Amendments to the Canada-US Tax Treaty

The fifth Protocol to the Canada-US Income Tax Convention was signed on September 21, 2007, and is anticipated to come into force in early 2008. With certain exceptions, the amendments will take effect for taxable years commencing after the calendar year in which the Protocol comes into force.

Elimination of withholding taxes on interest

Withholding tax on interest paid between Canadian and US residents will be eliminated. For arms-length interest, the change will be effective for amounts paid or credited on the first day of the second month after the month in which the Protocol comes into force.  

There will be a phased-in elimination for interest between related persons, from the current rate of 10%, to 7% for amounts paid after the date on which the withholding changes become effective and before the end of that calendar year (presumably 2008), 4% in the following year, and 0% thereafter.

Draft legislation has been released to amend the Canadian Income Tax Act, eliminating withholding tax on interest paid to arms-length non-residents, regardless of their country of residence. These provisions will be effective concurrent with the treaty withholding tax changes.   

The Protocol also eliminates withholding taxes on guarantee fees, which are presently treated as interest for withholding tax purposes.  

Withholding taxes on dividends

The Protocol does not propose to reduce the treaty withholding rates on dividends, which will continue to be 15% generally, and 5% for corporate shareholders who hold at least 10% of the voting shares of the dividend payor. However, the Protocol introduces rules to look through certain "fiscally transparent" entities, including partnerships, to determine if a particular partner/owner meets the 10% ownership threshold for the 5% withholding rate. This will allow corporate partners, for example, to obtain the lower withholding rate if their proportion of the voting shares owned by the partnership is at least 10%. 

The Protocol will extend the 15% treaty withholding tax on distributions by US-based Real Estate Investment Trusts (REITs), presently restricted to individuals owning less than 10% of the REIT, to other persons, including corporations, that are below certain   ownership thresholds. 
    
Withholding taxes on royalties and real estate rentals

Withholding taxes on royalties will continue to be limited to 10% under the treaty, except those royalties that are exempt from withholding entirely. Withholding tax will continue to apply to real property rentals (see accompanying article in this issue of Tax Alert).

Expansion of definition of permanent establishment for service providers

Business profits earned on the other side of the border generally are taxable under the treaty only where they are connected with a permanent establishment of the taxpayer in the other country. The Protocol expands the definition of permanent establishment to cast a wider net over certain cross-border service providers. A taxpayer resident in one country will be considered to have a permanent establishment in situations where services are provided in the other country in respect of the same, or a connected, project for 183 days or more in any 12-month period, and are provided either to a resident of that other country or in respect of a permanent establishment of another person not resident in that other country. It will also catch enterprises that provide services through an individual who is present in the other country for 183 days or more in any 12-month period, if more than 50% of the enterprise's gross active business income during that period is derived from those services. These rules will apply to the third taxable year commencing after the Protocol comes into force, but in any case exclude service days and revenues arising prior to January 1, 2010.     

Stock option sourcing rules

The Protocol removes uncertainty over sourcing of stock option benefits. Where an option is granted in one country and the employee subsequently works for the same or a related employer in the other country, the benefit will be allocated between the countries based on the proportion of time between the grant date and the exercise date that is spent at the principal place of employment in each country.       

Deduction of pension contributions

The Protocol introduces rules to allow employees crossing the border, but continuing to participate in a pension plan in the original country, to deduct plan contributions for both Canadian and US tax purposes. The changes will affect those who relocate on a short-term basis (5 years or less),commuters who work and make pension contributions cross-border, and US citizens residing in Canada. 

Relief from double-taxation of pre-emigration gains

The Protocol provides that, where an individual moves between the two countries and is deemed to dispose of property in one country at the time of emigration, the individual may elect in the other country to be deemed to have disposed of, and to have re-acquired, the property at its fair market value immediately prior to the date of emigration. Ordinarily, the election will not result in any tax in the second country, and will provide an increased cost base for determining gains on future dispositions.

US Limited Liability Corporations

LLCs are usually treated as flow-through entities for US tax purposes, but are generally considered to be foreign corporations for Canadian tax purposes. The Canada Revenue Agency takes the view that LLCs are denied many of the benefits under the present treaty, causing a number of problems:  

• If the "mind and management" of an LLC reside in Canada, the LLC could be found to be a Canadian resident under common law and subject to Canadian tax on its worldwide income. For other corporations, the treaty provides relief by deeming a corporation to be resident where it is incorporated.
• Where US LLCs carry on business in Canada, Canadian income tax could be assessed on business profits even where the LLC has no permanent establishment in Canada. 
• Dividends received by an LLC from a Canadian corporation would not qualify for reduced rates of withholding tax under the treaty that ordinarily apply to US residents.

The Protocol has addressed the issue of withholding tax by providing rules on sourcing of income that are designed to have the members of the LLC, rather than the LLC itself, report the income for Canadian tax purposes. Further guidance from the federal government will be required as to the mechanics of this relief in specific fact situations. Unfortunately, the Protocol does not include general recognitions that LLCs are US residents, and therefore it will continue to be important to avoid inadvertently establishing common-law residence of an LLC in Canada (for example, by having a majority of LLC directors resident in Canada).

Hybrid entities

Many cross-border structures are devised to take advantage of the fact that certain entities can be classified as flow-through in one country, and non-flow-through in the other. For example, a partnership may elect to be treated as a corporation for US tax purposes, but remain a flow-through entity to its partners for Canadian tax purposes. The Canadian government considers some of the tax advantages created under these structures to be inappropriate, and the Protocol now adds provisions that seek to limit those benefits, effective the first day of the third calendar year ending after the Protocol comes into force. The effect of the changes will need to be evaluated for all cross-border structures involving such entities, not just those the government was targeting. 

One unexpected change adversely affects Unlimited Liability Companies. ULCs are commonly used by US residents to invest in Canada since they can be treated as partnerships, or as "disregarded entities," for US tax purposes. The Protocol will deny the reduced rate of treaty withholding on dividends paid by such entities to US residents, boosting the withholding rate to 25% from the 5-15% that applies presently. The rate on interest paid to non-arms-length US residents by ULCs will also increase to 25%, versus the 0% (after phase-in) that will apply to interest payments by other corporations. Arms-length interest paid by ULCs will not be subject to withholding, due to the Canadian domestic amendments described above.    

The Protocol includes various other changes that will affect cross-border planning. Please contact your Collins Barrow tax advisor for more information.   

Dean Woodward and Brian McColl are tax partners in Collins Barrow's Calgary office