The Canadian federal budget of March 19, 2007 announced that Canadian and U.S. officials had agreed in principle on major elements of an updated Canada-U.S. Tax Convention (the "Treaty") which would eliminate withholding tax on arm's length interest, and, subject to a phase-in, on non-arm's length interest. It was also announced that interest paid by a person resident in Canada to an arm's length non-resident, regardless of country of residence will be exempt from withholding tax under the Income Tax Act (Canada) (the "ITA") once the exemption under the Treaty is implemented.

Subsequently, the Minister of Finance released draft amendments to the ITA on October 2, 2007 implementing the budget proposals which amendments specifically provided that the withholding tax exemption was to apply once the Treaty was amended to exempt cross-border payments of interest to arm's length persons from withholding tax. Because both countries have to ratify the Treaty changes, it was uncertain as to when the exemption in the ITA would become effective. On November 13, 2007, the Department of Finance released revised draft amendments which included a significant change regarding the effective date for the withholding tax exemption on arm's length interest. The exemption in the ITA will apply after 2007 once the ITA amendments are passed. Consequently, the exemption under the ITA will not be dependent on the Treaty amendments, and will take effect prior to the Treaty exemption.

The exemption will apply generally to arm's length interest payable by a Canadian borrower to any non-resident, with the exception of "participating debt interest". Generally speaking, "participating debt interest" would consist of interest that is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.

Unless the change is enacted before January 1, 2008, there will be transitional issues in respect of interest payments subject to withholding tax which are made after 2007 but before the exemption is enacted. Lenders and borrowers will have to decide whether to rely on the proposed retroactive effect of the change.

For further information on certain proposed changes to the Treaty, please read our recent e-LERT on the subject.