The March 19, 2007 Federal Budget announced that an agreement in principle had been reached to amend the Canada-United States Income Tax Convention, 1980 (the “Treaty”). On September 21, 2007 the Minister of Finance announced the signing of the Fifth Protocol to the Treaty, which updates and amends certain provisions of the Treaty.


The Protocol introduces the much-anticipated rule to reduce and eventually eliminate source country withholding on cross-border payments of interest. However, the protocol does not exempt all payments of interest and contains an anti-avoidance rule.

Generally, under the Protocol, interest arising in one country and beneficially owned by a resident of the other country will be taxable only in the other country. For example, lenders and borrowers will no longer need to structure a borrowing in order to meet a specific exemption from Canadian non-resident withholding tax on interest, such as the “5/25” exemption.

The complete exemption from withholding tax will not apply to all payments of interest. Specifically:

  • interest arising in Canada that is determined with reference to (a) receipts, sales, income, profits or other cash flow of the debtor or a related person, (b) any change in the value of any property of the debtor or a related person, (c) any dividend, partnership distribution or similar payment made by the debtor to a related person, may continue to be taxed by Canada but the rate of tax will not exceed 15% if the beneficial owner of the interest is a resident of the US for purposes of the Treaty;
  • interest arising in the US that is contingent interest of a type that does not qualify as portfolio interest under US law may continue to be taxed by the US but the rate of tax will not exceed 15% if the beneficial owner of the interest is a resident of Canada for purposes of the Treaty; and
  • where, by reason of a special relationship between the payer and the beneficial owner of the interest, or between both of them and some other person, the amount of the interest exceeds the amount that would have been agreed to in the absence of such relationship, the Treaty reductions shall only apply to the latter amount.


The Protocol must be ratified by Canada and the United States before it comes into force. The announcement on September 21, 2007 by the Minister of Finance did not indicate when ratification is anticipated. The Protocol will enter into force on the later of (a) the date of the later of the notifications of ratification by Canada or the US to the other, or (b) January 1, 2008. The rules in the Protocol relating to withholding tax on interest will apply to interest paid or credited on or after the first day of the second month that begins after the entry into force date. For example, if Canada notifies the US that it has ratified the Protocol on January 15, 2008 and the US notifies Canada that it has ratified the Protocol on February 15, 2008, the Protocol would enter into force on February 15, 2008. The provisions of the Protocol relating to withholding tax on interest would then be effective for interest paid or credited on or after April 1, 2008.

Notwithstanding the general implementation rule, the Protocol provides for a phased-in application for interest paid or credited to “related persons”. During the first calendar year of application (in the above example, the remainder of 2008 following the April 1 effective date), the Protocol will apply a reduced withholding rate of 7%, with a rate of 4% in the second calendar year of application (2009 in the above example). Thereafter, the full exemption will apply to interest paid or credited to related persons. A “related person” will include a person deemed under Article IX of the Treaty to be related to another person, including a person who participates directly or indirectly in the management or control of the other person. During the phase-in period, the implications of this deeming rule should be given serious consideration.

Based on the March 19, 2007 Budget materials, it is anticipated that once the Protocol is ratified the Income Tax Act (Canada) will be amended to eliminate withholding tax on interest paid or credited to all arm’s length non-residents, regardless of their country of residence. It is anticipated that such a measure would be effective on the same date as the Protocol’s rate reduction for interest paid or credited to an unrelated person.


The Protocol will not eliminate the need for foreign financers to consider other impediments to their lending directly to Canadian residents.

While greater access to foreign capital is presumably the policy initiative that underpins the elimination of withholding taxes on payments of interest from a resident of Canada to an unrelated resident of the US, that same policy initiative has not resulted in the removal of other important federal and provincial regulatory hurdles which may continue to compel the use of direct lenders in Canada. For example, Section 510 of the Bank Act (Canada) (the “Bank Act”) prohibits any foreign bank (which includes anyone who has any affiliate which is a “bank” in its local jurisdiction) from directly or indirectly carrying on a banking business in Canada unless authorized to do so by creating a regulated Canadian bank, by being designated or receiving a ministered approval under Part XII or establishing a branch as an authorized foreign bank under Part XII.1 of the Bank Act.

Based upon discussions on September 21, 2007 with the Office of the Superintendent of Financial Institutions (“OSFI”), the regulator under the Bank Act, there will be no harmonization of policy with that of the tax authorities and, as far as OSFI is concerned, lending transactions that are “in Canada” must be made through the branch or affiliate authorized in Canada. Accordingly, the greater access to capital, and the greater opportunity to consider new structures, with foreign banks may be limited to debt issuances where there is no lending “in Canada” by those U.S. residents who merely purchase the paper, or where there is no risk that the loan will be treated as made in Canada. Even in those cases, the foreign lenders will have to consider whether they will be or become Canadian taxpayers and whether the interest income will be income taxable in Canada (and we note that the test for tax purposes of when business is carried on in Canada may differ from the regulatory test for the purposes of the Bank Act). Unless there is a material shift in legislation or its interpretation by OFSI, we expect that to a very large extent, and certainly in the senior operating debt space, Canadian entities will continue to be funded through syndicates of lenders which are the authorized branches or affiliates of US lenders.


The Protocol introduces many other changes to the Treaty, including:

  • extending Treaty benefits to limited liability companies;
  • allowing taxpayers to require that certain key double tax issues, such as transfer pricing, be settled through arbitration;
  • ensuring there is no double taxation on emigrants’ gains;
  • harmonizing pension contribution rules in Canada and the U.S.; and
  • clarifying the taxation of stock options for cross-border employees.

We will distribute a further bulletin addressing these matters over the coming days.