On July 10, 2008, the U.S. Department of the Treasury released its long awaited Technical Explanation of the Fifth Protocol (the "Protocol"), which protocol will amend the Canada-U.S. Tax Convention (the "Convention"). The Protocol was signed by representatives of Canada and the U.S. on September 21, 2007. We have previously discussed the Protocol in Taxation Law @ Gowlings No. 116, and in Special Bulletins of Canadian Tax @ Gowlings on September 25 and October 10.

The Technical Explanation was prepared in advance of a meeting of the U.S. Senate Committee on Foreign Relations on July 11 at which testimony regarding the Protocol was heard. In connection with the meeting, Canada's Minister of Finance Jim Flaherty issued a press release stating that Canada "supports" the Technical Explanation and is in "agreement" with it, and had an opportunity to both review the Technical Explanation and provide comments thereon. Accordingly, the Technical Explanation should prove to be an important document for interpreting the provisions of the Protocol in the future. However, although many (ourselves included) had hoped that the Technical Explanation would address certain negative implications and uncertain aspects of the Protocol, for the most part it does not address these implications and uncertainties (and, in some cases, raises new issues). Highlighted below are some of the more important issues in this regard.

Although the Protocol has not yet been reported out of the Senate Committee on Foreign Relations, the fact that the July 11 hearing was held does increase the likelihood that the Protocol will pass the Senate and be ratified within the calendar year, which would be consistent with past U.S. practice on ratification. This is an important milestone as many of the milestones, effective dates and deadlines within the Protocol depend on the calendar year of ratification. Canada has already ratified the Protocol.

In addition to the Technical Explanation, the U.S. House-Senate Joint Committee on Taxation released on July 8 its own Explanation of the Convention (the "JC Explanation"). The JC Explanation goes into more depth about aspects of the Convention concerning hybrid entities, aspects that will be of concern to many who invest in Canada from or through the U.S.

Application of Reduced Withholding Rates

The Protocol provides for amendments to Article XI of the Convention reducing the maximum rates of withholding tax which may be applied to interest. For interest received from a related party, the maximum rates are to decline over a period of three years, but the language in the Protocol had originally been somewhat unclear as to when the reduced rates would apply.

The Technical Explanation clarifies that withholding rate reductions for related party interest "will likely apply retroactively" after ratification; that is, provided that the Protocol is ratified in 2008, related party interest paid at any time during 2008 will be subject to a maximum withholding rate of 7 percent, related party interest paid during 2009 will be subject to a maximum withholding rate of 4 percent, and related party interest paid thereafter will not be subject to withholding.

For interest received from an unrelated party the Protocol eliminates withholding tax immediately upon ratification. This provision is of particular interest to Canadian banks or other entities that do not qualify for a "portfolio exemption" in the United States. Similarly to related party interest, the Technical Explanation clarifies that the withholding tax exemption for unrelated party interest "will likely apply retroactively" after ratification; that is, provided that the Protocol is ratified in 2008, unrelated party interest paid at any time during 2008 will not be subject to withholding tax.

Although we have not yet received any indication from the Department of Finance or the Canada Revenue Agency as to how to account for withholding on interest where the withholding tax rate is reduced or eliminated retroactively, we remain hopeful that relief will be made available to taxpayers who withheld (or whose interest was withheld) at a rate greater than the effective rate after the retroactive provision comes into effect.

Taxation of Hybrid Entities

The Protocol provides for amendments to Article IV of the Convention that will deny treaty benefits to the recipients of certain kinds of payments from "hybrid" entities. These are entities, for example, that are treated as fiscally transparent under the tax laws of the recipient's State but which are not treated as fiscally transparent under the tax laws of the State in which the hybrid entity is resident.

The Technical Explanation confirms certain elements of the scope of the Protocol's changes to Article IV to certain quite common cross-border corporate structures that most international tax practitioners had considered "benign". For example, it confirms that new paragraph IV(7)(b) will apply (and deny treaty protection) to dividends, interest payments and royalty payments made by a Canadian entity to a U.S. shareholder if the Canadian entity is a corporation for Canadian purposes but a disregarded entity for U.S. purposes. A typical example would be a Canadian unlimited liability company or corporation (more on this below). Similarly, the Technical Explanation confirms that paragraph IV(7)(b) will apply to such payments made to a Canadian entity by a U.S. limited partnership that has elected to be treated as a corporation for U.S. tax purposes.

