Canada: New Protocol To The Canada-U.S. Income Tax Convention

The Honourable Jim Flaherty, Minister of Finance, and Henry M. Paulson, Jr., U.S. Secretary of the Treasury, have signed the Fifth Protocol (the "Protocol") to the Canada-U.S. Tax Convention (the "Convention") on September 21, 2007. The Protocol has taken approximately ten years to negotiate and provides many benefits for both Canadians and Americans.

We would like to highlight certain of the important changes introduced by the Protocol. Our in-depth analysis of the Protocol and the implications in respect of cross-border transactions will be forwarded by email in the near future.

The current Convention generally reduces withholding tax on interest to 10%.

The Protocol will eliminate withholding tax on interest paid between unrelated (arm’s length) persons as of the second month after the Protocol enters into force. For interest paid between related persons (e.g. a subsidiary and its parent) there will be a full exemption as of the third year after entry into force. For the first and second years after entry into force, the source country tax rate is reduced from 10% to 7% and 4%, respectively. The Protocol provides that the withholding rates applicable to interest will not extend to (i) interest arising in the U.S. that is contingent interest of a type that does not qualify as portfolio interest under U.S. law, and (ii) interest arising in Canada that is determined by reference to receipts, sales, income or other cash flow of the debtor or a related person, changes in the value of property of the debtor or a related person, or to certain distributions made by the debtor to a related person. Such interest will instead be subject to a 15% withholding tax rate.

The current Convention does not provide any rules regarding the treatment of "hybrid" entities, such as LLCs, that are treated as corporations under the laws of one country but are treated as fiscally transparent in the other country. The Canada Revenue Agency had taken the position that a fiscally transparent LLC would not be entitled to benefits under the current Convention.

The Protocol provides that income earned through an LLC by a person who is a resident of the U.S. for purposes of the Convention will be treated by Canada as having been earned directly by that person provided the person is taxed on the amount in the same way as if the income had been derived directly. In this case, such persons will be entitled to the reduced rates of withholding tax under the Convention.

Additional important changes in the Protocol:

• Certain key double tax issues, such as transfer pricing, may be settled through binding arbitration;
• Double taxation on emigrants’ gains will be eliminated by providing for a step-up in the tax cost of property in certain cases;
• There will be mutual tax recognition of pension contributions; and
• The tax treatment will be clarified for stock options granted to employees while working in one country but who exercise or dispose of the options while working in the other country.

The Protocol must be ratified in both Canada and the U.S. in accordance with applicable procedures. Canada and the U.S. will give each other notice once its applicable procedures are satisfied. The Protocol enters into force on the date that is (i) the later of the notifications of ratification, or (ii) January 1, 2008, whichever is later.

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.