On Friday, September 21, 2007, Jim Flaherty, Canada’s Finance Minister, and US Treasury Secretary Henry Paulson Jr., signed the fifth Protocol (the "Protocol") to the Canada-U.S. Tax Convention (1980) (the "Convention"). Diplomatic notes constituting Annex A and Annex B to the Convention were released concurrently.
In March 2007, the Canadian Federal Budget announced an agreement in principle on the major elements of a new Protocol and noted that formal negotiations were expected to conclude in the very near future. However, as the summer drew to a close, expectations of having the Protocol signed this year diminished. The announcement of the signing of the Protocol came as a pleasant surprise, although it contains a few unpleasant changes for businesses with cross-border structures.
The release of the Protocol concludes nearly a decade of negotiations between the two countries. The Protocol contains several important changes to the Convention that were announced in the March 2007 Canadian Federal Budget, including the elimination of withholding tax on cross-border interest payments and the extension of treaty benefits to certain US limited liability companies ("LLCs"). In addition, the Protocol contains a number of far-reaching and unexpected changes that will have a significant impact on cross-border transactions, including a "corollary rule" that will severely limit access to treaty benefits for hybrid entities and an extension of the limitation on benefits ("LOB") provision into a reciprocal rule.
The Protocol enters into force on the later of January 1, 2008 and the date on which the Contracting States exchange diplomatic notes indicating that their ratification procedures have been satisfied. In Canada, ratification requires Parliament to implement the Protocol by enacting legislation. The Backgrounder to the Protocol states that the Canadian government intends to introduce a Bill in Parliament for this purpose "at an early opportunity." In sum, the Protocol will enter into force on January 1, 2008 only if both the Bill receives Royal Assent and the US Congress ratifies the Protocol before the end of the year. It remains uncertain whether both countries will ratify the Protocol this year, and the nearly four-year delay between the signing and entry into force of the original Convention proves that there could potentially be some delay.
Elimination of Withholding Tax on Interest
As anticipated, the Protocol eliminates withholding tax on cross-border interest payments. Paragraph 1 of Article XI (Interest) of the Convention now provides simply, "Interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed only in that other State." However, it is important to note that this change does not apply to interest on participating debt issued by a Canadian resident, which will be subject to the same 15% rate of withholding tax generally applicable to dividends under paragraph 2(b) of Article X (Dividends) of the Convention
The elimination of withholding tax on interest for arm’s length debt applies to amounts paid or credited on or after the first day of the second month beginning after the date on which the Protocol enters into force. For interest on non-arm’s length debt, transitional rules in the Protocol provide that the existing Convention rate of withholding tax on interest will be reduced to 7% and 4% in the first and second calendar year, respectively, ending after entry into force of the Protocol, and will be eliminated entirely for all subsequent years.
The Income Tax Act (Canada) (the "Act") currently provides exemptions from Canadian withholding tax on interest in certain limited circumstances, the most important of which is found in subparagraph 212(1)(b)(vii) (the "5/25 exemption"). The 5/25 exemption applies to interest paid by a Canadian corporation to a non-resident lender where the Canadian borrower is not subject to an absolute or contingent obligation to repay more than 25% of the principal amount of the debt obligation within the first five years of its issue, except generally in the case of an event of default. Importantly, the 5/25 exemption applies only where the non-resident lender deals at arm’s length with the Canadian corporate borrower. The usefulness of the 5/25 exemption has always been limited because it applies only to medium and long-term debt and does not generally apply to revolving credit. In addition, there is often uncertainty associated with administrative positions of the Canada Revenue Agency (the "CRA") with respect to the operation of these provisions.
Where the 5/25 or other exemptions are unavailable, the existing Convention limits the rate of withholding tax on interest payments made by a Canadian resident to a US resident to 10%. In this context, the elimination of withholding tax on interest paid between arm’s length parties should enable Canadian borrowers to access the US debt market more extensively and reduce their borrowing costs where it is not possible to comply with the structural constraints of the 5/25 exemption or qualify for other withholding exemptions. With expanded relief offered by the Protocol, US resident lenders may become more active players in the Canadian debt market.
The elimination of withholding tax on interest paid between arm’s length parties introduces transitional problems for existing debt obligations relying on the 5/25 exemption. In anticipation of this fact, the Canadian Department of Finance issued a comfort letter on September 4, recommending an amendment to the 5/25 exemption to ensure borrowers issuing debt obligations before the Protocol enters into force are not disadvantaged. The letter recommends an amendment to existing subparagraph 212(1)(b)(vii) of the Act so otherwise qualifying debt obligations may require the repayment of more than 25% of their principal amount within five years, provided that such repayment obligation can arise only if a change to the Act or a tax treaty has the effect of relieving the non-resident lender from liability for tax in respect of interest on the debt in such circumstances. The change would apply to all debt obligations entered into on or after March 19, 2007.
