As reported in Stikeman Elliott’s April 12, 2007 Structured Finance Update, it was announced in the March 2007 Federal Budget that an agreement in principle had been reached between Canada and the U.S. that would update the Canada-U.S. tax treaty with the effect of eliminating withholding tax on interest paid on arm’s length cross-border financings between Canada and the U.S. It was also announced in the Federal Budget that the Income Tax Act would be amended to eliminate Canadian non-resident withholding tax on interest paid by Canadian residents to all arm’s length foreign residents, regardless of their country of residence. The amendments to the Income Tax Act were intended to be conditional on the implementation of the changes to the Canada-U.S. tax treaty and were initially proposed to be effective once the arm’s length exemption in the Canada- U.S. tax treaty came into effect. The measures announced in the Federal Budget were welcome news as the proposed changes with respect to Canadian non-resident withholding tax will facilitate a Canadian resident’s access to foreign debt financing without the structural limitations currently imposed by the so-called “5/25 exemption” contained in the Income Tax Act.

More recently, the Fifth Protocol to the Canada-U.S. tax treaty was signed on September 21 and will enter into force on the later of January 1, 2008 and the date on which the Protocol is ratified by each of Canada and the U.S. The withholding tax exemption for arm’s length interest contained in the Protocol will be effective at the beginning of the second calendar month following the month in which the Protocol enters into force. This will be March 1, 2008 at the earliest, but it has become increasingly clear that ratification of the Protocol will not take place in 2007 and the timing of such ratification remains uncertain, although still expected some time in 2008.

Draft amendments to the Income Tax Act were released on October 2 by the Canadian Department of Finance to effect the elimination of Canadian non-resident withholding tax on interest payments made by Canadian residents to arm’s length foreign residents, regardless of their country of residence. Consistent with the statements made in the Federal Budget, this exemption was originally proposed to take effect on or after the date on which the arm’s length exemption in the Protocol came into effect (as discussed above, March 1, 2008 at the earliest). Given the uncertainty with respect to the timing of the ratification of the Protocol, the effective date for the withholding tax exemptions was uncertain

These draft amendments to the Income Tax Act were recently introduced in the House of Commons on November 13 with a surprising change to the effective date. The proposed withholding tax exemption in the Income Tax Act is now proposed to apply to interest payments made after 2007, regardless of the date that the Protocol comes into effect. The effect of this recent change is that the withholding exemption in the Income Tax Act for arm’s length interest effectively overrides the need for U.S. residents to resort to the ratification of the Protocol for such an exemption in most circumstances. Consequently, assuming that the proposed amendments to the Income Tax Act are enacted as proposed, interest payments made by Canadian residents to arm’s length persons not resident in Canada (including U.S. residents) will be eliminated for any such payments made on or after January 1, 2008. If the draft legislation receives Royal Assent after 2007, it will be effective retroactive to January 1, 2008.

Ratification of the Protocol will still be important with respect to other measures contained therein (i.e., provisions dealing with LLCs and other hybrid entities, limitations on benefits, and the eventual elimination of withholding tax on non-arm’s length interest).

It is also important to note that the proposed withholding tax exemption in the Income Tax Act (as well as the proposed exemption in the Protocol) deals only with interest or amounts that are deemed to be interest for the purposes of the Income Tax Act. That is, these exemptions do not apply to dividends, royalties, rents, lease payments, distributions from trusts, etc. In addition, these exemptions are also subject to a limitation with respect to interest that is considered to be of a participating nature (and what constitutes participating interest in the Protocol is narrower than what constitutes participating interest in the Income Tax Act).