In his 2007 Canadian Federal Budget (the Budget), the Minister of Finance (the Minister) announced that an agreement in principle had been reached on a number of significant amendments to the Canada-U.S. Tax Convention (the Treaty) that deal with some long-standing impediments to cross-border transactions. These proposed amendments are included in the 5th Protocol (the Protocol) to the Treaty which was signed on September 21, 2007. In addition, the Minister of Finance released draft legislation (the Proposals) to amend the Income Tax Act (Canada) (the Tax Act) on October 2, 2007 relating, but not limited to, a number of measures originally announced in the Budget.
Elimination of Withholding Tax on Interest
The Protocol proposes to eliminate Canadian withholding tax on interest payments made by a resident of Canada to an unrelated U.S. resident and to phase out, over a 3 year period, such withholding tax on interest payments made to a related U.S. resident. The withholding tax rate is currently 25% under the Tax Act, which rate is reduced to 10% under the current Treaty if the U.S. resident is entitled to Treaty benefits.
A U.S. resident will only be entitled to benefits under the Treaty, including the proposed benefits described above, if such resident meets the requirements of the proposed Limitation on Benefits (LOB) provision. The Protocol makes the existing LOB provision reciprocal and provides a number of objective tests that both Canadian and U.S. residents seeking Treaty benefits must meet. The purpose of the LOB provision (which is the first of its kind in a Canadian tax treaty) is to prevent "treaty shopping" by denying Treaty benefits to an entity established by a resident of a third country in Canada or the U.S. merely for the purpose of claiming Treaty benefits.
In addition to the amendments to the Treaty noted above, the Proposals to amend the Tax Act also include an exemption from withholding tax on interest paid to arm's-length non-residents, regardless of their country of residence. This exemption will be effective January 1, 2008.
Limited Liability Companies (LLCs)
The Protocol will extend Treaty benefits, such as the reduced withholding tax rates on interest and the exemption for capital gains in certain circumstances, to U.S. LLCs. LLCs are currently not eligible for such benefits under the Treaty because the Canada Revenue Agency (the CRA) maintains the view that since LLCs are disregarded entities and not liable to tax in the U.S. they should not be considered residents of the U.S. for purposes of the Treaty.
The Protocol extends treaty benefits to LLCs by permitting each member of an LLC to obtain the applicable Treaty relief on the income that is considered to be derived by each such member, provided that the member is a resident of the U.S. that satisfies the requirements of the LOB provision and meets certain other conditions. Accordingly, U.S. residents who earn income or gains through LLCs will be entitled to the applicable reduced withholding tax rates or exemptions set out in the Treaty where the U.S. treatment of the income is identical to what would have been the treatment if the income had been earned directly by the U.S. resident.
In cases where an LLC that is treated as a partnership for U.S. tax purposes earns capital gains on the sale of shares of a private Canadian corporation that did not derive more than 50% of its value from Canadian real estate, the gain from the sale that is attributable to each partner is currently fully taxable, however, when the Protocol becomes effective, such gain should be exempt from Canadian tax, provided that the partner qualifies for Treaty benefits. Notwithstanding this exemption, it will be necessary for the LLC to obtain a clearance certificate under section 116 of the Tax Act, otherwise the purchaser will be entitled to withhold 25% of the gross proceeds and remit that amount to the CRA. However, in order to support a claim for Treaty benefits, the CRA would require evidence of residency of each of the LLC partners. For an LLC that is widely held, such as a U.S. investment fund, it may not be possible to obtain sufficient information concerning the limited partners. Therefore, U.S. investment funds may continue to use entities resident in third countries as a result of these administrative difficulties.
Initial Public Offerings on AIM
The Proposals provide for a complete change in the concept of a "prescribed stock exchange". The proposed "designated stock exchange" category will be comprised of stock exchanges that have been designated by the Minister and will include the stock exchanges that are currently "prescribed stock exchanges" in the Income Tax Regulations. The determination of whether a share of a Canadian company is "taxable Canadian property" will be based on this category. The Minister has not indicated whether certain stock exchanges which are currently not "prescribed stock exchanges", such as the Alternative Investment Market (AIM) of the London Stock Exchange, will become "designated stock exchanges". However, AIM will fall within the proposed "recognized stock exchange" category which will apply for the purpose of the section 116 withholding procedure. Therefore, non-resident vendors of shares listed on AIM will be exempt from the withholding and reporting requirements of section 116, but, as noted above, may still be taxable in Canada on any gain realized subject to only relief available under an applicable treaty.
Although it was announced in the 2000 Budget that the Tax Act was to be amended to provide a "rollover" for Canadian shareholders of a Canadian corporation in cross-border share-for-share acquisitions, the Budget and the Proposals did not address this issue. Canadian shareholders of a Canadian corporation currently do not receive tax-free rollover treatment on a share-for-share acquisition by a U.S. acquiror. This problem is often addressed through the use of an exchangeable share structure (typically by the issuance to the Canadian shareholders of preferred shares of a Canadian subsidiary of the U.S. acquiror, such shares being exchangeable for shares of the U.S. acquiror).
Implementation of Proposed Changes
The above-noted proposed changes to the Treaty will become effective when both the Canadian and U.S. Governments ratify the Protocol. The earliest date on which the Protocol could become effective is January 1, 2008. The Proposals to amend the Tax Act were released in draft form for comment and the government has indicated that following this period, it will introduce the legislation in Parliament at the earliest opportunity.