Canada: Technical Explanation To Protocol Offers Limited Guidance On Limitation On Benefits

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, July 2008


Under prevailing U.S. tax treaty policy, newly negotiated or renegotiated U.S. tax treaties must contain "limitation on benefits" (LOB) rules. Such rules are intended to prevent perceived "treaty shopping" by residents of third countries by requiring a person to meet not only a test of residence, but also additional tests of connection to a jurisdiction, in order to qualify for benefits pursuant to a tax treaty. LOB rules were added to the Canada-United States Income Tax Convention (the Treaty) by the protocol signed in 1995, but these rules operated solely with respect to U.S. Treaty benefits. Canada's approach to perceived treaty shopping has consistently been to reject bright-line rules in favour of domestic anti-abuse provisions such as the general anti-avoidance rule (GAAR).

In an abrupt and unprecedented change of course, Canada agreed to make the LOB rules in the Treaty bilateral when it signed the Fifth Protocol to the Treaty (the Protocol).

In the Protocol, few modifications were made to the specific language of the LOB rules to reflect the fact that these rules would now operate on a bilateral basis. The language essentially is a carryover from the 1995 version with no wholesale overhaul of the rules to reflect advances in U.S. treaty policy since 1995. While the rules do in some instances establish reasonable "filters" for treaty shopping, in other instances, they dramatically overshoot the policy objective by denying treaty benefits even where it is clear there is no treaty shopping issue.

Furthermore, in the Protocol, there was no adaptation of the LOB rules to reflect the different Canadian domestic tax environment. At least three major issues were left unaddressed:

  1. The fact that the Income Tax Act (Canada) (the Act) generally taxes non-residents on capital gains from dispositions of non-real-property assets such as shares of Canadian private operating companies. Under the LOB rules, as drafted, it appears that a foreign controlled U.S. company will become subject to Canadian capital gains tax on dispositions of shares of private Canadian non-real-estate companies. This would be the case even if the U.S. company is controlled by a resident of a country with which Canada has a tax treaty providing for capital gains relief.

  2. The LOB rules fail to acknowledge Canada's different approach to entity classification, particularly its differing view of certain kinds of fiscally transparent entities such as limited liability companies (LLCs). As drafted, the LOB rules in the Protocol would deny full Treaty benefits to U.S. companies with one or more LLCs in their chain of ownership.

  3. It is understood that the "active conduct of a trade or business" exception is construed broadly under U.S. tax principles. In Canada, there may be some jurisprudential impediments to a broad construction of this exception.

It was hoped that the Technical Explanation (TE) to the Protocol might address some of these anomalies.

While the TE does solve some of the problems related to fiscally transparent entities, it does not address other problems with the LOB rules. Unless further interpretive guidance is provided by the Canada Revenue Agency (CRA), the CRA will likely receive a large number of requests for discretionary competent authority relief and may lack the administrative capacity to address such requests on a timely basis.

In the remainder of this article, we discuss the main areas of controversy with the LOB rules, and the extent to which these matters are addressed in the TE, and certain interpretive issues addressed in the TE.


Under the LOB rules, full eligibility for Treaty benefits is available only to U.S. residents (as defined in the Treaty) who are "qualifying persons" (as defined in the LOB rules).

Qualifying persons include natural persons, certain public companies (and their subsidiaries), private companies that meet an ownership and base erosion test, governmental entities, and certain pension funds, estates and not-for-profit entities.

Public Companies

A qualifying person generally includes a company whose "principal class of shares" is "primarily and regularly traded" on one or more "recognized stock exchanges." If the company has issued any tracking shares (which track a particular asset or business), those shares must also meet these tests.

The term "principal class of shares" of a company is defined in the LOB rules to mean the ordinary or common shares of the company, provided that such class of shares represents the majority of voting power and value of the company. If the company does not have such a class of shares, the "principal class of shares" is that class or any combination of classes of shares that represents, in aggregate, a majority of voting power and value. The TE indicates that in a case where a company has more than one group of classes of shares that could be identified as accounting for more than 50% of voting power and value, it is only necessary for one such group to satisfy the "primarily and regularly traded" requirement.

The terms "regularly traded" and "primarily traded" are not defined in the Protocol. Normally, where a term is not defined in the Treaty, it has the meaning ascribed to it under the laws of the country whose taxes are in issue (normally the source country) pursuant to paragraph 2 of Article III of the Treaty and, in Canada, as provided under section 3 of the Income Tax Conventions Interpretation Act. The TE affirms that paragraph 2 of Article III applies to these terms. However, while each of these terms is defined by U.S. law, neither such term is defined under Canadian law. If and when Canada adopts a domestic meaning of these terms, either by statute or through jurisprudence, then that meaning will govern. Until that time, however, the TE indicates that Canada will import the U.S. meaning of these terms and that such U.S. meaning "will be considered to apply, with such modifications as circumstances require."

