Canada's Department of Finance and the U.S. Department of
the Treasury each announced the entry into force of the fifth
Protocol amending the Canada-U.S. Income Tax Convention (the
"Treaty") today. The Protocol which was first signed on
September 21, 2007 brings into effect a number of significant new
measures which will impact on cross border tax matters.
Today's announcement means that some of the changes to the
Treaty will have immediate effect (or even retroactive application
for 2008) while other changes to the Treaty are to be phased-in
over time based on today's entry into force. The following is a
brief description of some of the important changes to the Treaty
and the relevant dates when these changes will apply.
Withholding Taxes on Interest
In 2007, Canada introduced domestic legislation to eliminate the
withholding tax on interest payments made after December 31, 2007
except with respect to interest payments to non-arm's length or
related party lenders and with respect to interest that is computed
by reference to sales, income, profits or cash flow of the debtor
(so-called participating debt). As a result of the Protocol,
Article XI of the Treaty was amended to provide that interest paid
to related party lenders resident in the U.S. (other than
participating debt interest) will also be exempt from Canadian
withholding tax. This change will be phased-in, as follows. For
2008, the rate of withholding tax for related party lenders will be
reduced from the current Treaty rate of 10% to 7%. This means that
related party interest payments received by U.S. residents in 2008
that were subject to 10% Canadian withholding taxes prior to today
will be entitled to claim a refund for the 3% overpayment. The
applicable withholding tax rate for 2009 will be 4% and 0% for 2010
and beyond. The rest of the changes to Article XI (including the
participating debt exception that is somewhat narrower than the
exception provided for in the Income Tax Act (Canada) (the
"Act")) will have effect on February 1st,
Fiscally Transparent and Hybrid Entities
The fifth Protocol contains new rules which apply to fiscally
transparent and hybrid entities. These new rules are among the most
welcome amendments to the Treaty as well as the most controversial.
The changes which extend Treaty benefits to limited liability
companies will apply for taxable years that begin after 2008. For
U.S. resident shareholders of Canadian unlimited liability
corporations, the new rules will restrict the availability of
certain Treaty benefits as of January 1, 2010.
Amendments to the mutual agreement procedures in the Treaty
provided for in the Protocol are now effective. These changes
provide for mandatory arbitration in circumstances where the
competent authorities (the Canada Revenue Agency and the Internal
Revenue Service) have been unable to resolve a cross-border tax
issue; for example, disputes arising from transfer pricing
adjustments. Under these new rules, arbitration proceedings are
generally to begin two years after the information relating to the
dispute has been provided by the taxpayer to both competent
authorities, unless they have previously agreed to a different
date. This requirement will apply to cases already under
consideration by the competent authorities but with the two year
time period described above commencing today.
Limitation of Benefits
The expanded limitation of benefits provisions added to Article
XXIXA of the Treaty by the Protocol will have a significant impact
on cross-border tax matters by limiting the availability of Treaty
benefits to "qualifying persons". These amendments
reflect Canada's new approach to restricting treaty shopping
after failing to persuade the Canadian courts to do so by applying
existing provisions of the Act. These new restrictions will apply
after January 31, 2009 in respect of withholding taxes and will
apply to taxable years which begin after December 31, 2008 in
respect of other taxes.
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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