The fifth protocol (Protocol) to the Canada-U.S. Income Tax Convention (Treaty) was signed on September 21, 2007. The Protocol contains the changes to the withholding tax rules for interest and the treatment of limited liability companies (LLCs) that were previously announced in the Canadian federal budget of March 19, 2007. The Protocol also contains a number of unexpected changes such as the new rules for "hybrid" entities and the new "limitation on benefit" provisions applicable to Canada. Many of these changes could have significant consequences for existing cross-border structures and proposed M&A transactions. This bulletin summarizes these and other changes relevant to M&A transactions.
Elimination Of Withholding Tax On Interest
The Protocol will generally eliminate withholding tax on interest paid between Canadian and U.S. resident persons that are not "related."1 This change will be effective two months after the date on which the Protocol enters into force. If ratification procedures in both countries are completed before the end of 2007, the Protocol will enter into force on January 1, 2008. Otherwise, the Protocol will enter into force upon the completion of the ratification procedures. Accordingly, the change with respect to withholding tax will be effective March 1, 2008 at the earliest. The Protocol also provides for the gradual elimination of withholding tax on interest paid between Canadian and U.S. persons that are "related persons." Under the Treaty, the current maximum rate of withholding tax on interest paid between related persons is 10%; this will be reduced to 7% during the portion of the first calendar year after which the above-noted exemption applies, 4% for the immediately following calendar year and nil for the next and subsequent years.
As announced in the 2007 Canadian federal budget, in conjunction with the Protocol changes, Canada will unilaterally amend its domestic tax laws to eliminate withholding tax on interest paid by Canadian resident borrowers to non-Canadian lenders. This change was introduced in draft legislation released on October 2, 2007 and will become effective when the corresponding change in the Protocol (relating to interest paid between persons that are not related) becomes effective.
These changes will be very significant to Canadian resident borrowers since the only broadly available exemption from Canadian withholding tax to date has been the so-called 5/25 exemption provided for under Canada’s domestic tax laws. Acquirors of Canadian entities, particularly Canadian acquirors, will now have greater access to foreign debt financing. Cross-border tax structures will also benefit since the withholding tax on interest payments between related parties in such structures reduces over time.
New Treatment Of LLCs And Other Fiscally Transparent Entities
The current Treaty does not readily accommodate the treatment of LLCs that are regarded as fiscally transparent entities for U.S. tax purposes. The taxation laws of Canada do not regard LLCs as being fiscally transparent. Furthermore, the Canadian tax authorities have in the past taken the position that an LLC is not eligible for benefits under the Treaty on the basis that it is not a "resident" of the United States for purposes of the Treaty (since as a fiscally transparent entity, it is not "liable to tax" in the United States). The Protocol provides welcome relief in this regard by providing for a "look through" rule that extends the application of the Treaty to U.S. residents who derive an amount through an entity such as an LLC that is treated as fiscally transparent under the laws of the United States (and provided that the amount is treated under the taxation laws of the United States in the same way as if the amount had been derived directly by the U.S. resident).
The same look-through provision should also apply to partnerships, provided that the Canadian taxation authorities would consider a partnership to be an "entity" for this purpose. In any event, the authorities have a longstanding administrative position of looking through a partnership to its partners for purposes of the Treaty, and they will likely turn to this position for guidance in determining how to apply the new look-through rule for LLCs. Unfortunately, this administrative position is often problematic (particularly for private equity partnerships), since the taxation authorities have required detailed information about the identity of the partners, their nature and status and some form of evidence that a particular partner is indeed a resident of the United States and thereby entitled to benefits under the Treaty. This same position will likely apply in determining whether members of an LLC should be entitled to Treaty benefits. In addition, under the new "limitation on benefits" provisions introduced in the Protocol, a member of an LLC (as well as a partner of a partnership) will be required to establish that the member/partner is not disqualified under those provisions from being entitled to the benefits of the Treaty.
Dividends And Fiscally Transparent Entities: Relaxing The 5% Rule
Under the current Treaty, the general reduced rate of withholding tax for dividends is 15%. However, a lower 5% rate of withholding tax applies if the "beneficial owner" of the dividends is a company that owns at least 10% of the voting stock of the company paying the dividend. The Canadian taxation authorities have taken the position that where a partnership "owns" the shares of the company paying the dividend, the partners will not be considered to be the "owners" of the shares. Under this position, a U.S. corporate partner of a partnership that owns shares of a Canadian corporation would not be entitled to the 5% rate on dividends received by the partnership from the corporation even though the U.S. corporate partner holds more than a 10% interest in the partnership. The Protocol provides welcome relief from this position by providing that, for the purposes of the lower 5% rate, a company shall be considered to own the voting stock owned by an entity that is considered fiscally transparent (such as an LLC and likely also a partnership) in proportion to the company’s ownership interest in the entity.
