In March 2007, the Conservative government tabled its second federal budget. The budget proposed a number of international and business income tax measures.
The budget confirmed the government’s intention to proceed with its previously announced ‘Tax Fairness Plan,’ which includes the specified investment flow-through (SIFT) proposals for the proposed distribution tax regime for income funds and other flow-through entities, discussed in the previous two issues of the Business Law Quarterly. The expectation is that the SIFT proposals will proceed as currently announced, subject to any change in government or other political developments.
However, the most significant tax-related announcements involve international tax. Four developments in the 2007 budget are especially relevant to U.S. and other foreign investors structuring acquisitions of Canadian businesses.
Canadian Withholding Tax on Interest to be Eliminated (U.S. Treaty Residents)
Canadian and U.S. representatives have agreed in principle on the major elements of an amended Canada-U.S. Tax Treaty that will eliminate Canadian withholding tax on interest paid by a Canadian resident borrower to U.S. resident lenders.
Withholding tax will be eliminated both for interest paid to arm’s length lenders and to lenders that are related to (or are non-arm’s length with) the Canadian borrower. Withholding tax will be eliminated on interest paid between arm’s length parties effective the first calendar year following the entry into force of the revised treaty protocol.
For interest paid between non-arm’s length parties, the withholding tax rate on interest will most likely be phased in. Under this proposal, the rate would decline from the existing 10 per cent treaty rate to 7 per cent, 4 per cent and 0 per cent in the first, second and third years following the entry into force of the treaty protocol, respectively. Canada’s thin-capitalization rules will continue to apply to related party/non-arm’s length party debt.
Canadian Withholding Tax on Interest to be Eliminated (All Countries)
Domestic legislation will also be implemented to eliminate Canadian withholding tax on interest paid to arm’s length lenders, whether they reside in the United States or elsewhere outside of Canada. Unlike those of the Canada-U.S. Tax Treaty provisions, this exemption will not apply to related party/non-arm’s length party debt. The Department of Finance has indicated informally that this exemption will be effective at the same time as the treaty exemption.
U.S. Limited Liability Companies (LLCs) and Tax Treaty Benefits
Tax treaty benefits will be extended to U.S. LLCs under the amended Canada-U.S. Tax Treaty, where such benefits have previously been denied. As LLC structures are often used in cross-border private equity and other transactions, this measure will avoid the need to interpose a treaty entity between an investor’s LLC and the Canadian assets. It remains unclear whether LLCs will be entitled to treaty benefits in their own right or whether a look-through approach (in other words, where the members of the LLC must qualify for treaty benefits) will be adopted for LLCs under the amended treaty. Depending on the approach, circumstances may occur where interposing a treaty entity may continue to be beneficial.
Designated Stock Exchanges
The budget also proposes to revise the ‘prescribed stock exchange’ concept that is currently used in the Income Tax Act. The advantages of having a share listed on a prescribed stock exchange include the treatment under securities lending rules and the exception from the Section 116 withholding imposed on non-residents selling taxable Canadian property.
The budget proposes to replace the current lists of prescribed stock exchanges with a three-tier system of (i) designated stock exchanges, (ii) recognized stock exchanges, and (iii) stock exchanges. The new system is designed to lower tax barriers for domestic and international investors and recognize both new and reorganized stock exchanges, including the Alternative Investment Market (AIM) of the London Stock Exchange.