On December 15, 2008, the Fifth Protocol to the Canada - US Income Tax Convention (Treaty) came into force. The provisions of the Protocol substantially amend the Treaty and take effect at different times, depending on the nature of the tax being relieved. For most taxes, the provisions of the Protocol take effect for taxation years that begin after the calendar year in which the Protocol enters into force. However, a number of specific provisions take effect on particular dates such as those related to withholding tax on cross-border payments, the extension of treaty benefits to investors in limited liability companies, the denial of treaty benefits for certain hybrid entities such as unlimited liability companies, the application of the limitation on benefits provision to Canadian tax benefits otherwise afforded by the Treaty, an expanded definition of permanent establishment, and provisions dealing with dual-resident companies and an individual’s pre- and post-immigration gains.
Dual Corporate Residents and Pre- and Post-Immigration Gains
Article 2 of the Protocol replaces Article IV(3) of the Treaty and provides that if a company is a resident of both Canada and the US, then the company shall be deemed to be a resident of the state under whose laws it was created. Article 8 of the Protocol incorporates new rules into Article XIII of the Treaty, which prevents double taxation on pre-immigration gains on deemed dispositions of certain assets by allowing the individual to elect to be treated in their new country of residence as having disposed of and reacquired the property that has been deemed to have been disposed of for fair market value proceeds at the time of their change in residence. The foregoing rules apply retroactively as of September 18, 2000.
Withholding Tax on Cross-Border Interest Payments
Where a Canadian debtor and a US-resident beneficial owner of interest are related, or would be deemed to be related if Article IX(2) of the Treaty applies for this purpose, Article 27(3)(d) of the Protocol provides for a transitory rule under which the withholding tax rate will be reduced to seven per cent and four per cent for interest paid or credited during the first and second calendar years, respectively, ending after entry into force of the Protocol. For all subsequent years, interest on related-party debt will be governed by the general provision in new Article XI(1) of the Treaty, and therefore will not be subject to withholding tax. Consequently, interest paid on related-party debt was subject to a withholding tax of seven per cent for 2008, is subject to a withholding tax of four per cent for 2009, and will not be subject to withholding tax in 2010 and subsequent years.
The initial reduction in the withholding tax rate to seven per cent applies retroactively as of January 1, 2008.
Extension of Treaty Benefits to Limited Liability Companies
New Article IV(6) of the Treaty provides that Canadian-source income derived through an entity that is fiscally transparent for US tax purposes will be treated as "derived by" a US-resident member if the member is considered to derive such income through the entity for US tax purposes. Article IV(6) of the Treaty is intended not only to facilitate the treaty benefit claims of US-resident members of certain hybrid entities, such as limited liability companies, but also to codify the existing look-through approach used for partnerships not taxed as separate entities in the US, where treaty benefits are extended to the US-resident partners on the basis of their residence. The foregoing change applies in respect of withholding taxes for amounts paid or credited on or after February 1, 2009, and applies in respect of other taxes for taxation years commencing after 2008.
Denial of Treaty Benefits for Certain Hybrid Entities
Article IV(7)(b) of the Treaty provides that an amount of income, profit or gain will not be considered to be paid to or derived by a person who is a US resident where the person is considered for Canadian tax purposes to have received the amount from an entity that is a resident of Canada, but, by reason of the entity being treated as fiscally transparent for US tax purposes, the treatment of the amount for US tax purposes is not the same as its treatment would be if that entity were not treated as fiscally transparent for US tax purposes. Article IV(7)(b) of the Treaty is directed at unlimited liability companies since unlimited liability companies are the only type of entities that can, at present, be residents of Canada for Canadian tax purposes and be fiscally transparent for US tax purposes. The foregoing provision will apply as of January 1, 2010 for calendar year taxpayers.
Limitation on Benefits
Article 25 of the Protocol contains new Article XXIX A of the Treaty, a reciprocal limitation on benefits article that imposes additional tests on US residents that generally determine whether they have a sufficient nexus with the US to claim benefits under the Treaty. The limitation on benefits provision applies in respect of withholding taxes for amounts paid or credited on or after February 1, 2009 and applies in respect of other taxes for taxation years commencing after 2008.
The extended definition of permanent establishment will now deem a permanent establishment to exist in two circumstances where the service provider does not operate from a fixed place of business in a contracting state. In the first, a permanent establishment will be deemed to exist where the services are performed by an individual who is present in a contracting state for a period or periods aggregating 183 days or more in any 12-month period, and during that period or periods, more than 50 per cent of the gross active business revenues of the enterprise consists of income derived from the services performed in the other state by that individual. In the second, a permanent establishment will be deemed to exist where the services are provided in a contracting state for an aggregate of 183 days or more in a 12-month period with respect to "the same or connected project" for customers who are either residents of that other contracting state or who maintain a permanent establishment in that other contracting state and the services are provided in respect of that permanent establishment. This provision will apply as of January 1, 2010 for calendar year taxpayers.