On September 23, 2008, the United States Senate, by unanimous consent, approved the Fifth Canada-U.S. Protocol (the Protocol) to the Income Tax Convention between Canada and the U.S. (the Treaty). This approval represents the final hurdle for the Protocol in the ratification process as Canada has already ratified the Protocol with Bill S-2 receiving royal assent on December 14, 2007. The concluding steps in the ratification process are the signature by the President and the exchange of instruments between Canada and the U.S., which is anticipated to occur prior to the end of the year.
See the Fall 2007 issue of Tax Alert for our discussion of the Treaty amendments following the release of the Protocol provisions on September 21, 2007.
Notably, the provisions of the Protocol come into force on the date that notification instruments are exchanged. However, there are many exceptions as to the coming into force for many of the Protocol's significant provisions. With the expected exchange to occur on or before December 31, 2008, the following Protocol provisions will come into force on the following dates:
On July 10, 2008, the U.S. Treasury department, in connection with the U.S. Senate Foreign Relations Committee, issued a technical explanation on the Protocol, as did the U.S. Joint Committee on Taxation. The technical explanations serve as a paper of mutual understanding between both countries as Canada had the opportunity to review and comment. This article will shed some renewed light on the above provisions and the impact associated with their coming into force.
Treatment of hybrid entities (LLCs, S-Corps, ULCs)
The U.S. members of a Limited Liability Corporation ("LLC") will be eligible to claim treaty benefits on amounts received or realized by the LLC. The LLC would be required to file a tax return and other documentation to support the claim.
U.S. S-Corporations will be treated as "fiscally transparent entities" for U.S. tax purposes but will be recognized by Canada as entities that may claim treaty benefits.
Unlimited Liability Corporation ("ULC") payments of dividends or other payments to a U.S. parent or resident will not be entitled to treaty benefits, thus increasing the withholding amount of dividends from 5-15% to 25%. This is probably the most contentious issue for U.S. companies carrying on business in Canada through ULCs.
There may be a need for restructuring before the treaty benefit denial rules come into effect at the earliest date of January 1, 2010. There are alternatives to this structure that can be implemented to address this situation. Your Collins Barrow advisor can elaborate on these alternatives.
Limitation on benefits
The existing limitation on benefits is currently applicable for U.S. tax purposes. However, with the coming into force of the Protocol, the article will be applicable for Canadian tax purposes.
Central to the application of the limitation on benefits is the definition of the term "qualifying person." In order to receive treaty benefits, a person must be a "qualifying person.' The tests for determining a "qualifying person" can be rigorous and go beyond the scope of just the residency of the person or entity. This provision of the Protocol is expected to come into force on January 1, 2009 at the earliest. It contains an array of defined terms that have for the most part been provided for in the technical explanations, but can have significant impact on treaty benefits if a person or entity is found not to be a "qualifying person."
Permanent establishments
The Protocol adds new rules affecting the services provided by enterprises in the other contracting country. Briefly stated, those rules provide that an enterprise will be deemed to have a permanent establishment in the other country if it provides services in the other country and:
- the services are performed in the other country by an individual who is present in the other country for a cumulative total of 183 days or more in any 12-month period, and during that 12-month period more than 50% of the gross active business revenue consists of income derived from the services performed in the other country by the individual; or
- the services are provided in the other country for an aggregate of 183 days or more in any 12-month period with respect to the same or a connected project for customers resident in, or permanent establishments situated in, that other country.
These new rules, which are expected to apply as early as January 1, 2010, will have a major impact on businesses that provide cross-border services. There may need to be drastic changes from a logistical and administrative standpoint, along with continued monitoring of projects and personnel to avoid a default in the 183-day test.
Withholding tax - interest and guarantee fees
Under the provisions of the Protocol, withholding tax on interest, other than contingent interest, paid between related parties resident in Canada and the U.S. will be reduced as per the table above. Note that unrelated interest payments made from Canadian entities to non-residents are exempt from withholding tax through Canadian tax legislation with an effective date of January 1, 2008.
With the expected ratification process to be completed before the end of the year, many taxpayers have overpaid on their withholdings because of the potential retroactive treatment. Those taxpayers will be interested in receiving a refund on the overpayments and may also be interested in the treatment of retroactive payments in financial statement presentation.
If you do any business in the U.S., contact your Collins Barrow advisor to better understand how the Protocol may affect you.
Scott M. Rasenberg is a Senior Tax Manager in the Waterloo office of Collins Barrow.
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