The Fifth Protocol to the Canada - U.S. Tax Convention, dated September 21, 2007 (the "Protocol") will have a significant impact on cross-border transactions given the proposed treatment for hybrids and the elimination of withholding tax on interest on arm's length cross-border debt. Following are specific comments regarding the potential impact of the Protocol on limited liability companies, unlimited liability companies and debt financings. For a more general discussion regarding the Protocol, please see the CanadianTax@Gowlings issue of September 25, 2007.

Limited Liability Companies

- Overview

U.S. LLCs that are treated as fiscally transparent entities for U.S. tax purposes are currently denied the benefit of the Canada-U.S. Tax Convention, 1980 (the "Treaty"). The Canada Revenue Agency (the "CRA") has historically taken the position that while an LLC is a corporation for Canadian tax purposes, an LLC that is a disregarded entity for U.S. tax purposes is not a resident of the U.S. for purposes of the Treaty as it is not subject to tax in the U.S. The members of the LLC also do not enjoy the benefits of the Treaty in respect of their participation in the LLC.

The Protocol contains a new provision that is intended to allow U.S. residents who derive Canadian source amounts through an LLC to benefit from the Treaty. The Protocol does not extend the benefits to the LLC, but rather it applies to the members of the LLC that are resident of the U.S. allowing the member to claim treaty benefits with respect to income and gains realized "through" the LLC. Although there is still some uncertainty as to how the changes will be applied and interpreted, it is hoped that it is applied in a manner consistent with the intent of the Protocol.

- Effect on cross-border transactions

Given that members of an LLC will now be entitled to the benefits of the Treaty there are a number of implications for cross-border transactions.

For example, in acquiring a Canadian corporation, it is typical for the U.S. acquirer to establish a Canadian wholly-owned acquisition subsidiary through which to effect the Canadian acquisition. In doing so, however, it was imperative that the U.S. acquirer not be a "fiscally transparent" LLC as any dividends or interest paid by the Canadian acquisition corporation to the LLC would be subject to a Canadian withholding tax of 25%. Moreover, a fiscally transparent LLC would not be entitled to the general exemption from Canadian tax on Canadian sourced gains, with the result that, in most cases, the U.S. acquirer would be subject to Canadian capital gains tax on any gain realized on a sale of the shares of the Canadian corporation.

Two months following the time that the Protocol is ratified by each country (with possible effect as early as March 1, 2008), this will no longer be a concern when structuring a Canadian acquisition. That is, an LLC could be used as the direct U.S. parent of the Canadian acquisition corporation. Any dividends or interest paid by the Canadian acquisition corporation to the LLC will be treated as being earned by the members of the LLC such that they would benefit from a Treaty reduced rate of withholding tax. The Canadian withholding tax rate for dividends will be either 15% or 5% (the lower rate applying where the member is deemed to indirectly hold more than 10% of the voting stock of the Canadian acquisition corporation). The withholding tax rate for interest payments will, as discussed below, be either 15% or 0% (the lower rate applying if the parties are unrelated or dealing at arm's length and the interest is not participating interest). Similarly, any gains from the alienation of the shares of the Canadian acquisition corporation will be exempt from Canadian tax provided that the shares do not derive their value principally from real property situated in Canada.

In addition, U.S. private equity funds making investments into Canada may now be structured as LLCs rather than partnerships. Historically, a private equity fund that was an LLC (or had an LLC as a partner) making Canadian investments needed to either establish a U.S. blocker C-corporation below the LLC or establish a parallel offshore partnership. The former introduced a U.S. taxable entity that could give rise to tax leakage that would have to be managed, generally through leverage (which was not always possible) and the latter introduced significant complexity in respect of both the initial set-up of the parallel entity and its ongoing administration. It may be that U.S. funds structured as LLCs or with LLC partners will now be able to make direct investments into Canada as the U.S. members of the LLC should be entitled to benefit from the Treaty. However, the new provisions introduced by the Protocol may not be a panacea as they will likely create administrative and filing concerns for fund managers as they will need to obtain additional information from their members and provide such information to the CRA to ensure that the benefits of the Treaty are in fact available to fund investors. It also seems that an LLC will not be attractive to non-U.S. investors as they will not be entitled to the "look-through" treatment accorded to residents of the U.S. nor will they be entitled to the benefits of a tax treaty between Canada and the investor's country of residence. Accordingly, private equity funds with international investors will probably still be structured as partnerships.

Unlimited Liability Companies

As noted above, the Protocol goes beyond LLCs and contains a comprehensive set of new rules in the Residency article that deny Treaty benefits to persons who hold an interest in certain hybrid entities (such as Canadian unlimited liability companies or "ULCs").