According to the TE, the relevant U.S. regulations provide that for shares to be considered "regularly traded," material trades must be made on at least 60 days in the relevant taxable year and the total number of shares traded must be at least 10% of the average number of shares outstanding during the year. Shares will be considered "primarily traded" on an exchange if the number of shares in the company's principal class that are traded on recognized exchanges exceeds the number traded on other established securities markets.

Under these rules, some thinly traded companies will fail the public company test because their shares will not be considered regularly traded. As well, companies whose shares are listed on both a North American and European exchange will fail to qualify if more shares are traded on the European exchange (which is not considered a recognized exchange for this purpose) rather than on the North American exchange.

Subsidiaries Of Public Companies

Subsidiaries of public companies also qualify as qualifying persons if more than 50% of the vote and value of all shares of the subsidiary are owned, directly or indirectly, by five or fewer persons each of which meets the public company test. In addition, each entity in the chain of ownership must itself be a qualifying person.

On its face, the latter requirement effectively disqualifies all public company subsidiaries that are owned through a chain that includes one or more LLCs. This is because, under Canadian principles, LLCs are regarded as corporations, whether or not they are fiscally transparent for U.S. tax purposes. As fiscally transparent LLCs are not liable to tax in their own right however, they are not regarded as residents of the U.S., and therefore cannot themselves be qualifying persons. The TE makes it clear that the mere inclusion of a fiscally transparent LLC in the chain of ownership will not create a problem in meeting this test. The TE states:

"By applying the principles introduced by the Protocol (e.g., paragraph 6 of Article IV) in the context of this rule, one 'looks through' entities in the chain of ownership that are viewed as fiscally transparent under the domestic laws of the State of residence (other than entities that are resident in the State of source)."

This is a welcome statement, and its intent appears clear so far as it applies to a typical ownership structure involving LLCs in the chain of ownership. It seems that the reference to "the principles" of paragraph 6 of Article IV is intended to mean that in applying the ownership test, Canada will look through an LLC if it is fiscally transparent under U.S. law, even if its members do not derive any amounts from sources in Canada. While Canada continues to generally view an LLC as a corporation, and not as a resident of the U.S. (unless it has elected to be taxed as a U.S. corporation), it appears that the TE effectively overrides this view for the limited purpose of determining whether the ownership test in the LOB rules is met.

Private Companies

A private company is a qualifying person provided that it meets both an ownership test and a "base erosion" test.

Ownership Test

A private company will meet the ownership test if 50% or more of the aggregate vote and value of its shares is not owned, directly or indirectly, by non-qualifying persons. If the company has issued any tracking shares (which track a particular asset or business), those shares must also meet these tests.

The TE states again in this context that the look-through principles introduced by paragraph 6 of Article IV are to be taken into account when applying the ownership and base erosion tests:

"Therefore, one 'looks through' an entity that is viewed as fiscally transparent under the domestic laws of the residence State (other than entities that are resident in the source State) when applying the ownership/base erosion test."

It seems clear that Canada intends that in applying the ownership test, fiscally transparent LLCs are looked through. The TE refers to the example of a U.S. corporation owned by an LLC. If the LLC is owned by 10 U.S. resident individuals, the U.S. corporation meets the ownership test. The LLC is "looked through." This changes the result otherwise obtained by application of normal Canadian principles, which treat the LLC as a corporation and not a U.S. resident. The TE also states that if instead the LLC is owned by 10 individuals, six of whom are not residents of the U.S., then the U.S. corporation will not meet the ownership test. This is the same result as would have been obtained had the LLC not been in the chain of ownership, though it differs materially and adversely from the result obtained if the individuals in question directly held the Canadian investment.

Base Erosion Test

A private company that meets the ownership test must also satisfy a base erosion test. Specifically, the amount of expenses deductible from gross income that are paid or payable, directly or indirectly, to non-qualifying persons must be less than 50% of the company's gross income. The base erosion test effectively requires not only majority U.S. ownership of a U.S. entity, but also that the recipients of significant deductible amounts, directly or indirectly, from the U.S. entity must also be U.S. residents that are themselves qualifying persons. Thus, for example, an otherwise qualifying U.S. private company will fail the base erosion test if it is highly leveraged (or is a licensee of intellectual property) and pays significant amounts of deductible interest (or royalties) to non-U.S. lenders (or licensors). The fact that the recipients of these amounts may be residents of third countries with which Canada has comprehensive tax treaties will not affect the analysis.

