Canada: Fifth Protocol to the Canada-U.S. Income Tax Convention – Strategies for a New Era In Canada-U.S. Transactions

Last Updated: November 13 2007
Article by Ken Snider

The fifth protocol (the "Protocol") to the Canada–U.S. Income Tax Convention ("the Convention") was signed by the Canadian Minister of Finance, James Flaherty, and the U.S. Treasury Secretary, Henry Paulson, Jr. on September 21, 2007. It will have a significant impact on many types of cross–border transactions that will have to be assessed on case–by–case basis. The Protocol must be ratified in both countries and will enter into force on the date that is the latter of the notification of ratification, or January 1, 2008. Various provisions have different effective dates after the Protocol enters into force. The changes will have to be considered in respect of existing structures and transactions to be entered into prior to entry into force. This bulletin focuses on a few of the changes expected to have broad application and some practical strategies to consider in response. There are other important changes in the Protocol that are beyond the scope of this bulletin. For further information, please contact any of the names listed at the end of the document.

Elimination of Withholding Tax on Cross–Border Interest Payments

Currently, the Income Tax Act (Canada) (‘ITA’) imposes a withholding tax of 25% on interest paid to a non–resident of Canada, unless an exemption applies or the rate is reduced under a tax treaty. Currently, the Convention generally limits withholding tax on cross–border interest payments to 10%.

The Protocol will eliminate withholding tax on interest and guarantee fees. The exemption for non–related–party interest will be effective at the beginning of the second month following the month the Protocol comes into force. If the payer of the interest and the beneficial owner of the interest are "related", the withholding tax will be reduced to 7% in the first calendar year, to 4% in the second calendar year, and then eliminated completely in subsequent years following the entry into force of the Protocol.

The term "related" is not defined by the Convention. An annex to the Protocol clarifies the interpretation of undefined terms. It provides that any undefined term shall, unless the context otherwise requires or the competent authorities otherwise agree to a common meaning, have the meaning which it has at that time under the laws of the particular country for purposes of the taxes to which the Convention applies. This meaning will prevail over the meaning of the term under the laws of the other country.

The definition of "related persons" in the ITA is very lengthy and is based on legal control regardless of whether the persons deal on arm’s length terms.

In addition, draft legislation released by the Canadian Department of Finance on October 2, 2007 states that once a treaty provides an exemption from Canadian withholding tax, there will not be withholding tax paid to any arm’s length lender. This exemption, once enacted, will apply to loans entered into on or after March 19, 2007.

Contingent interest arising in the U.S. of a type that does not qualify as "portfolio interest" will not be exempt. Interest arising in Canada that in general is "participating" will not be exempt. In both cases such interest will be subject to a 15% withholding tax.

Practical Considerations

Until the Protocol enters into force, the primary Canadian exemption for withholding tax on interest remains the "5/25" exemption. This is an exemption for interest payable by a corporation resident in Canada to an arm’s length person if the borrower is not obligated to repay more than 25% of the principal within five years, unless there is an event of default. While the draft amendments to the ITA provide an exemption from withholding tax on arm’s length interest, as noted above it will still be important to structure new loans to comply with the "5/25" exemption prior to entry into force of the exemption. Once the new provisions enter into force, lenders and borrowers will be able to negotiate their loan transactions without regard to the limitations imposed by the "5/25" exemption, and over time non–arm’s length loans between U.S. and Canadian residents will become more tax efficient. Consequently, Canadian borrowers will have greater access to U.S. and other foreign capital markets subject to regulatory considerations. New creditor opportunities may arise for non–resident investors making short term loans (e.g. revolving loans), loans to non–corporate entities (e.g. income trusts, and REITS), and acquiring distress loans and mortgage–backed securities.

Treaty Relief for U.S. LLCs

Based on the administrative policy of the Canada Revenue Agency ("CRA"), limited liability companies (‘LLCs’) that are treated as fiscally transparent for U.S. tax purposes are not eligible for benefits under the Convention. Alternate ownership structures for Canadian investments have generally been required to avoid double taxation. This has led to considerable frustration.

The Protocol will extend treaty benefits, not to fiscally transparent LLCs directly, but to U.S. resident members who derive income through an LLC. The Convention currently provides for a 5% withholding rate on dividends paid to a corporate shareholder which owns at least 10% of the voting stock of the payor corporation. For this purpose, the Protocol provides that a U.S. resident corporate member of an LLC shall be considered to own the voting stock of the Canadian payor corporation owned by the LLC in proportion to its ownership interest in the LLC. Therefore, it is possible for a U.S. corporate member of an LLC to qualify for the 5% rate. However, the Convention will not apply where the income is not taxed directly in the hands of the U.S. residents, or where the income of an LLC is taxed in the hands of members of the LLC who are not U.S. residents. Where the income or gain will not be treated as derived by the U.S. person, the income or gain of the LLC will not be subject to treaty protection.