However, the Technical Explanation unfortunately does not address the question of whether new paragraph IV(7)(b) will apply to deny treaty protection to interest or royalty payments made by a Canadian corporation that is considered by U.S. law to be a partnership. The Technical Explanation is clear that a dividend in such circumstances would be caught by paragraph IV(7)(b), but makes no mention of interest or royalty payments. This silence is likely due to such a payment being an issue only for Canadian tax purposes (characterization of the payment for U.S. purposes is apparently unproblematic). The uncertainty of the application of the provision in this case will make the withholding tax obligations of Canadian payors unclear and further clarification on this issue would be helpful.

As alluded to above, the Technical Explanation is silent on perhaps the most important issue facing those who have invested in Canada through the U.S. using hybrid entities - the application of the provisions of the Protocol to non-abusive structures using Canadian unlimited liability companies or corporations ("ULCs"). In private discussions, public statements and the Technical Explanation, both the Department of Finance and the Treasury Department have identified hybrid structures that they consider to be abusive. However, in the JC Explanation, the Joint Committee acknowledges that not all hybrid structures are abusive:

As a general matter, it is a legitimate objective for Canada and the United States, separately or jointly, to attack these or other types of structures that give rise to double deductions (or to single deductions with no income offsets). Commentators have noted, however, that many U.S. companies utilize Canadian ULCs to structure their Canadian investments and businesses, without engaging in such potentially abusive transactions, for a variety of legitimate reasons… The Committee may wish to inquire whether a rule might have been negotiated in lieu of subparagraph 7(b) that would have more narrowly targeted abusive cross-border structures while at the same time causing less disturbance to nonabusive structures.

We note that although such an issue was not raised in the Senate Committee hearings on the Convention, the Committee did leave the record open for further questions and hopefully such questions will be put before the Treasury officials called as witnesses prior to ratification. This recognition by the Joint Committee that there are non-abusive structures using hybrids may also assist in navigating the domestic "treaty-shopping" rules of each jurisdiction in any possible restructuring of hybrid structures.

It is likely that the new anti-hybrid rules in the Protocol will take effect on January 1, 2010. It is probably trite to state that rather than have to restructure cross-border investments, most taxpayers would far prefer to see Canada and the U.S. renegotiate certain aspects of these rules prior to that effective date. However, there is no indication in either the Technical Explanation or the JC Explanation that such a renegotiation is expected or likely.

Limitation of Benefits

As noted in our prior discussions of the Protocol, the Protocol also amends Article XXIX(A) of the Convention to introduce reciprocal limitation of benefits provisions designed to address so-called "treaty shopping" by limiting treaty benefits to residents of Canada or the U.S. that satisfy specified requirements. In general terms, these provisions require that residents satisfy a "qualifying person" test, an "active business test," or a "derivative benefits" test to obtain treaty benefits. The Technical Explanation clarifies certain elements of these tests. We anticipate that compliance with the limitation of benefits rules, and in particular the so-called "look-through rules", will impose significant administrative costs on taxpayers and require corporations to know significantly more about their shareholders and exercise greater control over share transfers and other changes in the composition of their owners. The Technical Explanation does not address the administrative and compliance challenges created by the limitation of benefits rules.

Qualifying Person Test. The Protocol identifies five situations in which a resident of Canada or the U.S. will be a "qualifying person." These include (i) a company if the principal class of shares or units (and any disproportionate class of shares or units) is "primarily and regularly" traded on one or more recognized stock exchanges (the "public company requirement"); and (ii) a company if 50% or more of the aggregate vote and value of its shares and 50% or more of the aggregate vote and value of each class of its disproportionate shares is not owned directly or indirectly by non-qualifying persons, subject to limitations on expenses paid directly or indirectly to non-qualifying persons under a "base erosion" requirement.

The Technical Explanation confirms that the phrases "primarily traded" and "regularly traded" are to have the meanings such terms have under U.S. law until Canada adopts its own meanings for such phrases. The Technical Explanation also confirms that under U.S. law, if more shares of the principal class of shares - generally, ordinary or common shares - are traded on a recognized stock exchange than on other securities markets during the year, the shares will be "primarily traded" on a recognized stock exchange. Furthermore, the Technical Explanation explains that under U.S. law, shares are regularly traded if trades in the class of shares are made in more than de minimis quantities on at least sixty days during the taxable year and the aggregate number of shares in the class traded during the year is at least 10% of the average number of shares outstanding during the year. The Technical Explanation also clarifies that trading on one or more recognized stock exchanges may be aggregated for purposes of meeting the "regularly traded" requirement.

The Technical Explanation confirms that the company ownership requirement will be satisfied if on at least half the days of the taxable year the specified percentage of shares are not owned, directly or indirectly by non-qualifying persons. The Technical Explanation further confirms that the ownership test will not be satisfied if, for example, a Canadian company is more than 50% owned by a U.S. resident company that is, itself, wholly owned by a third country resident because the third country resident will not be a "qualifying person." The Technical Explanation does state that Canada and the U.S. will view the ownership requirement to be satisfied if at least 50% of a U.S. or Canadian company is owned, directly or indirectly, by a second company or trust that satisfies the public company requirements. The Technical Explanation also confirms that in analyzing whether the ownership and base erosion requirements have been satisfied, one must look through entities in the chain of ownership that are viewed as fiscally transparent in the person's country of residence (other than entities that are resident in the source country).

Active Business Test. If a resident of one state is not a "qualifying person," the Protocol extends treaty benefits to the resident if the resident, or a person "related" to the resident, is engaged in the active conduct of a "trade or business" (other than certain investment businesses) in the residence state with respect to income derived by the resident from the other state "in connection with" or "incidental to" that trade or business (including any such income derived directly or indirectly through one or more residents of the other state), but only if the trade or business carried on in the residence state is "substantial" in relation to the activity carried on in the other state giving rise to the income in respect of which the treaty benefits are claimed.

The Technical Explanation clarifies that the determination of whether persons are "related" is to be made under the local laws of the U.S. or Canada, as applicable. The Technical Explanation also confirms that income derived "in connection with" a resident's trade or business includes income from business activities that are "upstream," "downstream," or "parallel" to the activity conducted in the other country. The Technical Explanation further clarifies that income is considered "incidental" to a trade or business if, for example, it arises from the short-term investment of working capital of the resident in securities issued by persons in the source country. The Technical Explanation also confirms that an item of income may be considered to be earned in connection with or to be incidental to an active trade or business in one of the treaty countries even though the resident claiming the benefits derives that income directly or indirectly through one or more persons that are residents of the other treaty country. For example, the Technical Explanation states that a Canadian resident could claim benefits with respect to an item of income earned by a U.S. operating subsidiary, but derived by the Canadian resident through a wholly owned U.S. holding company interposed between it and the operating subsidiary. Another example addresses a Canadian partnership, wholly-owned in equal parts by three unrelated Canadian companies, that forms a wholly-owned U.S. holding company with a U.S. operating subsidiary. In this example, the Technical Explanation states that the Canadian partners may claim treaty benefits with respect to income derived through the U.S. holding company, even if the partners were not considered related to the U.S. holding company under U.S. law.

The Technical Explanation also confirms that the substantial activity requirement is intended to counter treaty-shopping abuses in which a company resident in one country attempts to qualify for benefits by engaging in de minimis connected business activities in the treaty country in which it is resident. The Technical Explanation clarifies that the substantial activity requirement does not require that the trade or business in the residence country be as large, in terms of income, assets or similar measures, as the income-producing activity in the source country but must not represent only a small percentage of the activity in the source country.

Derivative Benefits Test. The Protocol also employs a "derivative benefits" provision that is intended to allow a resident company to claim treaty benefits with respect to dividend, interest and royalty income if the company's owners would have been entitled to the same benefits in respect of the income had the owners derived the income directly, subject to limitations on expenses paid to non-qualifying persons under a base erosion test. The Technical Explanation confirms that in analyzing whether the base erosion requirement has been satisfied under the derivative benefits test, one looks through entities in the chain of ownership that are viewed as fiscally transparent in the person's country of residence (other than entities that are resident in the source country).

General Anti-abuse Provisions. The Protocol contains an anti-abuse rule that the limitation of benefits provisions will not be construed as restricting the ability of Canada or the United States to deny benefits under the Convention in any case in which it can reasonably be concluded that to do otherwise would result in an abuse of the Convention's provisions. The Technical Explanation clarifies that this provision permits a treaty country to rely on general anti-abuse rules to counter arrangements involving treaty shopping through the other treaty country.

Summary

As noted above, the Technical Explanation, as well as the JC Explanation, provide some further guidance in respect of issues raised by the Protocol. However, there are still many unanswered questions, including what, if anything, will be done by the two States to address the impact of the Protocol on "non-abusive structures", or what taxpayers and tax practitioners can do in this regard.