On July 10, 2008 the U.S. Treasury Department released theTechnical Explanation (the TE) to the September 21, 2007 protocol (the Protocol) to the Canada-U.S. Income Tax Convention (the Treaty) and the Canadian Department of Finance issued a press release indicating its agreement with the TE. Although the TE does not amend the Protocol or the Treaty itself, it is an important interpretive aid that sets out the intentions of Canada and the United States and clarifies several important aspects of the Protocol.
This update summarizes the most significant changes to the Treaty resulting from the Protocol and the main clarifications provided in the TE. Many of these Protocol changes will significantly impact existing cross-border structures and proposed transactions.
The Protocol and two sets of diplomatic notes (Annex A, which details the binding arbitration procedures, and Annex B, which addresses various interpretive issues) are available from the Department of Finance website. The TE is also available from the U.S. Treasury Department’s website. Osler has prepared a blacklined document displaying the changes made to the Treaty by the Protocol. It can be obtained from any member of our National Tax Department.
Highlights of the Protocol include:
- Interest withholding taxes – Protocol eliminates withholding tax on most crossborder interest payments and many guarantee fees (phased in over two years for related party interest);
- Hybrid entity rules - new rules allow (or deny) treaty benefits for certain amounts derived through or paid by hybrid entities that are treated as fiscally transparent in one country but not the other (such as certain partnerships, U.S. limited liability companies or Canadian unlimited liability companies);
- Limitation on benefits - a comprehensive limitation on benefits provision applies to both Canada and the United States;
- Binding arbitration – a new process requires the tax authorities of Canada and the United States to resolve certain issues through “baseball style” binding arbitration;
- Services permanent establishment – a new rule may deem a permanent establishment to arise if cross-border services are provided over a period that exceeds 183 days;
- Determination of business profits – new rules affect the manner in which income is attributed to a permanent establishment.
- Pensions – new rules address pension contributions and accrued pension benefits in cross-border employment situations; and
- Stock options – new rules apportion the taxation of stock option benefits between Canada and the United States in crossborder situations.
Application of the TE in Canada
While the TE was prepared by the U.S. Treasury Department, the Canadian Department of Finance reviewed and commented on it, and agrees with its contents. The Introduction to the TE notes that, in the view of both Canada and the United States, the TE “accurately reflects the policies behind particular Protocol provisions, as well as understandings reached with respect to the application and interpretation of the Protocol and the Convention.” The Canadian government’s agreement with the contents of the TE, and its participation in the preparation of the TE, was confirmed in a press release issued by the Department of Finance on July 10, 2008.
Entry into Force of the Protocol
The Protocol will enter into force once Canada and the United States have notified each other that its ratification procedures are complete. Canada ratified the Protocol on December 14, 2007. The U.S. Senate Committee on Foreign Relations reviewed the Protocol on July 10, 2008 and ratification by the United States is expected later in 2008. However, concerns have been expressed to the U.S. Senate Committee regarding certain portions of the Protocol (such as the rule for services permanent establishments and part of the hybrid entity rule). It is possible that these concerns may delay ratification in the United States, or even lead to a further protocol. Some of these concerns were expressed by members of the U.S. Senate Committee and by the staff of the Joint Committee on Taxation (the U.S. Congress Joint Committee), a non-partisan committee of the United States Congress, in its Explanation of the Protocol prepared in connection with the U.S. Senate Committee hearings.
With respect to withholding taxes (other than on interest payments), the Protocol will generally be effective two months after it enters into force. The Protocol will generally be effective for other taxes for tax years that begin in the calendar year after ratification, except that special timing applies to certain provisions as discussed below (such as for withholding tax on interest payments and the hybrid entity rules).
Elimination of Withholding Tax on Interest and Guarantee Fees
Subject to various exceptions, Canada and the United States levy withholding taxes on interest paid to non-residents at a rate of 25% and 30%, respectively. Although Canada and the United States each have important domestic withholding tax exemptions, they are not comprehensive. As of January 1, 2008 Canada’s withholding tax exemption generally applies to interest, other than “participating debt interest,” paid to arm’s length non-residents. The United States has exemptions for bank deposits, short-term original issue discounts and “portfolio interest,” but these exceptions do not apply to certain “contingent interest,” certain interest paid to a 10% owner of the issuer, interest paid to banks lending in the ordinary course of their business, or interest paid to certain foreign corporations related to the borrower.
Once ratified, the Protocol will provide incremental interest withholding tax relief to Canadian and U.S. persons. The Protocol provides that, subject to the potential application of the limitation on benefits provision, nonresident withholding tax on interest (other than certain participating interest in Canada or contingent interest in the United States) that is paid to an unrelated resident of the other country will generally be eliminated. Although this rule is slightly different from the domestic Canadian exemption, it will likely have little practical effect on Canadian withholding taxes (but should eliminate U.S. withholding taxes in many circumstances where the portfolio interest exemption does not otherwise apply).
- The TE provides that, for U.S. purposes,“related” has its meaning under section 482 of the Internal Revenue Code and, for Canadian purposes, has its meaning under section 251 of the Income Tax Act.
Of greater importance is the relief afforded for interest payments to related persons. Under the Protocol, withholding tax on interest paid by a resident of Canada or the United States to a related resident of the other country will be reduced to 7% during the first calendar year in which the Protocol becomes effective. Such tax will be reduced to 4% for the immediately following calendar year and then eliminated for subsequent years.
- The TE clarifies that the elimination or reduction of withholding taxes on interest under the Protocol applies retroactively to January 1 of the calendar year in which the Protocol comes into force. If the Protocol is ratified in 2008, the 0% rate for payments to unrelated persons and the reduced 7% rate for payments to related persons will apply as of January 1, 2008. For payments to related persons, the rate would then be reduced to 4% as of January 1, 2009 and to 0% as of January 1, 2010.
