By way of background, the “Fifth Protocol” is a protocol to amend the Canada-U.S. Tax Convention (the “Treaty”). It was signed by representatives of both countries on September 21, 2007. While Canada has concluded all of its internal steps necessary to ratify the Protocol, the U.S. must still do so. As part of the American process, the U.S. Joint Committee on Taxation furnished the Senate Committee on Foreign Relations with its Explanation (the “JC Explanation”) on July 8, 2008 and on July 10, 2008 the U.S. Department of the Treasury released its Technical Explanation of the Fifth Protocol (the “Technical Explanation”). Also on July 10, 2008, the Minister of Finance (Canada) indicated Canada’s agreement with the Technical Explanation.

Both the Technical Explanation and the JC Explanation go into some detail regarding “hybrid entities”, which will be of concern to those who invest in Canada from or through the U.S. These hybrid entities are treated as fiscally transparent entities pursuant to the tax laws of the payment recipient’s country and as separately taxed entities pursuant to the tax laws of the country in which the hybrid entity is resident. For example, currently, U.S. limited liability companies (“LLCs”) are fiscally transparent in America but are treated and taxed as regular corporations in Canada. Similarly, Canadian unlimited liability companies (“ULCs”) are treated as corporations in Canada but recognized as fiscally transparent in America if they “check the box” to be treated as disregarded entities for purposes of U.S. tax.

It was thought that the Protocol would regularize the treatment of LLCs and ULCs under the Treaty. However it ended up creating further anomalies and there was some hope that the Technical Explanation might provide additional clarification. Unfortunately a number of issues which had been raised with respect to the Protocol were not addressed, especially as regards nonabusive cross-border structures.

Historically, the Canada Revenue Agency (“CRA”)’s position has been that an American LLC, which is a disregarded entity for U.S. tax purposes, cannot therefore be considered as resident in the U.S. and be entitled to the benefits of the Treaty. The Protocol contains a lookthrough rule which will treat Canadian income, dividends and interest as being earned by the members of the LLC. If the members are U.S. residents, they will be entitled to reduced Treaty withholding rates.

In trying to apply this aspect of the Protocol, certain commentators had raised concerns about the “same treatment test”, about S-Corporation withholding tax rates, about the continued tax filing obligations of the LLC (notwithstanding that its members derive the income), about the determination of “beneficial ownership” regarding interest and dividends, and about the limitation of benefits rules. These commentators have noted that the Technical Explanation did not fully address some of the uncertainty challenges in the Protocol.

The Technical Explanation also failed to meet clarification expectations in the area of ULCs. For example, the Technical Explanation confirmed that subparagraph 7(b) of Article IV of the Protocol would apply to deny Treaty protection to dividends, interest payments and royalty payments by a ULC to a U.S. shareholder where the ULC is a disregarded entity for U.S. purposes, but did not address the case of interest and royalty payments where a Canadian corporation is considered by U.S. law to be a partnership. Most importantly, the Technical Explanation was silent, notwithstanding that the JC Explanation acknowledged the benign aspect of certain ULCs, on whether the Protocol’s anti-hybrid provisions would apply to non-abusive structures involving ULCs where “double dipping” on tax deductions was not the reason for the cross-border structure.

If the Protocol is fully ratified by the U.S. in 2008, it will become effective on January 1, 2010. A number of existing cross-border structures will have to be examined closely before then to avoid the potential for double taxation.