On September 21, 2007, Canada and the United States signed a Protocol agreeing to significant amendments to the Canada-U.S. Tax Treaty. The Protocol will come into force once ratified by both governments. If ratified in 2007, it will come into force generally as of January 1, 2008.
While key elements of the proposed amendments had been broadcast for some time (elimination of cross-border withholding tax on interest and extension of treaty benefits to U.S. LLCs, for example), the Protocol will implement additional, far-reaching changes in the context of cross-border structures.
A summary overview of some of the key changes that may be relevant to advisors and clients is as follows:
Elimination of Withholding Tax
The 2007 Canadian federal budget announced the government's intent to phase out withholding tax on cross-border interest, and the Protocol is consistent with this goal.
Cross-border interest is currently subject to a 10% Treaty rate of withholding. Subject to a phase-in rule applicable to related-party debt, the Protocol will amend Article XI of the Treaty to ensure that most cross-border interest between unrelated parties is simply not subject to withholding tax. For unrelated parties, this elimination of withholding tax will apply to amounts paid or credited on the first day of the second month that begins after the day on which the Protocol enters into force (if the Protocol enters into force Jan. 1, 2008, for example, this would be March 1, 2008).
This is a significantly positive change. For Canadian borrowers, it will eliminate the need to structure cross-border financings under the 5-year debt exemption from withholding tax, for example. This will allow for better access to shorter-term debt, including access to U.S. lenders for Canadian revolving loans, and also perhaps a more straightforward covenant package that is not impacted unduly by tax considerations.
The essence of the phase-in rule is that as between related parties, the current 10% Treaty rate will be reduced to 7% during the first calendar year ending after entry into force, 4% for the second calendar year, and then zero.
There will be provisions that treat contingent/participating type of interest as being subject to withholding at a dividend-equivalent Treaty rate.
In the 2007 federal budget, the Department of Finance also announced that once the withholding tax exemption was implemented under the Canada-U.S. Tax Treaty, Canadian withholding tax would also be eliminated on interest paid to all arms length parties, wherever resident.
Permanent Establishment Issues
Significant changes to the permanent establishment (PE) rules will be implemented under the Protocol.
Under a new rule, an enterprise of one country will be deemed to have a PE in the other country (and therefore be subject to potential taxation in that country) in certain circumstances where cross-border services are provided in a way that would not otherwise amount to a PE (say, under the rule dealing with dependent agents with authority to contract).
A PE will be deemed to exist where the services are performed in the other country by an individual who is present for 183 days or more in any 12 month period, provided more than 50% of the enterprise's gross active business revenues during the relevant period (which appears to be a reference back to the 183 day period, not the 12 month period) derives from the services so provided by that individual. A second new rule will deem a PE to exist more broadly where cross-border services are provided (not limited to any one individual) for 183 days or more in any 12 month period with respect to a project for residents of the other country (or for a PE maintained in that other country). These rules will apply no sooner than as of 2010, and application of the tests will ignore pre-2010 activities and revenues. For building sites or construction or installation projects, the existing rule (which provides that the project will constitute a PE only if it lasts for more than 12 months) will continue to apply.
A further change in the area of permanent establishments is that as referenced in diplomatic notes attached as Appendix B to the Protocol, the determination of what business profits are to be attributed to any particular PE should follow the principles of the OECD Transfer Pricing Guidelines.
While the Treaty currently has the concept of arbitration in the event the competent authorities cannot otherwise resolve a Treaty interpretation issue (in Article XXVI, par. 6), the reference to arbitration must be by consent of both competent authorities and that of the taxpayer, and is dependent on an exchange of diplomatic notes, and so there is currently no way to compel binding arbitration. Technical notes to the current Treaty provisions indicate that the U.S. was reluctant to implement the arbitration procedure until there had been an opportunity to evaluate the process in practice under other Treaties such as the one with Germany.
The Protocol now proposes binding arbitration in specified circumstances, with a procedure set out in some detail in Appendix A to the Protocol.
An overall concept here is that binding arbitration will apply only in certain key areas of interpretation (unless the competent authorities on an ad hoc basis decide to apply arbitration beyond those areas), and there is an "out" in the sense that arbitration will not be used where the competent authorities agree that the particular case is "not suitable for determination by arbitration". However, binding arbitration will at least become a default rule in specified areas.
