QuickCounsel

Fifth Protocol to the Canada-US Tax Treaty

Overview Elimination of Withholding Tax Fiscally Transparent Entities Other Hybrids Limitation on Benefits Additional Resources Rate this QuickCounsel

Overview

The Canada-United States Income Tax Convention (1980) (the "Treaty") recently underwent important changes with the entry into force of the Fifth Protocol (the "Protocol") in December of 2008. The wide ranging changes will affect many aspects of cross border transactions and commerce, as several of the conventional wisdoms will no longer apply. Some of the main changes applicable to cross-border transactions are described below.

Back to top

Elimination of Withholding Tax on Interest Payments

The Protocol amended the Treaty to eliminate source-country withholding tax on cross-border payments of interest. Subject to certain exemptions, interest arising in one country and beneficially owned by a resident of the other country will be taxable only in the other country. Certain types of interest will not benefit from the exemption, such as "participating" interest arising in Canada, and interest arising in the US that is contingent interest of a type that does not qualify as portfolio interest under US law. "Participating" interest is, generally, interest that represents a participation in the income or profits of the payor, and specifically includes any interest determined by reference to (i) income, profit or cash flow of the debtor (or a related person); (ii) a change in value of property of the debtor (or a related person) or (iii) to any dividend, partnership distribution or similar payment made by the debtor (or a related person). If interest is not exempt under these rules, if the beneficial owner of the interest is a resident in Canada or the United States, as the case may be, withholding tax at the rate applicable to dividends (15%) will apply.

This elimination of source-country withholding tax is effective retroactive to January 1, 2008 for interest paid to persons who are not "related" to the payor. The rate reductions are phased-in for interest paid to "related persons": retroactive to January 1, 2008, the withholding rate applicable to such interest is 7%, with a rate of 4% applying to interest paid in 2009. Thereafter, the full exemption will apply. A "related person" will include a person deemed under the Treaty to be related to another person, including a person who participates directly or indirectly in the management or control of the other person. Note that Canada recently amended its domestic tax rules to eliminate withholding taxes on most types of interest paid by Canadian residents to arm’s length persons, so the effect of the Protocol on Canadian withholding tax on arm’s length interest payments will be limited.

Back to top

Fiscally Transparent Entities

Limited liability companies ("LLCs") that are disregarded for US tax purposes have not, historically, been treated by the Canadian tax authorities as residents of the US for purposes of the Treaty and accordingly have not been entitled to Treaty benefits. The changes implemented by the Protocol do not go as far as treating an LLC as a US resident. Instead, the Protocol has introduced a look through rule. If, under US rules, a resident of the US derives income through a fiscally transparent entity that is not resident in Canada (such as an LLC), and because of the fiscal transparency the US resident has the same tax treatment as if the income were derived directly by the person, then for purposes of the Treaty the US resident is considered to have derived the income. Treaty benefits are therefore available to the US resident on the income so derived (subject to the limitations on benefits rules, discussed below). To obtain the benefit of this look-through rule it is not necessary that the fiscally transparent entity be formed under US law. The only restriction is that it is not a resident of Canada. Thus the look-through, and benefits under the Treaty, may be available with respect to a fiscally transparent entity formed under the law of a third country.

It should be noted however, that even when the Treaty would be available, it may be necessary to interpose a "blocker" entity resident in a third jurisdiction in order to reduce the information gathering and reporting obligations that would arise if treaty benefits were to be claimed by a number of US investors in a fiscally transparent entity. For example, in order to establish entitlement to lower Canadian withholding tax rates on interest or dividends, information will generally be required about the investors in the fiscally transparent entity. Private equity funds organized as LLCs are often precluded from disclosing information sufficient to demonstrate the treaty residence of the investors. Even if there is no express prohibition, the information may be difficult to gather, particularly where there are tiered LLCs or partnerships in the structure. Properly structured, the use of a blocker entity in another jurisdiction can maintain tax efficiency without triggering onerous compliance requirements. However, in the Technical Explanation to the Protocol, it is noted that the Canada Revenue Agency will treat the LLC as the only "visible" taxpayer, and will provide guidance for how an LLC is to establish entitlement to Treaty benefits. This guidance has not yet been released.

Back to top

Other Hybrids

The Protocol introduced an anti-hybrid rule that is intended to limit the benefit of certain cross border tax planning structures. The effect of the rule is to deny Treaty benefits to persons who receive amounts of income, profit or gain from certain hybrid entities, if the tax treatment of such amounts in the jurisdiction of the recipient is not the same as if the hybrid entity had not been used. This rule will apply, for example, to distributions to US residents by unlimited liability companies ("ULCs") formed under certain provincial corporate statutes (such as a Nova Scotia ULC or "NSULC"), where the ULC has "checked the box" so as to be a disregarded entity for US tax purposes. An amount of income, profit or gain paid by a ULC (including, for example, interest or dividends) to a US resident will no longer qualify for a reduced rate of withholding tax under the Treaty. Rather, the statutory withholding rate of 25% will apply to such amounts.

The rule will also affect the use of partnerships formed under Canadian law that have US resident partners and that elect to be treated for US tax purposes as a corporation. Currently, payments (for example, of interest) by a resident of Canada to such a partnership are subject to withholding tax at Treaty-reduced rates. The amended Treaty will deny Treaty benefits to such payments, with the result that the statutory rate of 25% will apply.

The anti-hybrid rules will also apply to certain outbound from Canada structures where, for example, a Canadian corporation is the member of an LLC that carries on business in the US.

These rules will not come into effect until January 1, 2010. Where cross-border hybrid structures exist, steps should be taken prior to year end to assess the impact of the Protocol and reorganize the structures where necessary.

These rules, which were intended to target certain financing structures which the Canadian government found offensive, will also impact the tax efficiency of inoffensive inbound to Canada acquisition or investment structures.

Back to top

Limitation on Benefits

The Protocol introduced Canada’s first reciprocal limitation on benefits ("LOB") provision by amending existing Article XXIX-A of the Treaty. The purpose of this provision is to limit or, in some cases, deny benefits under the Treaty to residents of non-contracting states who form entities in the US or Canada in order to obtain more favourable tax treatment under the Treaty (sometimes referred to as "treaty shopping"). Prior to this amendment, Canada had relied on its domestic anti-avoidance rules to combat perceived abuses of treaty shopping. The LOB provision is generally effective for taxable years that begin after 2008. The new LOB provisions can give rise to anomalous results, and can require additional due diligence to determine entitlement to Treaty benefits.

Back to top

ADDITIONAL RESOURCES

Government Sources

Sponsor Resources

Back to top

Have an idea for a quick counsel or interested in writing one?

• Email ACC at quickcounsel@acc.com or call +1 202.293.4103 ex 341 with your ideas and inquiries.

Back to top