It had been hoped that the TE might provide guidance on the meaning of the "directly or indirectly" language. While it may be very difficult (and in some cases impossible) for a U.S. entity to confirm that the payee of interest or royalties is a qualifying person, it is almost invariably impossible to confirm that the payee is not paying the amount in question to a third entity that is not a qualifying person. For example, if a U.S. entity pays royalties to an arm's-length U.S. licensor, even if it could be confirmed that such U.S. licensor is a qualifying person, it is entirely unrealistic to expect the payor to be able to confirm that the licensor does not pay such amounts to another non-U.S. entity. It had been hoped that the TE might clarify that the "directly or indirectly" language was intended to deal only with non-arm's-length situations or other situations where the payor knows or ought reasonably to know that the amounts in question are being paid on to a non-qualifying person.

The TE does state that where the payee of a deductible amount is itself a fiscally transparent LLC, then that payee is looked through, again applying the principles of paragraph 6 of Article IV.

One can expect many situations to arise in which U.S. companies will be unable to affirmatively conclude that they qualify under the base erosion test. Companies with existing debt or licensing arrangements will not have obtained representations from lenders/licensors regarding their status, let alone that of any third parties to whom they themselves make payments. No grandfathering is provided for situations such as long-term loans or licenses that were entered into before announcement of the Protocol. Furthermore, even prospectively, it is not realistic to expect many private U.S. entities to be able to be certain that the base erosion test, particularly insofar as it refers to "indirect" payments, has been met. No doubt, this will result in large numbers of requests for discretionary competent authority relief in situations where there is no treaty shopping motive, but it cannot be confirmed that the LOB rules have been met.

General Comments On The Qualifying Person Test

The TE states that the LOB rules are self-executing, though it notes that the tax authorities may, on review, determine that a taxpayer has improperly interpreted the paragraph and is not entitled to the benefits claimed. In addition to the impact on establishing structures that are intended to be eligible for Treaty benefits, this also raises issues for Canadian residents making payments to U.S. residents that may be subject to Canadian withholding tax depending on whether Treaty benefits are available.

At the 2008 International Fiscal Association Canadian branch conference, representatives of the CRA indicated that the CRA is reviewing procedures that can be applied by such a payer, including the potential of creating a new form (comparable to the U.S. W8-BEN form) to supplement existing diligence requirements.


Limited Treaty benefits are available to a person who is not a qualifying person if a test related to the conduct of an active trade or business is met. If a U.S. resident or a related person is engaged in the active conduct of a business in the U.S., then Treaty benefits are available with respect to income derived from Canada that is "in connection with or incidental to" that trade or business. Specifically excluded is income from a business of making or managing investments, except where the entity in question is a financial institution, such as a bank, securities dealer or deposit-taking institution.

Since the release of the Protocol, there has been much speculation as to the approach to be taken by Canada to this test. For example, it is not clear whether Canada would consider a U.S. resident to have derived income in connection with an active business if the income consists of interest or dividends paid by a Canadian active business company to a U.S. active business company, or gains from the disposition of shares of the Canadian company. Canada may instead take the view that such items of income as interest and dividends constitute passive property income, despite the fact they were sourced from active earnings. It is understood that the U.S. view has been somewhat broader than Canadian jurisprudence would suggest. Commentators hoped the TE would clarify the Canadian approach.

The statements in the TE, while generally indicative of a broad approach, are somewhat disappointing in their lack of clear guidance. The TE essentially restates the provisions of the technical explanation to the 1995 protocol, but does not expressly state that Canada will adopt the broader U.S. approach for purposes of the LOB rules. This is of particular concern given that in other sections of the LOB rules, the TE does expressly state that Canada will adopt the U.S. interpretation.

According to the TE, income is considered derived "in connection" with an active trade or business if, for example, the income generating activity in the U.S. is "upstream," "downstream" or "parallel" to that conducted in Canada. Thus, for example, if the Canadian activity of a U.S. resident company consisted of selling the output of a U.S. manufacturer or providing inputs to the manufacturing process, or of manufacturing or selling in Canada the same sorts of products that were being sold by the U.S. trade or business in the U.S., the income generated by that activity would be treated as earned in connection with the Canadian trade or business. Income is considered "incidental" to trade or business if, for example, it arises from the short-term investment of working capital of the U.S. resident in securities issued by persons in Canada.