There is a procedure for the appointment of a three-member arbitration board, which will have broad discretion to adopt procedures for the conduct of the arbitration.
An interesting element of the arbitration process is that the arbitration board will not be empowered to simply arbitrate independently, but must adopt as its determination one of the proposed resolutions submitted by the competent authorities (this style of arbitration is sometimes referred to as "last best offer" arbitration, and can have the advantage of forcing parties to adopt reasonable positions to begin with). In addition, if one of the Contracting States fails to make a submission, the arbitration board must adopt the proposed resolution submitted by the other Contracting State.
Limitation of Benefits
The Protocol will implement a new limitation of benefits (LOB) provision to better address "treaty shopping." These rules are designed primarily to prevent persons from third countries shoe-horning into Treaty benefits by using an intervening entity in Canada to qualify for U.S. Treaty benefits or vice versa.
While the current Treaty contains an LOB provision in Article XXIX-A, this applies only to limit U.S. Treaty benefits and is not reciprocal to Canada. The Technical notes to the existing Treaty state that Canada has preferred to rely on general anti-avoidance rules to combat treaty-shopping. Indeed, Canada has recently amended its GAAR to expressly apply to treaty interpretation, retroactive to 1998.
The new LOB will apply in both countries. While the rules are complex, many of the provisions follow existing concepts, subject to some revisions. Importantly, the LOB retains the existing concepts of an overriding discretion of a competent authority to grant Treaty benefits where the LOB rules would otherwise preclude them, or to deny Treaty benefits "where it can reasonably be concluded that to do otherwise would result in an abuse of the provisions of this Convention" (paragraphs 6 and 7 of Article XXIX-A).
Perhaps the most far-reaching changes under the Protocol will be in the area of conduit entities, some positive, some potentially adverse.
(a) Canadian acceptance of U.S. LLCs
There has been a long-standing issue in that the Canadian tax authorities have in the past not been willing to view U.S. LLCs as "residents" of the U.S. for Treaty purposes (unless the LLC had elected to be treated as a corporation for U.S. tax purposes), and so have denied Treaty benefits to U.S. LLCs on this basis. This had become virtually a trap for the unwary, given the prevalence of LLCs. For example, a U.S. LLC investing in Canada through a standard Canadian subsidiary corporation would not have been entitled to Treaty rates of withholding on cross-border dividends and interest, and instead would have been subject to full 25% Canadian withholding. Interestingly, the Canadian tax authorities had not extended this treatment to U.S. "S" corporations.
The Protocol will provide Treaty relief for U.S. persons investing in Canada through a U.S. LLC, although not by way of a blanket rule.
In general terms, the new rules will "look through" the LLC, as a fiscally transparent entity, and treat its U.S. members as the persons entitled to Treaty benefits (including Treaty rates of withholding tax).
For purposes of determining taxes withheld at source, eg. with respect to dividends or interest, the changes will apply as of the first day of the second month beginning after the day on which the Protocol enters into force (March 1, 2008 at the earliest).
(b) Look-through rules for purposes of dividend taxation
A related amendment to Article X (Dividends) will provide that for purposes of applying the low 5% Treaty withholding rate that applies to dividends where the recipient is a corporation owning at least 10% of the voting stock of the dividend payer, one will now expressly look through "fiscally transparent entities" (that are not resident in the country of residence of the dividend payer). One would expect this rule to apply the look-through equally to a partnership and an LLC.
(c) Challenges for Canadian ULCs and other cross-border hybrids/structures
Canada's hybrid corporation is the Unlimited Liability Corporation (ULC), which can be created under the laws of Nova Scotia, Alberta, and soon, British Columbia. This has become the vehicle of choice for U.S. corporations expanding into Canada. The ULC is treated as a regular corporation for Canadian tax purposes but as a conduit (partnership or disregarded entity) for U.S. tax purposes, and this divergence in treatment has presented the tax opportunities. While the ULC liabilities can reach up to current and former shareholders/members, it is usually possible to structure around this with a suitable "blocker" entity. ULCs are generally easy and economical to set up and maintain.