The March 2007 Canadian Federal Budget also announced an intention to amend the Act to eliminate Canadian withholding tax on interest paid to all arm’s length non-residents, regardless of their country of residence. Disappointingly, the Backgrounder does not provide any further details regarding this proposal.
Residency Provision for Hybrid Entities
The Protocol goes well beyond simply dealing with the problem confronting US LLCs under the existing Convention and contains a comprehensive set of new rules in the residency article that either grant or deny treaty benefits to persons having interests in hybrid entities "at large."
Historically, the CRA had denied treaty benefits to US LLCs (other than those which elected to be taxed as corporations for purposes of US tax laws) on the grounds that they were not liable to tax in the US and thus were not residents of the US for treaty purposes. In addition, since US LLCs are considered to be corporations for Canadian tax purposes, CRA was not prepared to "look-through" the US LLC and provide treaty benefits to members that were residents of the US for treaty purposes.
Although this measure had been expected, there had been speculation as to the means by which transparent US LLCs (or their members) would be granted treaty benefits. The Protocol achieves this by adding to the existing residency article of the Convention certain deeming rules that apply in the case of "fiscally transparent" entities. For instance, in the case of a US LLC, this rule provides that an amount of income, profit or gain will be considered to be "derived by" a member of the US LLC where the member is considered to derive an amount through the US LLC under US tax law and, by reason of the US LLC being fiscally transparent, the treatment of the amount under US tax law is the same as it would have been if the member had received it directly. The phrase "considered to be derived" is curious. While there are provisions in the Convention that use the phrase "income derived by", many of the provisions of the Convention do not refer to income "derived by" a resident of a Contracting State from the other Contracting State, but rather refer to income of, or beneficially owned by, a resident of a Contracting State. The intent of the Protocol is that the member of the fiscally transparent entity obtain the benefit of the applicable treaty relief on the income that is considered to be derived by the member provided the applicable conditions are satisfied and the member is a resident of the US for treaty purposes. In this regard, Article 5 of the Protocol (which amends paragraph 2(a) of Article X (Dividends) of the Convention) provides that a company that is a resident of a Contracting State will be considered to own the voting stock owned by an entity that is fiscally transparent under the laws of that State and that is not a resident of the Contracting State of which the company paying the dividends is a resident in proportion to the company's ownership interest in that entity. As a consequence, if the member of the US LLC holding shares of a Canadian corporation is deemed to own 10% of the voting stock of the Canadian corporation, the withholding tax rate on dividends will be reduced to 5%, rather than 15%. In the same way, the change will allow a corporate partner of a partnership receiving dividends from a corporation (of which the corporate partner is deemed to own 10% of the voting stock) to benefit from the reduced 5% withholding tax rate.
In respect of withholding taxes on certain amounts including dividends, interest and royalties paid to US LLCs, the treaty benefits apply for amounts paid or credited on or after the first day of the second month that begins after the date on which the Protocol enters into force. In respect of other taxes, such as those imposed on capital gains, the treaty benefits apply to taxation years beginning after the calendar year in which the Protocol enters into force.
As a "corollary" to the extension of treaty benefits to transparent US LLCs, the Protocol introduces a surprising and dramatic set of new rules in the residency article that are essentially designed to deny treaty benefits to certain hybrid entities commonly used in cross-border transactions between the two countries. The first "corollary" rule essentially 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 resident of a Contracting State (the "Residency State") where the person is considered under the taxation law of the other Contracting State (the "Source State") to have derived the amount through an entity that is not a resident of the Residency State, but by reason of the entity not being treated as fiscally transparent under the laws of the Residency State, the treatment of the amount under the taxation law of the Residency State is not the same as its treatment would be if that amount had been derived directly by that person.
This rule would appear to apply, for example, to so-called "synthetic NRO" financing structures that essentially use a "reverse hybrid" partnership with US corporate partners to finance Canadian group operations. In that context, two US companies typically establish and capitalize a Canadian partnership, which "checks the box" to be treated as a corporation for US tax purposes. The premise of the structure is that while Canada would "look-through" the Canadian partnership and view interest being paid to US corporate partners, the US would view the interest being paid to a Canadian corporation by reason of the "check-the-box" election. Under the existing Convention, the CRA seemed to accept reluctantly the application of the reduced treaty rate to the interest paid by the Canadian corporation to the Canadian partnership but had stated publicly that it was reconsidering its position, as it appeared to be at odds with the OECD Partnership Report and the OECD Commentary to Article 1.
The second "corollary" rule essentially 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 resident of a Contracting State (the "Residency State") where the person is considered under the taxation law of the other Contracting State (the "Source State") to have received the amount from an entity that is a resident of the Source State, but by reason of the entity being treated as fiscally transparent under the laws of the Residency State, the treatment of the amount under the taxation law of the Residency State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of the Residency State.