Practical Considerations

The question will arise whether it is advisable for an LLC to make a direct investment in Canadian property once the Protocol enters into force. An LLC may be a viable entity for making investments in Canada provided all the members are U.S. residents who are subject to U.S. tax on their income. However, while not clear at this point, we expect that the U.S. members of the LLC will be subject to the same Canadian tax compliance obligations that would apply to members of a partnership. An example would be the requirement to file notices and obtain clearance certificates under section 116 of the ITA on a sale of "taxable Canadian property" and the obligation to file a Canadian tax return reporting the gain even if it is exempt from Canadian tax by reason of the Convention. Consequently, unless the compliance issue is favourably resolved, use of an LLC by a U.S. private equity fund with many members may not be an acceptable investment vehicle for certain Canadian investments, even if all the members were entitled to treaty protection.

Where there are LLC members who are not entitled to the benefit of the Protocol, it may not be advisable to use a LLC. In particular, it appears that CRA’s long standing policy that LLCs are not entitled to treaty benefits will continue to apply. Therefore, to the extent members are not protected by the Protocol, an LLC (and its non–U.S. members) will not enjoy any treaty benefits. Alternate investment vehicles should be considered.

LLC agreements entered into both before and after the Protocol takes effect should be reviewed to assess the impact if less than all the income or gains of the LLC is considered to be derived by residents of the U.S. This might necessitate allocating some of the Canadian taxes not reduced by the Protocol to non–U.S. members.

The wording of the Protocol does not expressly refer to LLCs. It refers to deriving income through an entity other than an entity that is a resident of the source country. Therefore, the rule may apply to any fiscally transparent entity (not resident in the source country) and could apply to shareholders of a U.S. "S" corporation and beneficiaries of U.S. grantor trusts. This requires further clarification from the government.

Denial of Treaty Benefits for Certain Hybrid Entities

The Protocol unexpectedly includes two complex provisions which will adversely affect certain widely–used cross–border structures involving "hybrid" entities. A "hybrid" is an entity that is treated as a taxable entity in one jurisdiction but fiscally transparent in another jurisdiction. Hybrids and "reverse hybrids" have been used to obtain favourable tax consequences which the U.S. and Canada wanted to stop.

A "reverse hybrid" is legally a partnership in one country that is treated as a corporation in another country. This would include a partnership that has "checked–the–box" to be treated as a corporation for U.S. tax purposes but remains a partnership for Canadian legal and tax purposes.

It is understood that these provisions in the Protocol are unique for a Canadian tax treaty. While it is understood that these provisions are intended to stop "double dips", they in fact go much further, perhaps unintentionally. In particular, the provisions do not depend on the purposes for which the hybrid is used.

These changes have effect on the first day of the third calendar year that ends after the Protocol enters into force.

First Rule Reverse Hybrid

The first rule applies to amounts derived by a person otherwise entitled to treaty benefits through a reverse hybrid unless certain tests were not satisfied. Specifically, Canada will deny treaty benefits in respect of income, profit or gain paid to a resident of the U.S. if (i) the U.S. resident is considered under Canadian tax law to have derived such amounts through an entity that is not a resident of the U.S., and (ii) because the entity is not fiscally transparent in the U.S., the U.S. tax treatment of the amount is not the same as its treatment would be if the amount had been derived directly by that person.

A common example would be a Canadian limited partnership (which is fiscally transparent in Canada) that elected under the U.S. "check the box" rules to be treated as a corporation for U.S. tax purposes. This is illustrated below.

There will be Canadian withholding tax at the rate of 25% rather than 10% on the interest.

These structures were a tax–efficient way for a U.S. parent to finance its Canadian subsidiary. This change will not impact arm’s length interest that will not be subject to withholding tax because of an exemption under the ITA.

Similarly, the U.S. will deny treaty benefits in mirror circumstances. Consequently, the U.S. will deny treaty benefits in respect of income, profit or gain paid to a resident of Canada if (i) the Canadian resident is considered under U.S. tax law to have derived those amounts through an entity that is not a resident of Canada, and (ii) because the entity is not fiscally transparent in Canada, the Canadian tax treatment of the amount is not the same as its treatment would be if the amount had been derived directly by that person. An example is a Canadian resident earning U.S. source income through a U.S. LLC or a Barbados SRL. This is illustrated below.

Second Rule – Hybrid

The second rule applies to amounts derived from a hybrid in the other country. Consequently, Canada will deny treaty benefits in respect of income, profit or gain derived by a U.S. resident where (i) the U.S. resident is considered under U.S. tax law to have received an amount from an entity resident in Canada, and (ii) because the entity is treated as fiscally transparent under U.S. tax law, the U.S. tax treatment is different than if that entity were not fiscally transparent under U.S. tax law.

A common example is a Canadian unlimited liability company (a "ULC") which is fiscally transparent for U.S. residents. This is illustrated below.

The Protocol will not affect the payment of interest that is otherwise exempt from withholding tax under the ITA. If interest or dividends were paid to the U.S. parent, there would be Canadian withholding at 25%.

This provision should not affect treaty protection for capital gains realized on the sale of the shares of a ULC as generally it will not be a gain paid to or derived through the entity.

