On September 21, 2007, representatives of Canada and the US signed the Fifth Protocol to the Canada-United States Income Tax Convention ("Protocol"). The Protocol will enter into force after ratification by both countries, which is not expected to occur before the end of 2007.
Taxpayers should consider how the Protocol affects them, particularly in the case of:
- Taxpayers resident in Canada or the US making interest payments to residents of the other country;
- Taxpayers that have cross-border structures involving hybrid entities;
- Employers, employees and service providers working in a cross-border context;
- Persons who could become subject to the limitation on benefits article in the Canada-US Income Tax Treaty.
Elimination of Withholding Tax on Interest Payments and Guarantee Fees
The Protocol eliminates withholding tax on interest payments and guarantee fees made by a resident of Canada or the US to a resident of the other country. The elimination of withholding tax on interest means that US lenders will be able to provide revolving facilities and other facilities to Canadian borrowers without having to comply with the so-called 5/25 debt rule.
Avoidance rules have been introduced in the Protocol to ensure that inappropriate interest payments cannot benefit from the elimination of the withholding tax. Pursuant to these rules, withholding at a rate of 15% will be applied in the following situations:
- Interest arising in the US that is contingent interest of a type that does not qualify as portfolio interest for US tax purposes;
- Interest arising in Canada that is determined with reference to receipts, sales, income, profits or other cash flow of the debtor or a related person or to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment.
For interest payments between unrelated parties, the elimination of the withholding tax on interest will apply as of the second month beginning after the Protocol enters into force.
However, withholding on interest payments made between related parties will be eliminated progressively over a three-year period. For the first and second years, withholding on interest payments between related parties will be at rates of 7% and 4% respectively.
The Department of Finance (Canada) has stated in a recent comfort letter that it is their intent to modify Canadian tax law so that debts that require repayment of more than 25% of their principal amount within 5 years can qualify for the existing 5/25 withholding tax exemption so long as the obligation to repay the principal amount can arise only if a change to the Income Tax Act or the Canada-US Income Tax Treaty has the effect of relieving the non-resident lender from liability for withholding tax in respect of interest in such circumstances. Furthermore, the 2007 Canadian federal budget proposed to eliminate withholding tax on interest paid to all arm’s length non-residents, regardless of their country of residence once the exemption is implemented in the Canada-US Income Tax Treaty.
Modifications dealing with Limited Liability Companies, Partnerships and Hybrid Entities
Extension of Treaty Benefits to Limited Liability Companies ("LLC")
Under the Protocol, income that a US resident earns through a LLC will be treated as having been earned directly by the US resident for the purposes of the Canada-US Income Tax Treaty. The effective date for this measure depends on the type of income to which it applies.
Withholding Rate on Dividends where Shares are held through a Partnership
A company that owns shares of another corporation via a partnership will be considered to own the shares held by the partnership in proportion to the company’s interest in the partnership. This ensures that companies owning at least 10% of the shares of a corporation, either directly or indirectly via a partnership, will be able to benefit from the 5% withholding tax rate on dividends.
Elimination of Treaty Protection for Hybrid Entities
The benefits of the Canada-US Income Tax Treaty will no longer be available in respect of payments made to and by certain hybrid entities. Hybrid entities generally refer to entities that are treated differently for Canadian and US tax purposes. For example, Canadian unlimited liability companies constitute hybrid entities because they are treated as corporations for Canadian income tax purposes and as flow-through entities for US income tax purposes. Hybrid entities are often used in cross-border financing structures, both for investments by US residents into Canada and by Canadian residents investing into the US. Structures that include hybrid entities will have to be reviewed. This measure will enter into force on the first day of the third calendar year that ends after the Protocol comes into force.
Expansion of the Permanent Establishment Concept with regard to Service Providers
The concept of permanent establishment has been broadened with regard to Canadian or US resident enterprises that provide services in the other country. These measures have the effect of reversing recent case law that held that service providers were not taxable in jurisdictions in which they were rendering services where they did not have sufficient connections to be considered to have a permanent establishment in the other jurisdiction.