The TE also explains that the "directly or indirectly" language would allow a Canadian resident to claim benefits with respect to an item of income earned by a U.S. operating subsidiary but derived by the Canadian resident indirectly through a wholly owned U.S. holding company and would also permit a resident to derive income from the other Contracting State through one or more residents in that state that it does not wholly own.

This helpful language seems to imply that interest or dividends paid by a Canadian active business company to a U.S. active business company would be income derived in connection with an active business. However, in view of the general Canadian approach to these matters, a clearer statement to this effect would have been welcome.

Furthermore, there is no clear statement in the TE that lends explicit support to the proposition that a gain realized by a U.S. active business company from selling shares of a Canadian active business company might also be active income. While such an argument could be made in some cases, the TE does not specifically assist in this regard. In the absence of clarification on this point, it seems likely that where a foreign-controlled U.S. company sells shares of a Canadian company, the gain will be taxed in Canada. This will occur even if the U.S. company is owned by residents of a third country with which Canada has a tax treaty that includes a capital gains exemption. Such a result was likely unanticipated and will no doubt result in significant requests for competent authority relief if no further guidance is provided.


If a U.S. company is not a qualifying person, that company may also qualify for Treaty benefits in respect of interest, dividends and royalties received by it if it is owned to a sufficiently significant extent by one or more residents of another country with which Canada has a comprehensive tax treaty. The theory underlying this "derivative benefits" rule is that treaty shopping is not likely to have motivated a structure where the owners of a U.S. company are themselves U.S. qualifying persons and/or residents of such a third country who could have accessed the same treaty rates opposite Canada had they invested directly into Canada rather than through the U.S. In order to qualify under the derivative benefits rule, the U.S. company must also satisfy the same base erosion test as applies to other U.S. private companies.

For a U.S. company to qualify under the derivative benefits rule, more than 90% of the votes and value of all issued shares must be owned by persons each of whom is either a qualifying person or a person:

  1. that is a resident of a third country with which Canada has a comprehensive income tax treaty;

  2. that would meet the qualifying person test if it were a U.S. resident; and

  3. that would be entitled to a tax rate under the applicable treaty between Canada and the third country that, for the applicable type of income, is at least as low as the rate in the Treaty.

The importation of a hypothetical LOB in requirement (ii) above, while perfectly understandable in the U.S. treaty context, is somewhat odd from a Canadian perspective, as no other Canadian treaties currently have LOB rules of this nature. The TE provides an example of a third-country (perhaps U.K.) public company, and states that the shares of that company would have to be primarily and regularly traded on a stock exchange recognized under the Treaty (i.e., a North American exchange) or under the treaty between Canada and the third country. However, the treaty between Canada and the U.K. (and other countries) does not provide for the concept of a recognized exchange, so it is not clear how to apply this test.

Furthermore, it is even less clear how to apply this rule if the potential equivalent beneficiary is a private company. Under the Canada-U.K. Tax Treaty., ownership of a U.K. company that qualifies as a resident is not relevant in determining whether the U.K. company is entitled to treaty benefits. Presumably, the requirement in (ii) above is meant to import an ownership test into that treaty, effectively requiring majority U.K. ownership of the U.K. company in question. Apart from the difficulty in reaching that conclusion on the words of the Protocol, it is entirely unclear why, from a tax policy point of view, Canada would require such an ownership test to be met when there is no such test in the Canada-U.K. Tax Treaty. Clarification of this aspect of the derivative benefits rule would have been welcome, but unfortunately is missing from the TE.

The "at least as low" test raises a number of questions that are not addressed in the TE. The rule is a "binary" rule – it either applies or it does not, and where it does not, domestic statutory withholding rates (25% in Canada) apply. This effectively penalizes residents of a particular country if the treaty rate between such country and Canada is not as low as the rate negotiated between Canada and the U.S. for a particular type of income. For example, if a U.K. entity earns income from trade-mark royalties through a U.S. subsidiary, the derivative benefits rule may be of assistance, since the applicable rate under the Canada-U.K. Tax Treaty (10%) is as low as that under the Treaty (also 10%); if the U.K. rate had happened to be 15% (which is not as low as 10%), then 25% withholding would have applied. As this is inherent in the derivative benefits rule itself, one could not have expected the TE to make much of a difference with respect to this issue.

Moreover, it is unclear how to apply the "at least as low" test with respect to dividends. Under the Treaty, the withholding rate on dividends is generally 15%, but a 5% rate applies to dividends beneficially owned by a company that owns at least 10% of the voting stock of the payor. Many of Canada's other treaties similarly apply a two-tiered treaty reduced rate on dividends, although in some instances, the ownership of the Canadian company's shares can be "indirect."