The Protocol’s interest withholding tax exemption is subject to certain exceptions. In the case of interest arising in Canada and paid to a beneficial owner that is a U.S. resident, certain participating interest (including amounts determined by reference to income, profits or cash flow of the debtor or a related person, and dividends or similar distributions paid by the debtor) will be effectively treated as dividends and subject to withholding tax not exceeding the 15% rate generally applicable under the Treaty to dividend payments. For payments arising in the United States and paid to a beneficial owner that is a Canadian resident, the same treatment will apply to interest that is “contingent interest” of a type that does not qualify as portfolio interest under U.S. law.
- With respect to interest arising in the United States, the TE provides that “contingent interest” is defined by reference to section 871(h)(4) of the Internal Revenue Code, including the exceptions therein.
Finally, the reduced interest withholding tax rates do not apply to certain interest that exceeds an arm’s-length rate (i.e., interest paid to a person with a special relationship with the borrower in excess of what would have otherwise been paid in the absence of that special relationship).
Under the Protocol, guarantee fees are taxable only in the recipient’s country of residence, unless such fees are attributable to a permanent establishment in the other country, in which case Article VII (Business Profits) applies. This provision will apply to guarantee fees paid or credited after the first day of the second month beginning after the Protocol enters into force.
- The U.S. Congress Joint Committee has indicated that the exemption for guarantee fees was intended to prevent the United States from taxing such fees under the “Other Income” article. Canada generally exempts such fees from withholding tax under the Income Tax Act by treating them as interest, but only to the extent that they are paid to an arm’s-length non-resident. The TE does not address whether Canada will treat guarantee fees as interest as required under the Income Tax Act, and thus continue to levy withholding tax on related party guarantee fees during the phase-in of the interest withholding tax exemption. However, comments by Department of Finance officials have suggested that the “Other Income” article should generally apply to exempt guarantee fees paid to related persons from Canadian withholding tax without regard to the phase-in of the exemption under the Interest article.
- The TE notes that the reference to Article VII was inserted at the request of the United States in respect of fees paid to financial services entities in the ordinary course of business. The TE suggests that the provision of guarantees with respect to the debt of related parties would ordinarily not generate business profits and, in most cases, would be covered by the “Other Income” article.
Hybrid Entities - Accommodating LLCs and Other Fiscally Transparent Entities
The Protocol clarifies that income derived by a fiscally transparent entity may generally be eligible for treaty benefits to the extent that its members are resident in Canada or the United States. This provides relief from the longstanding position of the Canada Revenue Agency (CRA) (as yet untested in court) that a U.S. limited liability company (LLC) that is treated as fiscally transparent for U.S. federal income tax purposes is not a resident of the United States for purposes of the Treaty and, at the same time, is recognized as an entity separate from its members from Canada’s perspective. Under this current position, neither the LLC nor its members would be eligible for treaty benefits in respect of amounts derived by the LLC.
In new Article IV(6), the Protocol provides that an amount of income, profit or gain is considered to be derived by a person who is a resident of Canada or the United States if (a) the person is considered under the tax law of the resident country to have derived the amount through an entity that is not a resident of the other country, and (b) by reason of such entity being treated as fiscally transparent under the tax law of the resident country, the tax treatment of the amount is the same as if it had been derived directly by that person.
- The TE confirms that fiscally transparent entities (for U.S. tax purposes) include partnerships, common investment trusts, grantor trusts, and limited liability companies or similar entities that are treated as partnerships or disregarded as separate entities for U.S. tax purposes. For Canadian tax purposes, partnerships and “bare” trusts are considered fiscally transparent entities. (The TE does not mention the treatment of Canadian grantor trusts under subsection 75(2) of the Income Tax Act). Entities that are subject to tax, but with respect to which tax may be relieved under an integration system, are not considered fiscally transparent entities.
- The TE indicates that United States S corporations will generally be treated as fiscally transparent for U.S. tax purposes, but not for Canadian tax purposes. Canada will continue to view an S corporation as capable of being a resident of the United States, in which case the S corporation itself, rather than its shareholders, would be eligible for treaty benefits.
- The TE confirms that a U.S.-resident member of a fiscally transparent LLC may claim treaty benefits with respect to its share of (a) gains realized by the LLC on the disposition of taxable Canadian property, (b) interest, dividends or royalties received by the LLC from a Canadian resident, and (c) Canadian business profits or other income of the LLC. However, Canada will require the LLC itself, and not its members, to file any required Canadian tax returns in respect of such income. Canada will also subject the LLC itself to tax in respect of any amounts not allocable to a U.S.-resident member eligible for treaty benefits (or may apply a 25% withholding tax rate on interest, dividends or royalties attributable to non-U.S.-resident members.)
- Where a U.S. LLC carries on business in Canada, the TE provides that Canada will look to whether the LLC itself has a permanent establishment in Canada. If it does not, then only the portion of the LLC’s income that belongs to its U.S.-resident members would be exempt from Canadian tax under the Treaty. If the LLC does have a permanent establishment in Canada, then Canada will tax the LLC, rather than its members, on its business profits. In the inverse situation, the United States will look to the activities of both the fiscally transparent entity and its members in determining whether the entity has a permanent establishment.
- The TE suggests that Canada will apply criteria comparable to those applied by the United States in determining whether an amount derived through a fiscally transparent entity has received the “same treatment” as if the amount had been derived directly. The United States requires that the amount must be recognized by a member of a fiscally transparent entity on a current basis and must retain the same character and source to satisfy the same treatment requirement.
- Fiscally transparent entities are not restricted to U.S. or Canadian entities. The TE confirms that the new Treaty provision accommodating hybrid entities could override a second treaty. Consequently, U.S. interest holders of a third-jurisdiction entity that is disregarded for U.S. tax purposes could obtain benefits under the Treaty.