This rule would appear to deny treaty benefits, for example, on interest payments made by a Canadian unlimited liability company ("ULC") to its US corporate parent on "disregarded debt" for US tax purposes. Under the existing Convention, while Canada would view the interest paid by the Canadian ULC as interest paid by a Canadian corporation, the US would disregard the interest which is not the same treatment as if the ULC were not treated as transparent for US tax purposes. This rule would appear to undermine the future viability of certain "synthetic NRO" financing structures that might not have been caught by the first "corollary" rule, and certain types of "debt pushdown" structures that have recently been popular with US multinationals.
Although the above two examples of the potential application of the "corollary" rules focus on the denial of treaty benefits for interest payments received or made by certain hybrid entities in a financing structure, these rules could apply to any existing structure having any income, profit or gain paid or received by a hybrid entity including, for example, dividends.
The first and second "corollary" rules do not take effect until the first day of the third calendar year ending after the Protocol enters into force. Accordingly, there is limited grandfathering provided for existing financing structures targeted by these new measures.
Unintended Benefits for Members of US LLCs?
The drafting of the Protocol appears to create issues of treaty interpretation.
Under Article VII (Business Profits) of the Convention, the business profits of a resident of the US are exempt from Canadian tax, unless the US resident carries on business in Canada through a permanent establishment situated therein. Under the "fiscally transparent" rules discussed above, if the applicable conditions are satisfied, the member of the US LLC carrying on business in Canada should be considered to derive the business income earned by the US LLC. However, if the US LLC carries on business in Canada through a permanent establishment there is no rule that deems the US LLC's permanent establishment to be a permanent establishment of the member. This is in contrast to the deeming provision dealing with shares of a corporation owned by a fiscally transparent entity. Does this mean that such income will be exempt from Canadian tax in the hands of the member of the US LLC because the member does not have a permanent establishment in Canada or will a Court conclude that the member is deemed to have the income as it was actually earned and not divorced from its source – the permanent establishment of the US LLC? A similar issue arises in relation to Article XIII (Gains) of the Convention. Paragraph 4 of Article XIII provides that gains from the alienation of property, other than that referred to in paragraphs 1, 2 and 3, will be taxable only in the Contracting State of which the alienator is resident. Paragraph 2, as it is to be amended by the Protocol, refers to personal property forming part of the business property of a permanent establishment which a resident of a Contracting State has or had (within the twelve-month period preceding the date of alienation) in the other Contracting State, including gains from the alienation of such a permanent establishment. However, once again, there is nothing to deem the US LLC's permanent establishment to be that of the member. Does this mean that such gains will be exempt from Canadian tax in the hands of the member of the US LLC?
Limitation of Benefits Provision ("Treaty Shopping")
The LOB provision in Article XXIX-A (Limitation on Benefits) of the existing Convention seeks to prevent "treaty shopping." Under the existing LOB provision, a resident of a third country is prevented from establishing an entity resident in Canada as a conduit to invest in the United States merely for the purpose of claiming US treaty benefits. Under the existing Convention, the LOB provision is not reciprocal. Canada sought to counter abusive arrangements involving "treaty-shopping" through the US mainly through other applicable anti-abuse rules, including the general anti-avoidance rule (the "GAAR") in section 245 of the Act.
New Article XXIX-A now clearly makes the LOB provision reciprocal in that residents of the US will be denied Canadian treaty benefits unless they also satisfy the additional tests imposed by new Article XXIX-A. New paragraph 2 of Article XXIX-A extends Canadian treaty benefits to "qualifying persons" resident in the US who generally satisfy a publicly traded test or a combined ownership and "base erosion" test. New paragraph 3 of Article XXIX-A extends Canadian treaty benefits to "non-qualifying persons" resident in the US who satisfy an "active trade or business" test.
The new LOB provision may be used to deny Canadian treaty benefits to certain US residents, providing the CRA with a new alternative to the application of the GAAR in perceived "treaty shopping" cases.
Permanent Establishments of Service Providers
The Protocol introduces a new provision in the definition of "permanent establishment" in Article V (Permanent Establishment) of the Convention that deems an enterprise of a Contracting State (the "Residency State") providing services in the other Contracting State (the "Source State") to have a permanent establishment in the Source State if either:
- the services are performed by an individual who is present in the Source State for a period aggregating 183 days or more in a 12-month period and during that period more than 50% of the gross active business revenues of the enterprise are derived from those services; or
- the services are provided in the Source State for an aggregate of 183 days or more with respect to the same or connected project for customers who are either residents of the Source State or have a permanent establishment there.
New paragraph 9 of Article V, especially its second prong, will likely have an important impact on consultants and other service providers as it might now deem a permanent establishment to exist in the Source State even if a place of business might not have the necessary degree of permanence under the general principles of paragraph 1 of Article V.
