The March 2007 Canadian Federal Budget had announced an intention to amend the Income Tax Act (Canada) (the "Act") to eliminate Canadian withholding tax on interest paid to all arm’s length non-residents, regardless of their country of residence. This amendment was to apply to interest paid on or after the date on which the withholding tax exemption under the fifth Protocol (the "Protocol") to the Canada-US Tax Convention (1980)(the "Convention") comes into effect. As we outlined in our recent article, dated September 24, 2007, the Protocol proposes to eliminate withholding tax on interest paid to residents of the United States, with different effective dates depending on whether the interest is on debt from related or unrelated lenders. Note that the concept of "related person" under the Convention is broader than that in the Act.
Update on Protocol to Convention
Generally, the provisions in the Protocol that are relevant to withholding taxes are not applicable until the first day of the second month after the date on which the Protocol enters into force. Finance Canada, however, recently confirmed that the exemption for payments on debt from unrelated lenders and the reduction in the rate on debt from related lenders is to apply retroactively to the first day of the calendar year in which the Protocol comes into force. Thus, the exemption on interest payments to unrelated persons and the initial reduction in the withholding tax rate on interest payments to related persons to 7% under the Protocol will be effective in respect of amounts paid or credited on or after January 1, 2008 if, as expected, both countries ratify the Protocol in 2008. The exemptions from withholding tax proposed under the Protocol do not apply to participating interest, as defined in the Protocol.
Update on Changes to the Act
On November 13, 2007, a Notice of Ways and Means Motion to implement certain provisions of the Budget was tabled in the House of Commons. Included were provisions eliminating Canadian withholding tax on most interest paid to arm’s length non-residents. Surprisingly, despite the Budget statements, the new provisions are to apply after 2007, regardless of the date the Protocol comes into effect. Finance Canada has indicated that these provisions were intended to be consistent with the Protocol, on the assumption that it will come into force during 2008. As a result, and assuming the legislation is passed as proposed, starting on January 1, 2008, interest (other than participating debt interest) paid to all arm’s length non-residents, including residents of the United States, will be free of withholding tax. In addition, some of the existing exemptions from withholding tax, such as for certain mortgages on real property outside Canada, will continue to apply even if the interest ("fully exempt interest") is paid to a non-resident with whom the debtor is not dealing at arm’s length.
As stated above, the proposed exemption from withholding tax to be added to the Act will not apply to "participating debt interest", which is essentially the same type of interest that currently does not benefit from the existing exemptions from withholding tax, such as the "5/25 exemption" found in subparagraph 212(1)(b)(vii) of the Act. "Participating debt interest" is defined generally as interest that is contingent or dependent on the use or production from property in Canada or that is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable. This definition is broader than that proposed in the Protocol, which provides that the exemption from withholding tax in the Convention will not apply to interest that is determined with reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or any dividend, partnership distribution or similar payment made by the debtor to a related person. Thus, once the Protocol is in effect, it should be possible to pay participating interest free of Canadian withholding tax to residents of the United States, provided that the participating feature is not determined with reference to criteria that are connected to the economic performance of the debtor or a related person.