Although the new Treaty rule provides that an amount of income, profit or gain shall be considered to be derived by a person who is a resident of a Contracting State where certain conditions are met, it does not deem such person to be the beneficial owner of the income. This is of particular importance in the case of dividends, royalties and interest where a reduction in the withholding tax rate is dependant on the payee being the beneficial owner of such income. Despite this omission, the new hybrid entity rule appears to intend for the person deemed to derive the income to be entitled to Treaty benefits.
- The TE provides that “beneficial owner” is defined under the domestic law of the country imposing the tax and refers to the fact that a nominee or agent is not a beneficial owner. This interpretation in the TE (with which Canada agrees) suggests that an international fiscal meaning of “beneficial owner” should not be adopted. In the recent Tax Court of Canada case of Prévost Car Inc. (currently under appeal), the CRA had attempted to interpret “beneficial owner” as having an international fiscal meaning in the context of the Canada-Netherlands Tax Treaty.
- The TE contemplates that there may be a bifurcation between the beneficial owner and the person considered to derive the income. The TE provides that in the case of income, profits or gains derived through a fiscally transparent entity, the tax laws of the residence country and the rules in new Article IV(6) are first applied to determine whether an owner of the entity derives the income, profits or gains. The source country rules of beneficial ownership are then applied to determine whether that person is the beneficial owner of such amounts, rather than an agent or nominee of another person. In the case of Canada, the TE specifies that Treaty benefits will be available to otherwise qualifying members of a fiscally transparent entity if such fiscally transparent entity is considered to be the beneficial owner of the income under Canadian law. However, it is not entirely clear how the limitation on benefits rules will apply where a fiscally transparent entity is considered the beneficial owner of income derived by its members.
- The TE does not confirm that the tax authorities will look through multi-tiers of fiscally transparent entities in applying the new hybrid entity rule. However, the CRA has indicated that it will be adopting such an approach.
Dividends earned through Fiscally Transparent Entities
The Protocol clarifies the treatment of dividends (but not other income) earned by investors through LLCs and other fiscally transparent entities. The Treaty reduces the withholding tax rate from 15% to 5% on dividends paid to U.S. residents where the beneficial owner of the dividends is a company which “owns” at least 10% of the voting stock of the company paying the dividends. The Protocol amends this rule to provide that, for purposes of determining whether the 10% ownership threshold is met, a company that is a resident of Canada or the United States is considered to own the voting stock owned by an entity that is considered fiscally transparent under the laws of the residence country and that is not a resident of the source country, in proportion to the company’s ownership interest in that entity.
- Neither the Protocol nor the TE addresses the allocation of voting stock where the capital of the entity is composed of voting shares and various classes of preferred shares. Furthermore, the concept of “in proportion to the company’s ownership interest” is not found in U.S. or Canadian tax principles. Moreover, the TE does not provide any guidance as to whether an approach similar to the surplus entitlement percentage test under the Canadian foreign affiliate regime could be adopted.
Hybrid Entities—Treaty Benefit Denial Rules
The Protocol denies treaty benefits with respect to the use of two categories of hybrid entities that are disregarded in one country and not the other. Under each of these new rules, the result is that the recipient of payments will be deemed not to be a resident of Canada or the United States and thus will not be entitled to the benefits of the Treaty.
The first rule (Article IV(7)(a)) applies to payments to, or amounts derived by, a resident of Canada or the United States through a hybrid entity that is recognized by the residence country but that is disregarded by the other country. This rule appears to apply to common “reverse hybrid” arrangements used by U.S. residents in Canada. The TE provides examples of where this rule applies to deny Treaty benefits, such as where a Canadian company uses a fiscally transparent LLC to derive U.S.-source income. This rule is similar to, but broader than, the rules in section 894(c) of the Internal Revenue Code.
The second rule (Article IV(7)(b)) applies to payments to, or amounts derived by, a resident of Canada or the United States from a hybrid entity that is disregarded by the residence country but that is recognized by the other country. The TE also provides examples where this rule applies.
The text of the second rule is broadly drafted and, hence, applies to both deductible and nondeductible payments. It consequently applies to non-deductible amounts such as dividends or interest that would not be deductible under a thin capitalization rule. At the 2007 Canadian Tax Foundation Conference, the Department of Finance recognized that the scope of the second rule’s application possibly was broader than initially intended, a concern shared by the U.S. Congress Joint Committee.
- The TE does not narrow the scope of this denial rule and, thus, it appears that the use of Canadian unlimited liability companies (ULCs) will negatively be impacted. This is an unfortunate outcome since, as rightly pointed out by the U.S. Congress Joint Committee, ULCs have been used in many legitimate commercial transactions, allowing U.S. investors to operate in branch form for U.S. tax purposes, to better manage Canadian foreign taxes, and to increase the Canadian tax basis in Canadian assets acquired through a purchase of the stock of a Canadian company.
As a result of these changes, any cross-border arrangements using hybrid entities should be reviewed. Perhaps as a concession to the fact that these changes will require many taxpayers on both sides of the border to review (and perhaps restructure) current arrangements, the new hybrid entity treaty benefit denial rules are not effective until the first day of the third calendar year that ends after the Protocol enters into force. Assuming the Protocol enters into force in 2008, this change will be effective January 1, 2010.
Limitation on Benefits
A significant change in the Protocol is the introduction of Canada’s first comprehensive limitation on benefits (LOB) provision, which is intended to address the problem of “treaty shopping” by ensuring that treaty benefits are only available to residents of Canada or the United States that also satisfy certain other tests. This is a marked departure from Canada’s existing treaty policy. Until now, Canada has generally relied on its ability to prevent perceived misuses of tax treaties through its domestic general anti-avoidance rule (GAAR), which was retroactively amended in 2005 to apply explicitly to tax treaties. Canada has also recently argued that tax treaties contain an implicit anti-abuse rule and that the use of the term “beneficial owner” in most dividend, interest and royalty articles may be interpreted as a broad anti-treaty shopping provision. However, in its recent decision in MIL Investments S.A., the Canadian Federal Court of Appeal did not apply GAAR or an implicit antiabuse rule in the context of a perceived treaty shopping case. The Crown did not seek leave to appeal that case. This outcome is notable in light of the combination of specific and general antiabuse approaches that are adopted in the Protocol. In its recent decision in Prévost Car Inc., the Tax Court of Canada held that a Dutch holding company was the beneficial owner of dividends paid by its Canadian subsidiary, despite limited activities in the Netherlands and substantial influence being exercised by the holding company’s shareholders. The Crown has appealed that decision to the Federal Court of Appeal.
Canada may no longer be satisfied with relying on existing anti-abuse rules, at least in the context of this Treaty (perhaps due to the new interest withholding tax exemption) and could potentially seek to add comprehensive LOB provisions to other treaties in the future.
In addition to extending the application of the LOB provision to Canada, the Protocol also updates the rule to more closely reflect current U.S. treaty policy. To qualify for treaty benefits, a person must be a resident of Canada or the United States under Article IV. The person must generally also meet one of the following additional criteria: the person must be a “qualifying person,” the active business/substantial activity test must be satisfied, or the derivative benefits test must be satisfied. The LOB provision of the Protocol also permits a person not otherwise qualifying for Treaty benefits to apply for competent authority relief where the person was not created to obtain Treaty benefits, or where it would not be appropriate to deny Treaty benefits.
In general, the new LOB provision limits Treaty benefits to “qualifying persons” that are otherwise resident including: (a) natural persons, (b) governments and their agencies, (c) companies or trusts whose principal class of shares or units (and certain “tracking” shares or units) is “primarily and regularly” traded on a recognized stock exchange, (d) certain companies or trusts that are controlled by other qualifying persons, subject to a potential limitation on expenses paid to non-qualifying persons (base erosion rule), and (e) estates and certain pension trusts, non-profits and tax exempts.
- The new hybrid entity rules may result in a difference between the person that is treated as “deriving” income under the principles of Article IV and the person that is treated as the “beneficial owner” of the income in accordance with the laws of the source country. The TE suggests that the proper methodology is to first identify the person who derives the income under Article IV and then to apply the LOB provision to that person. While this guidance is helpful, it does not fully address situations where the source country regards the beneficial owner to be other than the person that derives the income. In particular, the technical explanation to the U.S. Model Treaty suggests that the LOB provision is to be applied to the person that is identified in accordance with the laws of the source country as the beneficial owner of the income. Taxpayers that engage in transactions or structures involving hybrid entities may encounter some uncertainty regarding their eligibility for treaty benefits (including the manner of establishing their entitlement to such benefits to the satisfaction of the source country).
- Publicly-traded entities whose “principal class” of shares (and any disproportionate class of shares or units) or units is “primarily and regularly” traded on a “recognized stock exchange” are qualified persons. The TE clarifies the meaning of these phrases:
- “Principal class of shares or units” means the ordinary or common shares of a company representing the majority of the voting power and value of the company. If no single class fits this description, then “principal class of shares” means those classes that in the aggregate represent a majority of the voting power and value of the company. However, a company whose principal class of shares is regularly traded on a recognized stock exchange will not qualify for benefits if it has a disproportionate class of shares (that is, a class of shares that disproportionately tracks the company’s earnings generated in the other country, such as “tracking stock”) not regularly traded on a recognized stock exchange.
- “Primarily traded” has the meaning set out in the relevant treaty country, usually the source country. For the United States, this is defined in Treas. Reg. section 1.884-5(d)(3), which states that as long as more shares of the principal class of shares are traded on a recognized stock exchange than on other securities markets during the year, the shares are primarily traded on a recognized stock exchange.
- “Regularly traded” also has the meaning it has under the laws of the relevant treaty country, usually the source country. For the United States, Treas. Reg. Section 1.884-5(d)(4)(i)(B) provides that shares are regularly traded if:
- trades in the class of shares are made in more than de minimis quantities on at least 60 days in the year, and
- the aggregate number of shares in the class traded in the year is at least 10% of the average number of outstanding shares in the year.
Trading on one or more recognized stock exchanges (in Canada or the United States, or both) may be aggregated for this requirement.
- Unless Canada adopts its own definitions, the TE contemplates that the U.S. interpretation of “primarily traded” and “regularly traded” applies for purposes of Canadian taxation, with such modifications as may be necessary.
- “Recognized stock exchange” means the NASDAQ System, any stock exchange registered as a national securities exchange with the U.S. Securities Exchange Commission, Canadian exchanges that are “prescribed stock exchanges” or “designated stock exchanges,” and any other exchange agreed on by the competent authorities. The TE states that the recognized Canadian exchanges at the time the Protocol was signed are the Montreal Stock Exchange, the Toronto Stock Exchange, and Tiers 1 and 2 of the TSX Venture Exchange.
Active Business/Substantial Activity Test
The Protocol also extends Treaty benefits to residents who are not otherwise qualifying persons but who are engaged in the active conduct of a trade or business in the jurisdiction where they are resident, but only for income “derived in connection with or incidental to that trade or business” and only if the trade or business is “substantial” in relation to activities in the other country. Certain investment activities do not constitute a trade or business for this purpose. U.S. entities that are controlled by persons outside of Canada or the United States and that are not publicly listed will need to become very familiar with this clause and the “derivative benefits” clause described below.
- The TE clarifies that if the investment activity is carried out with customers in the ordinary course of the business of a bank, insurance company, registered securities dealer or deposit taking financial institution, the activity will be considered “active.”
- The TE indicates that “derived in connection with an active trade or business” includes income-generating activities that are “upstream,” “downstream” or parallel to that conducted in the other country. For example, a Canadian manufacturer that sells its final product in the United States, purchases inputs to its manufacturing process in the United States, or manufactures and sells in the United States similar products to those being manufactured and sold in Canada would, in each case, earn income in the United States derived in connection with its trade or business in Canada.
- The active business test requires a determination of the connection between income and an active trade or business. The “in connection with” test is conceivably very broad. Canadian taxpayers and practitioners will be reminded of tests included in the Canadian foreign affiliate rules requiring a determination of whether income is incidental or pertains to an active business of a foreign affiliate, or is derived in what amounts to an integrated undertaking of more than one foreign affiliate in which a Canadian taxpayer has substantial interests. In the latter case, the degree of required integration is sometimes controversial. Interestingly, the TE offers a seemingly generous vertical and horizontal integration approach to allow income to be coloured as deriving from an active business.
- The TE also discusses the meaning of “incidental,” stating that income from a short-term investment of working capital made by a Canadian company in U.S. securities would be considered incidental. The TE further provides that income is treated as derived in connection with or incidental to a trade or business if earned directly or indirectly through one or more persons resident in Canada or the United States, and that the test will be satisfied even if, for example, a U.S. holding company is interposed between a Canadian-resident parent and its U.S.-resident operating subsidiary.
- The “substantiality” test does not require that the trade or business in the residence country be as large as the income-generating activity in the source country. The trade or business cannot, however, represent only a small percentage of the size of the activity in the other country. The TE provides an example of the type of structure this requirement aims to prevent. In the example, a third-country resident wishes to acquire a U.S. manufacturing company. Since the third country has no treaty with the United States, high withholding rates would apply to any dividends paid by the U.S. manufacturing company. Absent the substantiality rule, the third-country resident could qualify under this rule by acquiring the U.S. target through a Canadian acquisition company and then arranging for the acquisition company to have an outlet in Canada which sells a very small amount of the manufactured product.
Derivative Benefits Test
A “derivative benefits” clause extends Treaty protection for dividends, interest and royalties to companies controlled (requiring, generally, at least 90% ownership) by qualified persons or other persons if those other persons (a) are resident in countries that have a comprehensive income tax treaty with the United States or Canada, as the case may be, and would be entitled to the same kind of benefits under that treaty, (b) would be qualified persons or otherwise eligible for Treaty benefits if they were residents of the United States or Canada and (c) would be entitled to a rate of tax in that other treaty country on the relevant income that is at least as low as the tax rate in the Treaty. There is also a base erosion rule which requires that the amount of expenses deductible from gross income payable directly or indirectly to persons that are not qualifying persons for the preceding fiscal period is less than 50% of gross income.
The LOB article restates a previous general antiabuse rule that permits the denial of benefits under the Treaty where it can reasonably be concluded that to do otherwise would result in an abuse of the provisions of the Treaty.
- The TE refers to the independent status of Article XXIXA(7) that allows for the application of domestic anti-abuse rules in Canada and the United States. Thus, Canada may apply its domestic rules to counter abusive arrangements involving “treaty shopping” through the United States, and the United States may apply its substanceover- form and anti-conduit rules, for example, in relation to Canadian residents. The TE notes that this principle is recognized by the OECD in the Commentaries to its Model Treaty, and the United States and Canada agree that it is inherent in the Treaty.
The Protocol provides for “baseball-style” arbitration of cases which the competent authorities (the CRA and the Internal Revenue Service) have been unable to resolve by mutual agreement. Under this procedure, an arbitration board with three members must choose between the proposed resolutions submitted by Canada and the United States. The arbitration provisions will become effective on the coming into force of the Protocol and, as described below, will apply to unresolved cases whether filed before or after the Protocol comes into force.
There is no mechanism under the current Treaty to compel the competent authorities to reach an agreement to relieve double taxation. Failure of the competent authorities to agree has, in some cases, resulted in substantial delays or the denial of relief. The introduction of arbitration is an extremely important development that should result in the resolution of competent authority cases within three years or less. In this regard, the prospect of arbitration of unresolved cases may induce the competent authorities to reach a negotiated settlement at an earlier stage in the process.
Arbitration is available only for a case in which a tax return has been filed with Canada or the United States for the taxable year at issue and which either (a) involves the application of one or more provisions of the Treaty that the competent authorities have agreed by exchange of diplomatic notes should be the subject of arbitration, or (b) is a particular case that the competent authorities agree is suitable for arbitration on a “one-off” basis. In the diplomatic notes in Annex A to the Treaty, Canada and the United States agree that arbitration should apply to the application of the provisions of the Treaty in respect of the residence of an individual, the existence of a permanent establishment, the attribution of business profits to a permanent establishment, transfer pricing adjustments, and the apportionment of royalties to exempt and taxable amounts, along with other provisions that the competent authorities may agree to in the future. The competent authorities may mutually agree that a particular case is not suitable for arbitration, but must do so before the arbitration proceeding for that case begins.
- The TE refers to cases initially submitted as requests for advance pricing arrangements (APAs) in the context of the information necessary for the U.S. competent authority to undertake substantive consideration for a mutual agreement, but does not specify whether the binding arbitration provisions can be applied to resolve a disagreement over an APA. The U.S. competent authority has recently made public statements regarding the potential application of binding arbitration provisions in treaties entered into by the United States to APAs, noting that, in any case, binding arbitration would only be available in respect of tax years for which returns had been filed, and separately noting that the binding arbitration provisions in those treaties vary in scope. We note, however, that a failed APA could result in a transfer pricing adjustment, which could fall within the stated ambit of the arbitration procedures.
An arbitration proceeding will begin on the later of (a) the date that is two years after the “commencement date” of any case that has not been resolved by mutual agreement unless both competent authorities have agreed to a different date, and (b) the date each affected taxpayer and its authorized representatives deliver to both competent authorities a written agreement not to disclose to any other person any information received during the course of the arbitration proceeding from Canada, the United States, or the arbitration board, other than the determination of the board. The “commencement date” is the date of entry into force of the Protocol for existing cases and is otherwise the date on which both competent authorities have all the information necessary to undertake substantive consideration for a mutual agreement.
- To avoid a large number of simultaneous arbitration cases two years after the entry into force of the Protocol, the TE calls for the competent authorities to establish procedures by January 1, 2009 and begin scheduling arbitration proceedings. It is likely that the agreed procedures will address various open issues.
The Protocol provides that arbitration is to be conducted in accordance with the rules for procedure agreed to by Canada and the U.S. by exchange of diplomatic notes. Annex A to the Treaty provides that arbitration proceedings may be terminated before a determination by the board has been made, but only if the competent authorities reach a mutual agreement or if mutual agreement proceedings are terminated by the affected taxpayer. As noted, arbitration boards constituted under the binding arbitration provisions are to contain three members. Each of Canada and the United States is to appoint one member, and the two appointees are to agree on a third member.
- The TE states that it is agreed that the third member of an arbitration board ordinarily should not be a citizen of either Canada or the United States.
If the two board members appointed by Canada and the United States are unable to agree on a third appointee (or if either Canada or the United States fails to appoint a member), Annex A to the Treaty provides for the missing board member to be appointed by the highest ranking member of the Secretariat at the Centre for Tax Policy and Administration of the OECD who is not a citizen of either Canada or the United States.
Annex A to the Treaty also provides that the board must apply the following authorities in making its determination: (a) the provisions of the Treaty; (b) any agreed commentaries or explanations of Canada and the United States concerning the Treaty; (c) the laws of the United States and Canada to the extent they do not conflict; and (d) relevant OECD Commentary, Guidelines or Reports.
- As noted, the TE states that the Government of Canada has reviewed the TE and subscribes to its contents. Thus, the TE is likely an “agreed explanation” of the Treaty for the purposes of Annex A to the Treaty and must be applied by an arbitration board along with the other authorities listed in Annex A.
Annex A also states that the arbitration decision itself is restricted to the amount of income, expense or tax (excluding interest and penalties) reportable to a contracting state and that the board is not permitted to deliver reasons for its decision. If the affected taxpayers accept the arbitration board’s decision, then the Protocol provides that the decision constitutes resolution by the mutual agreement procedure in the Treaty and is binding on both Canada and the United States. If an affected taxpayer rejects the board’s decision, then the mutual agreement procedure is terminated.
Permanent Establishment For Service Providers
The Protocol introduces a new rule, in Article V(9), under which the cross-border provision of services may give rise to a permanent establishment of the service provider. This is the first time the United States has included such a rule in a treaty with a developed country.
Under this new rule, a service provider may have a permanent establishment even in the absence of a fixed place of business or an agent. Canada requested the inclusion of this rule in response to the decision of the Canadian Federal Court of Appeal in Dudney. In Dudney, a foreign consultant who spent 300 days in Canada in one year was held not to have had a Canadian permanent establishment, as his services were provided at the premises of his client, which were not under his control.
- The TE makes it clear that Article V(9) only applies to the provision of services (although it does not elaborate on the meaning of “services”), and only to services provided by an enterprise to third parties (and not to the enterprise itself). However, neither the Protocol nor the TE defines an “enterprise.” Article V(9) also only applies where the services are physically provided from within the source country.
- The TE indicates that, because Article V(6) applies notwithstanding Article V(9), days spent on preparatory or auxiliary activities are not taken into account in applying Article V(9). This is presumably a reference to activities that are preparatory or auxiliary to the provision of the services by the service provider (i.e., the “resident” at risk of creating a permanent establishment in the host country), and not to services that are preparatory or auxiliary from the perspective of the recipient of the services.
The new rule in Article V(9) deems an enterprise of Canada or the United States that does not otherwise have a permanent establishment in the other country (the host country) to have a permanent establishment in the host country if it provides services in the host country and it meets either one of the following two thresholds:
Article V(9)(a) - Key person services: The services are performed in the host country by an individual (i.e., a natural person) who is physically present there for one or more periods totalling 183 days or more during any twelve-month period, and the income derived from the services performed in the source country by that individual amounts to more than 50% of the enterprise’s gross active business revenues during that 183-day+ period. This provision is relevant to selfemployed individuals or to enterprises providing services through a small number of key employees. The residence of the customer is not relevant under this test.
- The TE confirms that the 183-day test under Article V(9)(a) is based on the number of days the relevant individual is physically present in the host country, without regard to whether such presence is related to the services being provided or whether the individual actually performs work on those days.
- The TE indicates that “gross active business revenues” means the gross revenues attributable to active business activities that the enterprise has charged or should charge for its active business activities, regardless of when the actual billing occurs and of domestic tax law rules concerning when such revenues should be taken into account. The TE also notes such active business activities are not restricted to the activities related to the provision of services; however, the term does not include income from “passive investment activities.”
Article V(9)(b) - Large project services: The services are provided in the host country for an aggregate of 183 days or more in any twelve-month period with respect to the same or connected projects for customers who either are host-country residents or who maintain a host-country permanent establishment in respect of which the services are provided. The diplomatic notes included as Annex B of the Protocol clarify that projects are considered to be “connected” if they constitute a coherent whole, commercially and geographically.
- The TE confirms that the 183-day test in Article V(9)(b) is based on days during which services are provided in the host country (and not just physical presence), and thus would not include non-working days such as weekends and holidays, as long as no services are being provided in the host country on such days.
- The TE indicates that the 183-day test in both paragraphs of Article V(9) relies on actual days, not “people days,” so that even if many individuals are providing services in the host country, their collective presence on a single calendar day will count as one day. According to the TE example, 20 employees providing services in a host country for 10 days counts as 10 days (and not 200).
- The TE states that the determination of whether projects are connected should be determined from the point of view of the enterprise (not that of the customer) and will depend on the facts and circumstances of each case.
- In determining the existence of commercial coherence, the TE notes the following factors as being relevant: (a) whether the projects would, in the absence of tax planning considerations, have been concluded pursuant to a single contract; (b) whether the nature of the work involved under different projects is the same; and (c) whether the same individuals are providing the services under the different projects.