The U.S. will deny treaty benefits in the mirror circumstances. Consequently, the U.S. will deny treaty benefits in respect of income, profit or gain derived by a resident of Canada where (i) the Canadian resident is considered under U.S. tax law to have received an amount from an entity resident in the U.S., and (ii) because the entity is treated as fiscally transparent under Canadian tax law, the Canadian tax treatment is different than if that entity were not fiscally transparent under Canadian tax law. An example would be a Canadian resident that receives amounts from a U.S. partnership which is treated as a corporation for U.S. tax purposes but treated as fiscally transparent for purposes of the ITA. This is illustrated below.

Practical Considerations

These changes will affect a wide variety of existing inbound and outbound structures involving hybrids. The future impact of the loss of treaty benefits should be assessed, and planning strategies identified well before the changes take effect. The loss of treaty benefits may have a material cost. While a detailed discussion of the various structures and the alternatives is beyond the scope of this bulletin, a few observations are warranted.

First, prior to the changes becoming effective, it may be desirable to undertake transactions that are currently subject to treaty benefits, such as paying dividends, and related party interest where such favourable treatment may not be available after the Protocol becomes effective.

Second, restructuring ownership may be beneficial. For example, rather than directly using a ULC to carry on business in Canada, a U.S. resident could carry on a branch business in Canada, use a U.S. partnership, use a regular Canadian corporation or interpose a Luxembourg SARL as the direct parent of the ULC.

Third, depending on the circumstances, restructuring the non–arm’s length interest and royalty payments so they are paid to an affiliate in a third country with a favourable tax treaty with Canada should be considered. Domestic Canadian anti–avoidance rules will have to be canvassed.

Fourth, in the case of a ULC, one could consider "unchecking" the box for U.S. purposes so the ULC is not fiscally transparent for U.S. tax purposes in order to access treaty benefits. There may, however, be adverse U.S. tax implications in doing so.

There may also be immediate tax costs of a restructuring and incremental taxation in alternative structures. Depending on the circumstances, foreign exchange gains and losses in respect of related and non–related party debt could be realized on a restructuring.

While "hybrids" will still enjoy treaty benefits for a few years, careful consideration must be given to whether it is advisable to use a hybrid in new transactions. This would generally depend on whether there will be perceived adverse implications of reorganizing prior to the effective date.

Limitation on Benefits Clause

The limitation on benefits ("LOB") clause in the current Convention was introduced in 1995 and was "one–sided". It would enable only the U.S. to deny treaty benefits in respect of certain Canadians. Canada had chosen not to rely on an LOB provision and instead had relied on the "general anti–avoidance rule" in the ITA. CRA, however, has been unsuccessful in applying this rule in the courts. The change to the LOB provision will, however, not prevent CRA from attempting again to apply the "general anti–avoidance rule" in the ITA or common law anti–avoidance rules.

The Protocol provides a comprehensive LOB provision replete with many definitions. In order to obtain treaty benefits, a person not only has to be a resident of one of the Contracting States, but must also satisfy the "qualifying person" test. A qualifying person will include a natural person, a company or trust whose principal class of shares or units (and any disproportionate class of shares or units) is primarily and regularly traded on one or more recognized stock exchanges, and certain corporations and trusts that satisfy ownership tests. A fiscally transparent person (such as an LLC) may not be a qualifying person based on the CRA position that it is not a resident of the U.S. for purposes of the Convention.

If the above tests cannot be met, the Convention is extended to non–qualifying persons who are engaged in the active trade or business in that country where they are resident; however, it will only extend to income derived in connection with that business, and where that business is "substantial" in relation to the activities carried on in the other country.

Treaty benefits for dividends, interest and royalties can also be extended to companies controlled (i.e. at least 90% owned in terms of vote and value), directly or indirectly, by a qualifying person, or where they qualify under the derivative benefits rule as follows: where they are a resident of a third state (with which Canada or the U.S. has a treaty), they would meet the qualifying person test, the rate of withholding tax is comparable to the rate under the Convention, and the amount of deductible expenses (which was payable to non–qualifying persons) is less that 50% of gross income.

Practical Considerations

It will be necessary to ascertain whether the U.S. person who is otherwise a resident of the U.S. for purposes of the Convention will be entitled to treaty benefits under the Convention. This will be necessary for current ownership structures that will be extant when the LOB comes into force and new transactions entered into both before and after the effective date. In regard to current agreements, there may be situations where certain payments benefiting from treaty benefits will no longer qualify. The gross–up provisions, if any, in these agreements will become relevant.

Due diligence will be necessary to confirm that the LOB provision will not deny benefits and interpretive issues will arise. For example, it is not clear whether there will be protection in respect of capital gains realized on the sale of a Canadian subsidiary under the "active business" exception. In addition, we anticipate that many compliance issues will arise, such as determining the appropriate rate of withholding where a public corporation pays a dividend. U.S. administrative practices in this regard will no doubt be considered by Canadians.

If the LOB provision would apply in a particular case, consideration should be given to restructuring by using an affiliate in a third country with a favourable tax treaty with Canada, subject to review of Canadian anti–avoidance rules.

www.casselsbrock.com

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions