Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
The Technical Explanation (TE) provides commentary and some welcome clarification on the withholding tax exemptions to be provided by the Fifth Protocol (the Protocol) to the Canada-United States Income Tax Convention (the Treaty) on cross-border interest and guarantee fee payments, and the timing of this relief. Since the release of the Protocol, there has been an important domestic development with respect to withholding tax on cross-border interest payments related to relief under the Protocol.
Domestic Elimination of Withholding Tax on Interest Paid to Unrelated Non-Resident Lenders
When the Protocol was first released, the Department of Finance announced that it was going to propose amending the Income Tax Act (Canada) (the Act) to eliminate withholding tax on interest paid to all arm's-length non-resident lenders (not just U.S. lenders), other than on "participating debt interest." The amendments were proposed to be effective at the same time that the Protocol came into effect.
The Department of Finance decided not to wait, and on December 14, 2007, Parliament enacted such amendments, which were effective January 1, 2008.
Generally, participating debt interest means interest that is paid or payable on an obligation, all or any portion of which interest is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.
Unrelated Lenders under the Protocol
The TE makes it clear that the elimination of withholding tax under the Protocol on cross-border interest payments to unrelated U.S. or Canadian residents will be effective on January 1 of the year in which the Protocol comes into force.
Given the new domestic withholding tax exemption mentioned above, the exemption under the Protocol will have limited application to payments of interest to U.S. residents from Canada. It will have greater application to payments to Canadian residents from the U.S. because the domestic U.S. withholding tax exemptions on interest payments (e.g., the "portfolio interest" exemption, which is not available to non-U.S. banks) are more limited.
Related Lenders under the Protocol
The Protocol also provides for the gradual elimination of withholding tax on cross-border interest payments to related parties (or deemed related parties under the Treaty) who are U.S. or Canadian residents qualifying for the benefits of the Treaty. Before counting on these Treaty benefits, the limitation on benefits provision and the anti-hybrid rules, both discussed in other articles in this bulletin, must be considered. During the first calendar year that ends after the Protocol enters into force, the Treaty reduced rate of withholding tax on interest will be 7%. The TE has now confirmed that, as expected, the reduced withholding rate will be retroactive to January 1 of the year in which the Protocol comes into force. During the second calendar year the rate will be 4%, and after that the withholding tax is eliminated (i.e., January 1, 2010, if the Protocol is ratified by the U.S. and comes into force in 2008).
Since withholding tax is exigible only when interest is paid or credited to a non-resident lender (rather than accrued), Canadian borrowers may wish to consider deferring payment of interest to related lenders until the withholding rate has been reduced or eliminated. However, section 78 of the Act, which can add previously deducted interest back into income of the borrower if the amount remains unpaid beyond the second tax year of the borrower after the interest accrues, must also be considered.
Such borrowers and lenders will also have to consider whether to wait for U.S. ratification before beginning to withhold at the reduced rate, in the expectation that the Protocol comes into force in 2008. Reducing withholding now exposes the parties to interest and potential penalties if the Protocol does not come into force in time; not doing so means that if the Protocol comes into force in 2008 refunds will have to be sought from the Canada Revenue Agency (CRA), which would be the case anyway in respect of interest payments already made in 2008. Applications for refunds may be made no later than two years following the end of the year in which the withheld amounts were remitted to the CRA by filing an Application for Refund of Part XIII Tax Withheld form (NR7-R).
One important qualification on the withholding tax exemption with respect to Canadian source interest is that various types of participating interest will not be treated as interest for purposes of the Treaty, but will instead be subject to the Treaty rate of withholding tax of 15% (the rate that applies to portfolio dividends). The types of interest caught by this rule are interest "determined with reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, 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 made by the debtor or a related person." (The TE explains that the Protocol erroneously uses the word "to" rather than "or" but that Canada and the U.S. will apply the correct formulation.) With respect to U.S. source interest, there is a similar qualification that applies to contingent interest of a type that does not qualify as "portfolio interest" under U.S. domestic tax law. Under the Act, if all or any portion of interest paid is participating then the entire amount of interest is subject to Canadian withholding tax. The TE does not clarify whether the rate of withholding for participating interest applies only to the participating portion of the interest, although this appears to be the better reading of the Protocol.
The Protocol provides that guarantee fees paid cross-border to a recipient qualifying for Treaty benefits will not be subject to withholding tax effective at the beginning of the second month following the month in which the Protocol enters into force.
Because guarantee fees are deemed interest under the Act, some commentators have raised the question of whether payment of guarantee fees with respect to the guarantee of a debt obligation of a Canadian resident paid to related U.S. residents will be subject to the full elimination of withholding or the gradual reduction described above for related-party interest. While a reading of the wording in the Protocol suggests the former, the TE did nothing to clarify the point. In November of last year, Department of Finance officials indicated that full rather than gradual reduction will occur.
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.