- The TE also provides an example of projects that lack geographic coherence in a case in which an enterprise is hired to execute separate auditing projects at 44 different branches of a bank located in different cities pursuant to a single contract. While the projects are commercially coherent, they are not geographically coherent. Thus, each separate auditing project would be considered separately for purposes of Article V(9)(b).
If the new rule is found to apply, the services are taxed on a net basis under Article VII (Business Profits) of the Treaty and, therefore, such taxation is limited to the profits attributable to the activities carried on in performing those services. It will be important to ensure that only the profits properly attributable to the functions performed and risks assumed in the provision of the services will be attributed to the deemed permanent establishment of the enterprise.
The U.S. Congress Joint Committee has raised several concerns relating to Article V(9) and, in particular, administrative and compliance issues applicable both to the enterprise providing the services and to its employees. For example, service providers will be required to establish an administrative infrastructure to track employees’ activities in the host state on a rolling 12-month basis and will need to anticipate and deal with the potential application of Article V(9) in unexpected situations. Employees earning more than $10,000 in the host country may be faced with the prospect of being taxed under Article XV of the Treaty in the host country in respect of remuneration that is “borne by” the newlyestablished Article V(9) permanent establishment of their employer.
- The TE states that the competent authorities are encouraged to consider adopting rules to reduce the potential for excess withholding or estimated tax payments with respect to employee wages that may result from the application of Article V(9).
The recently-concluded Canada-Mexico Tax Treaty, and the pending U.S.-Bulgaria Tax Treaty, have provisions similar to Article V(9). New Article V(9) is also similar in many respects to the sample article included by the OECD in pending revisions to the Commentary to Article 5 of the OECD Model Tax Treaty (see new paragraphs 42.11-42.48 and, in particular, paragraph 42.23) dealing with the taxation of services. The OECD Commentary should be a useful source of guidance to supplement the TE (although the U.S. Joint Committee notes certain differences between the OECD version of this rule and Article V(9)).
A building site or construction or installation project lasting more than 12 months continues to constitute a permanent establishment under Article V(3). Thus, new Article V(9) would not deem a permanent establishment to arise where construction services are provided for more than 183 days (but less than 12 months) since Article V(9) is subject to Article V(3).
Article V(9) is effective for the third taxable year after the Protocol’s entry into force (ignoring any days of presence, services rendered and gross active business income earned before January 1, 2010).
Determination of Business Profits for Article VII
Under Article VII, Canada or the United States may only tax the business profits of a resident of the other country to the extent that it carries on a business through a permanent establishment. Once a permanent establishment has been found to exist, the permanent establishment is attributed the business profits it would be expected to earn if it were a separate entity and dealing wholly independently with the enterprise of which it is a part.
This fiction raises issues, such as whether internal dealings should give rise, themselves, to profits in one or the other country (and not merely an allocation of costs actually incurred by the entity, for example, in transactions with third parties). Recent litigation in Canada and the United States has considered whether “notional” or “internal” dealings should be recognized. Another issue generally is whether the attribution exercise required by Article VII is confined to splitting the actual profit or loss of the entity as a whole or whether, for example, despite losses sustained by the entity, a permanent establishment could be profitable.
In Annex B to the Treaty, Canada and the United States have effectively adopted the approach for attributing profits to a permanent establishment outlined in the OECD’s Report on the Attribution of Profits to a Permanent Establishment. In so doing, they have explicitly incorporated by reference the analysis recommended in the OECD’s Transfer Pricing Guidelines. A restated Article 7 of the OECD Model Tax Treaty with relevant Commentary more fully adopting the OECD Report is expected later this year.
- The TE recognizes that the amount of income attributable to a permanent establishment under Article VII may be greater or less than the amount of income that would be treated as “effectively connected” to a U.S. trade or business under U.S. domestic rules. In particular, in the case of financial institutions, the TE notes that income from interbranch notional principal contracts may be taken into account under Article VII, despite the fact that they would be ignored for U.S. domestic law purposes. The TE also indicates that the so-called “consistency rule” will apply to ensure that Canadian taxpayers do not inappropriately combine the attribution principles of Article VII and the “effectively connected” principles of the Internal Revenue Code.
- The TE also notes that internal dealings that would not be recognized under U.S. domestic rules may be used to attribute income to a permanent establishment in cases where the dealings accurately reflect the allocation of risk within the enterprise. However, the books of a branch will not be respected where the results are inconsistent with a functional analysis. By way of example, the TE states that income from a transaction booked in a particular branch will not be treated as attributable to that location if the sales and risk management functions that generate the income are performed elsewhere.
- The TE states that deductions allowed for expenses incurred for the purposes of a permanent establishment will not be limited to expenses incurred exclusively for such purposes, but will include expenses incurred for the purposes of the enterprise as a whole. The TE also notes that deductions will be allowed regardless of which accounting unit of the enterprise books the expenses, so long as they are incurred for the purposes of the permanent establishment.
In Annex B to the Treaty, Canada and the United States have also agreed that the business profits attributed to a permanent establishment will only include the profits that are derived from the assets used, risks assumed and activities performed by the permanent establishment.
- The TE clarifies that the Transfer Pricing Guidelines apply only for purposes of attributing profits within the legal entity, and do not create legal obligations or other tax consequences that would result from transactions having independent legal significance. The TE states that Canada and the United States agree that notional payments used to compute profits attributable to a permanent establishment will not be taxed as if they were actual payments for purposes of other provisions of the Treaty; for example, a notional royalty used for this purpose will not be treated as a royalty for purposes of Article XII (Royalties).
- According to the TE, the method to be used in calculating the amount of a payment made by a branch to its head office or another branch in compensation for services performed for the benefit of the branch depends on the terms of the arrangements between the branches and head office. The TE provides an example with two alternative arrangements: one in which intra-company payments are determined on a cost-sharing basis, and another where such payments are made on an arm’s length feefor- services basis. According to the TE, in the circumstances of the two examples, either arrangement would be acceptable provided that it was made in writing and the enterprise acted in accordance with it.