As the tax benefits here are primarily U.S.-based and we are not trained as U.S. attorneys, our understanding of the advantages is mostly based on transactional work, but subject to this we understand that perceived U.S. tax advantages for using a ULC for investment in Canada have included the following (these are only some of the more common advantages):
(i) losses of a regular Canadian subsidiary do not flow through to U.S. shareholders, but losses of a ULC belong to its U.S. members/shareholders for U.S. income tax purposes, subject to any U.S. domestic loss restriction rules;
(ii) use of a ULC can maximize foreign tax credit utilization for U.S. tax purposes;
(iii) where a Canadian target company is converted into a ULC in an appropriate manner, the underlying asset tax cost can essentially be "stepped up" for a U.S. acquirer in the right circumstances, which can be an alternative to a U.S. s.338 election or used in conjunction;
(iv) use of a ULC could address U.S. tax consequences otherwise applicable to investment in Canada through a regular Canadian corporation that may constitute a CFC or a PFIC;
(v) in certain circumstances, ULCs have been used as financing vehicles to achieve a measure of "double-dip", subject to loss restriction rules such as U.S. "dual consolidated loss" regulations
On a review of the Protocol, the use of a Canadian ULC appears to be significantly impaired.
Take the simple example of a U.S. "C" corporation with a wholly-owned subsidiary that is a Canadian ULC. Clearly, dividends paid by the ULC subsidiary to its parent would qualify for Treaty withholding rates under the current Treaty. Our interpretation of par. 7(b) of the Protocol is that the Treaty withholding rates on dividends, interest or other applicable amounts will no longer be available for amounts paid by the Canadian ULC to the U.S. "C" corporation parent, such that these amounts will be subject to 25% Canadian withholding tax. This would adversely affect the structure of choice currently used in many inbound-to-Canada structures, and would mandate a review and perhaps reorganization of existing structures. The new rules would apply as of the first day of the third calendar year ending after the Protocol enters into force, which we read as applying as of Jan. 1, 2010 at the earliest, but there is no blanket grandfathering for existing structures.
Another structure that may be subject to adverse impact is the inbound-to-Canada structure utilizing a partnership of U.S. companies where the partnership is set up under Canadian law, an election is made to treat it as a Canadian corporation for U.S. tax purposes, and it is funded with cash on-loaned by the partnership to a Canadian operating company. In this type of structure, the goal has been that the Canadian operating company obtains a Canadian tax deduction for the interest while the U.S. partners need not include corresponding interest income (on the theory that the partnership is treated as a Canadian corporation for U.S. purposes and so the interest is not viewed as being received in the hands of the U.S. partners). A cost in this structure is the applicable Canadian withholding tax, but Canada in the past has tended to look through the partnership for purposes of applying withholding tax at 10% as though the interest were paid to the U.S. partners. It appears that this type of structure can now be subject to the proposed rules under par. 7(a) of the Protocol, with the result that the Canadian withholding tax again will be imposed at 25% not at Treaty rates.
Certain outbound "tower" structures may also be affected 2007 Canadian federal budget. Other outbound structures should also be reviewed in light of par. 7 of the Protocol
It is clear that the Canadian government in particular has decided to restrict access to "double-dip" types of structures, and indeed our recent conversations with a Department of Finance official confirmed that the Protocol rules referred to above are aimed at the structures described, and that this is not some inadvertent effect.
The Department of Finance official held out some hope that perhaps the government would be willing to entertain a narrower rule respecting ULCs that would be aimed at "double-dips" without shutting down the other U.S. utilization for these entities, although at this point an amendment should be considered a remote possibility.
Other planning may also be considered. It is clear that existing structures will have to be carefully reviewed and the structure of future cross-border investments carefully considered.
The Protocol will also implement important changes in other areas, including:
- eliminating cross-border withholding on guarantee fees;
- revising the treatment of contributions and benefits relating to certain retirement plans in order to facilitate cross-border movement of personnel;
- apportioning employee stock option benefits between Canada and the U.S.;
- preventing double taxation for emigrating Canadians on pre-emigration gains; and
- addressing cross-border distributions from Canadian income trusts and royalty trusts, and from U.S. REITs.