New Treaty Benefit Denial Rules For Hybrid Entities
The Protocol contained two unexpected provisions dealing with hybrid entities – that is, entities that are fiscally transparent in one country but not in the other.
The first rule applies to arrangements involving "reverse hybrids." The classic case involves U.S. residents forming a Canadian partnership and electing, for U.S. tax purposes, to treat the partnership as a corporation. The partnership would then be a fiscally transparent entity for Canadian tax purposes but a corporation for U.S. tax purposes. Under the current Treaty, Canada would look through the partnership and extend benefits under the Treaty to U.S. resident partners of the partnership. Under the new rule applicable in this situation, the U.S. resident partners would not be eligible for benefits under the Treaty.
The second rule applies to arrangements whereby U.S. residents invest in shares and debt of a Canadian corporation that is an "unlimited liability corporation" (a ULC can be formed under the laws of the provinces of Nova Scotia and, more recently, Alberta). A ULC is a form of Canadian corporation that can elect to be treated as a fiscally transparent entity for U.S. tax purposes. Canada extends benefits under the current Treaty to U.S. resident holders of debt and shares of a ULC in respect of interest on debt and dividends on shares.
Under the new rule applicable in this situation, a U.S. holder of debt and shares of the ULC will not be entitled to benefits under the Treaty in respect of interest on the debt where the treatment of the interest on the debt of the ULC under the taxation laws of the United States would not be the same as its treatment if the ULC were not treated as fiscally transparent under such laws. This differential in U.S. tax treatment will almost always exist with respect to interest on debt of a ULC since the debt will generally be "disregarded" so that the U.S. holder will not be considered to have received "interest" on the debt for U.S. tax purposes. Similar considerations will apply to dividends received by the U.S. holder on shares of the ULC.
A popular structure for acquisitions of Canadian corporations by U.S. residents involves the U.S. residents forming a Canadian acquisition corporation ("Holdco") and capitalizing Holdco with the required "equity" in the form of subordinated debt and pure share capital on a 2:1 basis (to comply with the Canadian "thin cap" rules). The subordinated debt component provides the Canadian corporation with additional interest shelter for Canadian tax purposes, at the expense of withholding tax on interest (which will ultimately be eliminated as described above). Depending on the nature of the U.S. investors, it was sometimes advantageous for U.S. tax purposes to make Holdco a ULC, since the interest on the subordinated debt would not be treated as interest for U.S. tax purposes (the debt itself being disregarded). Under the second of the new rules described above, U.S. residents would not be entitled to benefits under the Treaty in respect of the interest on the subordinated debt of the ULC: the interest would be subject to Canadian withholding tax at the rate of 25%.
As a result of the two new rules relating to hybrid entities, it will be necessary to review any cross-border arrangements that have been put into place using hybrid entities. Likely for this reason, the two new rules will not be effective immediately, giving taxpayers the opportunity to review and restructure such arrangements. The new rules will be effective on the first day of the third calendar year that ends after the Protocol enters into force. Assuming the Protocol will enter into force sometime in 2008, the two new rules will be effective January 1, 2010.
Limitation On Benefits Provision Applicable To Canada
The Protocol introduces Canada’s first comprehensive "limitation on benefits" (LOB) provision. The current Treaty contained such LOB provisions applicable to the United States but they did not apply to Canada. The Protocol extends the application of the LOB provisions to Canada, which introduce further complexity in determining whether a U.S. person is entitled to Treaty benefits. U.S. persons who will be entitled include natural persons, governments and their agencies, companies or trusts whose principal class of shares or units is "primarily and regularly" traded on a recognized stock exchange (which includes major Canadian and U.S. stock exchanges), as well as estates and certain pension trusts, non-profits and tax-exempt entities. Certain non-public companies and trusts may also qualify but other more complex tests will need to be satisfied. The LOB provisions permit a person that does not qualify for Treaty benefits to apply for relief from the "competent authority" in circumstances in which the person was not created to obtain Treaty benefits or where it would not be appropriate to deny Treaty benefits.
1. The changes do not apply to interest arising in Canada that is paid to a U.S. resident that is referred to as "participating interest" or to interest arising in the United States that is paid to a Canadian resident that is treated as "contingent interest" for the purposes of the U.S. "portfolio interest" exemption.
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.