the second month the New Protocol comes into force, while the Corollary Rule will apply two years after the Protocol enters into force.
This new provision to the Treaty will remove serious impediments to cross-border investments and may result in the use of LLCs in some circumstances in which unlimited liability companies are used currently for investment by U.S. companies in Canada, but will also impact so-called "reverse hybrid" structures.
Capital gains on emigration
Under the Treaty, capital gains of a taxpayer are generally taxable only by the country in which the taxpayer resides. When a taxpayer emigrates from Canada, such taxpayer is liable for tax on accrued capital gains of the properties owned by the taxpayer, a tax known commonly as the "departure tax." Currently the Treaty contains no provisions relieving a taxpayer from U.S. taxes when Canadian taxes have already been paid in respect of pre-emigration capital gains.
The New Protocol will allow a taxpayer who is subject to a "departure tax" in a country from which the taxpayer emigrates to choose to increase the tax cost of his or her assets so that pre-emigration gains on those assets will not be taxed again in the other country. Post-emigration gains on such assets would still be taxable in the country to which the taxpayer relocates.
To clarify by way of example, if a Canadian resident has property with a tax cost of $1,000 and a fair market value of $2,000 at the time of emigration to the U.S., the taxpayer would be liable for Canadian tax on a capital gain of $1,000 at such time. The emigrant can then choose for U.S. tax purposes to have realized a $1,000 gain and, accordingly, the U.S. would not tax the gain that accrued while the individual was resident of Canada and would only be able to tax any additional gain if the property value appreciates after the taxpayer relocates to the U.S.
This new rule will have a retroactive affect as it will apply to emigrations that took place after September 17, 2000, which was the date both countries agreed on the application of such rule.
Mutual tax recognition of pension contributions
No rules currently cover pension contributions made by cross-border commuters who reside in one country and work in the other and who make contributions to pension plans in the country in which they work. Similarly, there is no rule in place for persons who move from one country to the other on short-term work assignments and who continue to contribute to pension plans in the first country.
The New Protocol will provide that contributions to a plan in a country in which a person works may be deductible in the country in which they reside. Additionally, for persons who move for work purposes, contributions made to a plan in their original country may be deductible for tax purposes in the country in which they work. The new rule will facilitate cross-border exchange of workers.
For example, a person who resides in Canada and who works and makes contributions to a plan in the U.S. may deduct those contributions for Canadian tax purposes. As well, a person who leaves Canada to work on a short-term basis in the U.S. may deduct, for U.S. tax purposes, contributions made to a plan based in Canada.
These new measures will apply to taxation years that begin after the calendar year in which the New Protocol enters into force.
Employee Stock Options
Measures will be introduced to clarify the tax treatment relating to stock options granted to employees while employed in one country and who then work for the same or a related company in the other country before exercising or disposing of the right.
As announced under the new rule the income in question, being the benefit derived from the stock option, will be apportioned as between the two countries and will generally be considered to have been derived in a country to the extent that the individual's principal place of employment was in that country during the time between the granting of the option and its exercise (or the disposition of the share). This leaves open many questions which, hopefully, will be addressed when more details of this new rule are made public.
In certain situations residents of the U.S. and Canada may find themselves in situations where they are subject to double taxation, for which a resolution under the treaty cannot be achieved. Presently, if the treaty rules do not provide for a resolution to a double taxation problem the matter is left to be resolved between the revenue authorities. Unfortunately, if a double taxation issue cannot be resolved by the mutual agreement of the revenue authorities there is no further mechanism for dispute resolution.
The New Protocol will allow taxpayers to elect for binding arbitration, participation in which is mandatory for the revenue authorities. This mechanism of mandatory arbitration will be particularly important in cases of transfer pricing audits by one of the two countries. The determination of a higher transfer price by one country may well be unacceptable by the other country. Should the two tax authorities not reach an agreement with respect to such matters, the affected company will be entitled to require the matter be put to binding arbitration.
The new rule will not only apply to disputes that arise after the New Protocol enters into force, but will also apply to matters already under consideration by the revenue authorities at such time.
While new provisions of the Treaty introduced by the New Protocol are welcome, and address a number of issues that have been problematic in Canada-U.S. tax planning for some time, the New Protocol also includes a number of provisions that have not been previously discussed publicly. For example, the Limitation of Benefits article has been amended and, where it previously applied only from the U.S. perspective, it will now also apply from the Canadian perspective. This and other changes will have to be analyzed in greater detail.
The Gowlings National Tax Practice Group, which includes our Transfer Pricing and Competent Authority Group, can assist your organization in dealing efficiently with the impact that the changes in the New Protocol to the Canada-U.S. Tax Treaty could have on your business as well as to advise as to the best strategies to take advantage of the new benefits that can result from the entry into force of the New Protocol.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.