A number of international and business income tax measures relevant to investors, companies and others in the technology community were proposed in the March 2007 Canadian federal budget.
McCarthy Tétrault Notes:
U.S. Limited Liability Companies (LLCs) and Tax Treaty Benefits
Canadian and U.S. representatives have agreed in principle on the major elements of an amended Canada-U.S. Tax Treaty. 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 venture capital 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 (where members of the LLC must qualify for treaty benefits) will be adopted for LLCs under the amended treaty. Depending on the approach, there may be circumstances where interposing a treaty entity may continue to be beneficial.
Canadian Withholding Tax on Interest to be Eliminated (U.S. Treaty Residents)
The amended Canada-U.S. Tax Treaty will also eliminate Canadian withholding tax on interest paid by a Canadian resident borrower to U.S. resident lenders. Such measures will reduce the borrowing cost of debt funding. 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, it is proposed that the withholding tax rate on interest will be phased in so that the rate would decline from the existing 10 per cent treaty rate to seven per cent, four per cent and zero 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, whethe they reside in the U.S. or elsewhere outside of Canada. Unlike 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.
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 a share being 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 to facilitate recognition of both new and reorganized stock exchanges, including the Alternative Investment Market (AIM) of the London Stock Exchange.
Foreign Expansion and Interest Deductibility Restrictions
The Budget proposes to effectively disallow an interest deduction for Canadian corporations on money borrowed to acquire shares of a foreign affiliate. This proposal will increase the cost for technology companies looking to expand abroad through foreign acquisitions. Previously, a Canadian corporation could generally obtain an interest deduction for interest on money borrowed to acquire shares of a foreign affiliate, even if the distributions from the foreign affiliate were out of the affiliate’s exempt surplus and thus effectively not taxed in Canada. Disallowed interest will now be tracked in a "disallowed interest pool" and the amount in such pool will generally be deductible only to the extent of any income realized on the shares or debt of the foreign affiliate, other than tax-deductible distributions. The rules are intended to be broadly cast and contemplate a specific anti-avoidance rule.