An enterprise residing in one country will be considered to have a permanent establishment in the other country if services are performed in that other country for the enterprise by an individual and:
- The individual is present in the other country for 183 days or more in any 12 month period; and
- More than 50% of the gross active business revenues of the enterprise consists of income derived from the services performed by that individual in that other country.
The scope of the permanent establishment concept has also been expanded to include any services of an enterprise provided in the other country for a period of 183 days or more in any 12 month period with respect to the same or a connected project for customers who are either residents of the other country or who have a permanent establishment in the other country in respect of which the services are provided.
This measure will enter into force as of the third taxable year that ends after the Protocol comes into force. Days of presence, services rendered and gross active business revenues occurring or arising prior to January 1, 2010 will not be taken into account for the purposes of determining whether an enterprise has a permanent establishment due to this new article.
Withholding Tax Rate on Dividends paid by US Real Estate Investment Trusts ("US REIT")
For a Canadian resident to be able to benefit from a withholding rate of 15% on dividends received from a US REIT, one of the following conditions must be fulfilled:
- The beneficial owner of the dividends is an individual holding not more than 10% of the REIT;
- The dividends are paid with respect to a publicly traded class of stock and the owner of the stock does not own more than 5% of any class of stock of the REIT; or
- The beneficial owner of the dividends owns not more than 10% of the REIT and the REIT is diversified.
If none of these conditions is fulfilled, the US domestic law withholding tax rate will apply.
This measure will apply upon the later of (i) the second month that begins after the Protocol enters into force and (ii) January 1, 2008.
Adjustments for Departure Tax on Emigration
For Canadian income tax purposes, Canadian residents that cease to reside in Canada are deemed to have disposed of many types of property upon emigration from Canada. This can create double taxation where the other country does not recognize the deemed disposition. The Protocol allows an individual to choose to be considered as having disposed of and reacquired the property on a change in the country of residence. This measure will apply to deemed dispositions occurring after September 17, 2000.
Changes regarding Pensions and Annuities
The Protocol contains detailed rules concerning the deductibility of contributions as well as for the accrual of benefits in relation to qualifying retirement plans. Cross-border commuters will be able to deduct in their home countries contributions made to retirement plans or arrangements in the country where they work. Also, taxpayers who move from Canada to the US (or vice versa) for work will be able to deduct contributions made to a plan or arrangement in the US (or Canada, as the case may be) for up to five years. If ratification of the Protocol is completed in 2007, which is considered to be unlikely, these rules will apply in 2008. Otherwise, they will enter into effect for taxation years beginning after the calendar year in which the Protocol enters into force.
Mixing Funds invested on behalf of Exempt Entities
Under the Protocol, dividends and interest earned by a non-taxable entity operating exclusively on behalf of one or more exempt organizations described in Article XXI of the Canada-US Income Tax Treaty will be exempt from tax in both Canada and the US. Previously, the mixing of funds between multiple exempt organizations was not possible.
Attribution of Benefits arising on Employee Stock Options
The "Diplomatic Notes: Annex B to the Convention" provide guidance on how to apportion taxing rights between Canada and the US in respect of the employment benefit arising on the exercise or the disposition of an employee stock option. Where an employee is granted an employee stock option while employed in Canada or the US and then works for the same or a related employer in the other country, the employment benefit arising on the exercise or disposition of the employee stock option will generally be calculated based on the proportion of the days between the grant of the option and the exercise or disposition of such option that the employee was situated in either Canada or the US. This principle of proportionate attribution of income will not be applied where the competent authorities agree that the granting of the option is more appropriately treated as a transfer of ownership. This exception could apply, for instance, where the options granted are in the money or if the options have a short vesting period.
Ability to compel Mandatory Arbitration
Taxpayers will be able to compel Canadian and US tax authorities to refer a double taxation dispute to binding arbitration where the competent authorities have endeavoured but are unable to reach a complete agreement in a case. This measure will apply to disputes that are already under consideration under the mutual agreement procedure when the Protocol enters into force.
Extension of the Scope of the Limitation on Benefits Article
Under the Protocol, the limitation on benefits article has been extended so that it can be applied by Canada as well as the US.
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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.