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.
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.
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.
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.
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.
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.