Annex B to the Treaty goes on to state that a permanent establishment should be treated as having the amount of capital necessary to support the activities it performs.
- The TE states that the benefit of the lower capital requirements that arise from the operation of an enterprise through branches rather than subsidiaries must be allocated among the branches in an appropriate manner.
- The TE asserts that Annex B to the Treaty makes it clear that a permanent establishment cannot be entirely debtfunded.
- The TE notes that Annex B allows taxpayers to apply a “more flexible” approach to capital allocation than would be the case under U.S. domestic rules by taking into account the relative risk of its assets in the various jurisdictions in which it does business.
Annex B to the Treaty provides that the capital attributed to a permanent establishment of financial institutions (other than insurance companies) in a contracting state is to be determined by allocating the institution’s total equity between its various offices on the basis of the risk-weighted assets that are attributable to each office.
- The TE notes that risk-weighting is more complicated than the method prescribed by U.S. domestic rules. In order to ease the administrative burden, the TE states that taxpayers may choose to apply those rules to determine the amount of capital allocable to a U.S. permanent establishment as an alternative to the method prescribed by Annex B to the Treaty. However, the TE warns that such election is not binding for Canadian tax purposes unless “the result is in accordance with the arm’s-length principle”.
For insurance companies, the analysis is, not surprisingly, more in line with draft Part IV of the OECD’s Report: the profits attributable to a permanent establishment will include the premiums earned through the permanent establishment and the portion of the company’s overall investment income from its reserves and surplus that support the risks assumed by the permanent establishment.
The Treaty currently provides that an individual who is a citizen or resident of one country and who is a beneficiary of a trust or other arrangement that is a resident of the other country that is generally exempt from income taxation in the other country and operated exclusively to provide pension, retirement or employee benefits, may elect to defer taxation in the first country with respect to the income accrued in the plan until a distribution is made from the plan. Each country has its own procedures for making the election. That this election only applies to accrued income, not contributions or accrued benefits, has long been perceived to be a flaw in the current rules.
The Protocol contains new rules to address the treatment of contributions to, and benefits accrued in, “qualifying retirement plans” which are defined in Annex B to the Treaty. The new rules apply to individuals residing in one country (the residence country) and working in the other and who contribute to a qualifying retirement plan in the country where they work. The new rules also apply to individuals who move from one country to the other country (the source country) on short-term (up to five years) work assignments and continue to contribute to a qualifying retirement plan in the first country. In certain cases, the employers of such individuals may also benefit.
Provided certain conditions are met, individuals who reside in one country and work in the other (e.g., commuters) may deduct, for residence country tax purposes, the contributions they make to a qualifying retirement plan in the country where they work. Similarly, individuals who move for work and meet certain conditions may deduct, for source country tax purposes, their contributions to a qualifying retirement plan in the first country, for up to five years. (For this purpose, it is irrelevant whether such an individual becomes a resident of the source country while working there). In both cases, accruing benefits are not taxable.
For example, a resident of Canada employed in the United States may contribute to the employer’s pension plan in the United States. The employee’s contributions to the plan (up to the employee’s available RRSP deduction limit in Canada) will be deductible for Canadian tax purposes.
As a further example, an employee of a Canadian company who participates in the employer’s pension plan in Canada may be temporarily assigned to a related U.S. company. The employee keeps contributing to the pension plan of the Canadian company while working in the United States. For U.S. tax purposes, both the employee and the U.S. company will be able to deduct their contributions to the Canadian plan.
The tax relief afforded by the new rules only applies to the extent that contributions or benefits would qualify for tax relief in the country where the qualifying retirement plan is situated. For a citizen of the United States, the U.S. tax benefit may not exceed the amount that could be excluded from income for contributions and benefits under a corresponding plan established in, and recognized for tax purposes by, the United States. For purposes of Canadian taxation, the amount of the contributions otherwise allowed as a deduction to an individual for a taxation year shall not exceed the individual’s RRSP deduction limit (after taking into account contributions to RRSPs deducted by the individual for the year) Such deduction shall be taken into account in computing the individual’s RRSP deduction limit in Canada for subsequent taxation years.
The new rules are intended to facilitate movement of personnel between the two countries by removing a possible disincentive for cross-border commuters and temporary work assignments.
The new rules apply for taxation years that begin after the calendar year in which the amendments come into force.
Employee Stock Options—Apportionment of Taxing Rights
For purposes of applying Article XV (Income from Employment) and Article XXIV (Elimination of Double Taxation), a significant new rule regarding the “sourcing” of employee stock option benefits as between Canada and the United States is contained in Annex B to the Treaty.
Under the current Treaty, there is no specific rule that provides for apportionment of an employee’s stock option benefit between the two countries where the stock option was granted to the employee while employed in one country but was exercised or disposed of by the employee after moving to the other country to work for the same or a related employer.
Under the new rule, where an individual was granted an option to acquire shares or units (securities) of the employer (or a related entity) as an employee of a corporation or a mutual fund trust, the income arising from the exercise or disposition of the option will generally be considered to have been derived in Canada or in the United States in the proportion that (i) the number of days that the individual’s principal place of employment was in Canada or in the United States, respectively, during the period between the date of grant and the date of exercise or disposition is to (ii) the total number of days in that period. However, if the competent authorities of both countries agree that the terms of the option were such that the grant of the option is more appropriately treated as a transfer of ownership of the securities (e.g., because the options were in-the-money or not subject to a substantial vesting period), they may agree to attribute income accordingly.
This new rule clarifies the “sourcing” of option benefits for employees in these circumstances and ensures that double taxation will not arise. Where the employee also had a principal place of employment in a third country during the period between the date of grant and the date of exercise, it is not clear how the portion of any option benefits that are not apportioned to either Canada or the United States in accordance with Annex B to the Treaty will be taxed.