The Protocol contains many other elements, including permitting binding arbitration to resolve disputes between the competent authorities of the two countries referred to them pursuant to the mutual agreement procedure, clarifying the apportionment of stock option benefits between the two countries, giving mutual tax recognition of pension contributions, ensuring no double taxation of emigrants’ gains, and implementing many technical updates to several other provisions.
Mutual Agreement Procedure
The Protocol introduces a binding arbitration mechanism to resolve intractable disputes between the competent authorities of the Contracting States under the mutual agreement procedure. Article XXVI (Mutual Agreement Procedure) of the existing Convention does not provide a mechanism to resolve a case of double taxation where the competent authorities of the Contracting States cannot agree upon a resolution. Under the Protocol, provided certain requirements are met, a taxpayer may request binding arbitration where the competent authorities cannot reach a complete agreement in a case involving certain issues, such as the determination of an individual’s country of residence, the determination and attribution of profits to a permanent establishment, transfer pricing between related parties and certain royalty issues.
Binding arbitration will be optional for the taxpayer, who will not be required to accept the determination of the arbitrator. If a taxpayer were to exercise such right, presumably the taxpayer would proceed with an appeal in the judicial system in its country of residence and then seek through the mutual agreement procedures to have the competent authority of the other jurisdiction accept the court’s determination. However, in such a case the dispute cannot be resubmitted to binding arbitration.
The diplomatic note constituting Annex A to the Convention describes the arbitration process, whereby each competent authority submits its position in writing and the arbitrator selects from one of the two positions, generally rendering a decision in writing to the Contracting States within six months of the appointment of its chair. The new provision applies both to cases already under consideration under the mutual agreement procedure of the Convention and to cases that subsequently come under consideration.
Stock Option Benefits
The existing Convention does not contain a specific rule apportioning stock option benefits between the Contracting States. As promised in the March 2007 Canadian Federal Budget, paragraph 6 of the diplomatic notes forming Annex B to the Convention clarifies how stock option benefits will be taxed. Generally, stock option benefits will be considered to have been derived in a country to the extent that the individual employee’s "principal place of employment" was in that country during the time between the granting of the option and its exercise or disposition.
Contributions to a Qualifying Retirement Plan
As expected, the Protocol implements mutual recognition of contributions to a pension plan. The existing Convention is silent in respect of pension contributions. New paragraph 8 of Article XVIII (Pensions and Annuities) of the Convention provides that, if certain conditions are met, contributions to a qualifying retirement plan in a Contracting State by or on behalf of an individual may be deducted in computing the taxable income of the individual in the other Contracting State, and contributions made to the plan by the individual’s employer may be deducted in computing the employer’s profits in that other State. The new provision applies to taxation years beginning after the calendar year in which the Protocol enters into force. The Backgrounder states that the new rule is intended to facilitate movement of personnel between the two countries by removing a disincentive for commuters and temporary work assignments.
The Protocol introduces a provision to prevent the double taxation of pre-emigration gains. Article XIII (Gains) of the existing Convention permits each country to tax capital gains realized by its residents. Under paragraph 128.1(4)(b) of the Act, an individual resident in Canada who emigrates to the US is deemed to dispose of each property owned by the individual for proceeds of disposition equal to its fair market value, potentially triggering taxable capital gains. New paragraph 7 of Article XIII provides that where an individual is treated for tax purposes as having alienated a property and realizes a taxable capital gain, the individual may elect to be treated for tax purposes in the other Contracting State as having disposed of and reacquired the property at the time of changing residence. This step-up in the cost base of the property of the emigrant taxpayer in the new country of residence should prevent the double taxation of the accrued gain up to the date of departure upon the subsequent sale of the property in most instances.
Investments by Pension Plans and Similar Entities
Under Article XXI (Exempt Organizations) of the existing Convention, a trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that Contracting State and operated exclusively to administer or provide pension, retirement or employee benefits (a "Benefit Plan") is exempt from tax on interest and dividends derived in the other Contracting State. A trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that Contracting State and operated exclusively for the benefit of Benefits Plans (a "Pooled Fund") is also entitled to the same exemption. This latter exemption applies to certain Canadian pooled investment funds for pension plans. Under existing Article XXI, certain religious, scientific, literary, educational or charitable organizations resident in a Contracting State are exempt from tax in the other Contracting State (which would include tax on interest and dividends) to the extent they are exempt from tax in the Contracting State in which they are resident (a "Charity"). However, the US Internal Revenue Service took the position that inclusion of a Canadian Charity in a Canadian Pooled Fund would disentitle the Canadian Pooled Fund from the exemption from withholding tax on US source interest and dividends.
The Protocol will expand the class of permitted investors in a Pooled Fund to include a Charity.