Canada’s Department of Finance and the U.S. Department of the Treasury each announced the entry into force of the fifth Protocol amending the Canada-U.S. Income Tax Convention (the "Treaty") today. The Protocol which was first signed on September 21, 2007 brings into effect a number of significant new measures which will impact on cross border tax matters.
Today’s announcement means that some of the changes to the Treaty will have immediate effect (or even retroactive application for 2008) while other changes to the Treaty are to be phased-in over time based on today’s entry into force. The following is a brief description of some of the important changes to the Treaty and the relevant dates when these changes will apply.
- Withholding Taxes on Interest
In 2007, Canada introduced domestic legislation to eliminate the withholding tax on interest payments made after December 31, 2007 except with respect to interest payments to non-arm’s length or related party lenders and with respect to interest that is computed by reference to sales, income, profits or cash flow of the debtor (so-called participating debt). As a result of the Protocol, Article XI of the Treaty was amended to provide that interest paid to related party lenders resident in the U.S. (other than participating debt interest) will also be exempt from Canadian withholding tax. This change will be phased-in, as follows. For 2008, the rate of withholding tax for related party lenders will be reduced from the current Treaty rate of 10% to 7%. This means that related party interest payments received by U.S. residents in 2008 that were subject to 10% Canadian withholding taxes prior to today will be entitled to claim a refund for the 3% overpayment. The applicable withholding tax rate for 2009 will be 4% and 0% for 2010 and beyond. The rest of the changes to Article XI (including the participating debt exception that is somewhat narrower than the exception provided for in the Income Tax Act (Canada) (the "Act")) will have effect on February 1st, 2009.
- Fiscally Transparent and Hybrid Entities
The fifth Protocol contains new rules which apply to fiscally transparent and hybrid entities. These new rules are among the most welcome amendments to the Treaty as well as the most controversial. The changes which extend Treaty benefits to limited liability companies will apply for taxable years that begin after 2008. For U.S. resident shareholders of Canadian unlimited liability corporations, the new rules will restrict the availability of certain Treaty benefits as of January 1, 2010.
- Mandatory Arbitration
Amendments to the mutual agreement procedures in the Treaty provided for in the Protocol are now effective. These changes provide for mandatory arbitration in circumstances where the competent authorities (the Canada Revenue Agency and the Internal Revenue Service) have been unable to resolve a cross-border tax issue; for example, disputes arising from transfer pricing adjustments. Under these new rules, arbitration proceedings are generally to begin two years after the information relating to the dispute has been provided by the taxpayer to both competent authorities, unless they have previously agreed to a different date. This requirement will apply to cases already under consideration by the competent authorities but with the two year time period described above commencing today.
- Limitation of Benefits
The expanded limitation of benefits provisions added to Article XXIXA of the Treaty by the Protocol will have a significant impact on cross-border tax matters by limiting the availability of Treaty benefits to "qualifying persons". These amendments reflect Canada’s new approach to restricting treaty shopping after failing to persuade the Canadian courts to do so by applying existing provisions of the Act. These new restrictions will apply after January 31, 2009 in respect of withholding taxes and will apply to taxable years which begin after December 31, 2008 in respect of other taxes.