ULCs have recently become a popular Canadian acquisition vehicle as their hybrid nature makes them eligible for U.S. "check-the-box" treatment as fiscally transparent. This would permit tax losses to flow through to U.S. shareholders as well as offer other opportunities like tax credit utilizations and possible "double dips".

The Protocol rules relating to hybrid entities can be described, at best, as not being an example of clear and concise drafting. The consensus is that Treaty benefits will be denied (and full Canadian withholding tax will apply) on interest payments made by a ULC to its U.S. corporate parent on what is commonly known as "disregarded debt" for U.S. tax purposes. "Disregarded debt" is generally debt and interest income therefrom that is not recognized for U.S. tax purposes.

This proposed change could have a significant impact on debt "push down" structures (sometimes referred to as "reverse-hybrid" structures and sometimes used for multinational corporations) as well as cross-border acquisition structures involving a ULC as the Canadian acquisition vehicle. In this regard, interest paid by the ULC to its U.S. corporate parent would not be entitled to a reduced rate of withholding tax such that interest payments would be subject to a 25% Canadian withholding tax.

It should be noted that while existing ULC structures will not be grandfathered, the rules dealing with reverse-hybrids will not take effect until the first day of the third calendar year ending after the Protocol enters into force (with possible effect as early as January 1, 2010). Historic acquisition structures having a ULC component will need to be reviewed in the interim to determine whether restructuring is required so as not to incur additional tax under the Protocol. Query whether investments through a third-country is now required (or permitted).

Withholding Tax on Interest

- Arm's Length Lenders

The Protocol provides for the elimination of withholding tax on interest paid to both unrelated and arm's length U.S. residents by a Canadian resident. This elimination will be effective at the beginning of the second month following the month in which the Protocol comes into force (as early as March 1, 2008). A similar change that would have general application (in other words, that would apply to all non-resident arm's length lenders, not only to U.S. resident lenders) was proposed under Draft Legislation released by the Department of Finance (Canada) on October 2, 2007 (the "Draft Legislation").

One important qualification to the withholding tax exemption with respect to Canadian source interest is that various types of so-called "participating interest" will be subject to the Treaty rate of withholding tax of 15% rather than 0%. The type of interest that is caught by the rule is interest "determined with reference to receipts, sales, income, profits or other cash flows of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor or a related person."

As with the proposed changes to LLCs, this change will have a significant impact on cross-border acquisitions. More specifically, access to capital for acquisition transactions and operating lines will increase significantly as it will be easier to access both U.S. and international debt markets, and borrowing costs will be reduced as there will no longer be the need to gross-up a foreign lender for Canadian withholding tax. Under the current rules, interest paid by a resident Canadian borrower to a resident U.S. lender is subject to withholding tax at a rate of 10%. The most common exemption from this withholding tax (the so-called "5/25 exemption") is often impractical for borrowers to access as it requires loans to have a term of at least 5 years and to provide that no more than 25% of the principal be required to be repaid within the first 5 years, except in certain default scenarios. If applicable, this tax raises the cost of capital for Canadian borrowers as it is almost invariably borne by the borrower in the form of an interest payment "gross-up". It also requires somewhat convoluted covenant packages.

- Non-Arm's Length Lenders

The Protocol also provides for the gradual elimination of withholding tax on interest paid to related or non-arm's length parties who are U.S. residents qualifying for the benefits of the Treaty. During the first calendar year that ends after the Protocol enters into force, the reduced rate of withholding tax will be 7%. During the second calendar year the rate will be 4%, and after that the withholding tax will be eliminated.

- Current Transactions

There will be a waiting period before the elimination of withholding tax on arm's length interest becomes effective. In the interim, Canadian corporate borrowers will continue to rely on the 5/25 exemption.

The Draft Legislation also proposes to allow arm's length parties that have entered into lending arrangements (on or after March 19, 2007) that rely on the 5/25 exemption to build into loan agreements, provisions that would automatically eliminate certain limitations on mandatory prepayments that would otherwise be included in the loan agreement only because of the rules surrounding the 5/25 exemption (that is, the provisions in the loan agreement that cap mandatory prepayments to 25% would automatically "fall-away" once the Draft Legislation is in force).

At first blush, this amendment seems to facilitate the drafting of loan agreements that incorporate the anticipated elimination of the withholding tax on interest, as it was intended to do. However, based on past experience, borrowers may not incorporate the "fall-away" provisions for fear that if the Draft Legislation is not enacted, the loan agreements that include such "fall-away" provisions would not meet the existing 5/25 requirements with the result that a borrower would be liable for omitted withholding tax plus interest and penalties.


In summary, the impact of the Protocol on limited liability companies, unlimited liability companies and debt financing will be felt not only in cross-border acquisition structures, but also in leveraged buy-outs and dividend recapitalization debt architecture and covenants.