One question this raises is whether the third country equivalent beneficiary is treated as actually owning all (or some portion) of the shares of the Canadian company owned by the U.S. entity that is the actual recipient of the dividend. Another question concerns which rates to compare when the equivalent beneficiary is an individual who, if in direct receipt of the dividend, would have been subject to the 15% rate, but who owns shares of a U.S. company that itself owns more than 10% of the voting stock of the Canadian dividend payor. The 15% rate hypothetically applicable to the equivalent beneficiary is of course not as low as 5%, yet it would seem inappropriate for the statutory 25% rate to apply in such a case. It is understood that in other cases, the U.S. authorities have provided guidance on the application of similar rules. Such guidance would have been welcome, but unfortunately was not included in the TE.

For reasons that are not entirely clear, the derivative benefits rule applies only to reduce withholding tax on dividends, interest and royalties. It does not apply to other income such as business profits or to gains. This is out of step with many modern U.S. treaties, which instead provide generally for full eligibility under their derivative benefits rules and only apply the "at least as low" requirement with respect to dividends, interest and royalties. The exclusion of profits and gain from the derivative benefits rule in the Protocol is of particular concern in view of Canada's broad taxation of gains, and will have negative repercussions for third-country owned U.S. companies even where they do qualify for the derivative benefits rule.

Consider, for example, a U.K. parent that owns a Canadian active business company through a U.S. holding company. The U.S. company will not be a qualifying person and the derivative benefits rule will not protect it from Canadian tax on gains. The U.S. company will be taxable in Canada on any gain from disposing of the Canadian shares, even though no tax would have been payable had the U.K. parent held the Canadian shares directly. The failure to extend the derivative benefits rule to gains is a major shortcoming of the Protocol. It will no doubt lead to significant and clearly meritorious requests for competent authority relief or, in some cases, the use of blocker companies in third countries. Alternatively, it is possible the two governments may negotiate a sixth protocol to address this and other matters.


A person that is not eligible for the benefits of the Treaty may apply to the competent authority (the CRA, in the case of Canada) to determine on the basis of all relevant factors whether (a) its creation and existence did not have as a principal purpose the obtaining of benefits under the Treaty that would not otherwise be available or (b) it would not be appropriate, having regard to the purposes of the LOB rules, to deny Treaty benefits. If the CRA determines that either (a) or (b) applies to a particular U.S. resident, such person will be granted the full benefits of the Treaty.

The TE explains that the determination of whether a resident of the U.S. is entitled to the benefits of the Treaty can be made with respect to all benefits under the Treaty or on an item-by-item basis.

Taxpayers appear to have an absolute right to be heard by the competent authority with respect to a request for discretionary relief from an LOB. The TE adds that a taxpayer will not need to wait until benefits are denied under a specific LOB rule before applying for competent authority relief, and that if Treaty benefits are determined to be available, they may be granted retroactively. Unfortunately, there is no suggestion of any requirement for a timely response from the competent authority and it is difficult to imagine parties proceeding to complete a transaction where Treaty benefits are critical if the determination as to whether such benefits will be granted is to be made at a later date. As a result, the TE fails to provide material comfort that competent authority determinations will be of much practical assistance in many cases.


Despite Canada's dramatic about-face on the LOB rule, the Contracting States decided to leave the general paragraph in Article XXIX A providing for the denial of Treaty benefits to prevent abuse of the provision of the Treaty intact (subject to minor changes to reflect the fact that the LOB provision is now reciprocal).

The TE confirms Canada's view that it may still apply its domestic rules to counter "abusive" arrangements involving treaty shopping through the U.S., citing the principle from the Commentary to the OECD Model Tax Convention. It is suggested, however, that Canadian courts would be extremely unlikely to apply Canadian domestic law rules, and in particular GAAR, to deny Treaty benefits where a taxpayer has satisfied the LOB rules in the Protocol. To date, CRA has not been successful in its attempts to apply GAAR in the treaty context.

Moreover, the very presence of LOB rules further undermines any attempt by the CRA to apply GAAR to allegedly "abusive" situations.

In the TE, it is stated that the inclusion of this provision in the Protocol is not intended to suggest that the principle is not inherent in other tax treaties. One suspects that this wording was included at Canada's behest to assist it in countering suggestions by taxpayers to the contrary. It remains to be seen whether in fact this statement of intent will find favour with the Canadian courts.

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.

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    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.

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