The new Canada-U.S. Tax Treaty will probably facilitate fund flows between the two countries, largely due to the elimination of the with-holding taxes on most cross-border interest payments.

The protocol to amend the treaty was signed after almost a decade of negotiations on Sept. 21, 2007, and enacted into Canadian law on Dec. 14, 2007. On July 10, 2008, the U.S. Treasury Department released its technical explanations concerning the protocol, which clarified several areas that were unclear with respect to the application of the protocol. On Sept. 23, the U.S. ratified the treaty.

Prior to the U.S. ratification, Canada’s minister of finance, Jim Flaherty, stated in a release: “[The treaty] accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the protocol.”

Still, Ken Buttenham, partner with PricewaterhouseCoopers LLP in Toronto, says a lot of “loose ends” and “one-off” situations remain that will have to be addressed at a later date.

Adds David Louis, partner with law firm Minden Gross LLP in Toronto, tax practitioners are hoping there will be some sort of “limited protocol” that deals with unresolved issues, following ratification of the treaty by the U.S.

Although the treaty has been ratified by both countries, it will not come into force until the governments of Canada and the U.S. formally exchange “notes,” which most tax practitioners expect to happen before the end of this year.

While the protocol deals with a wide range of cross-border tax issues, the technical explanations provide clarification on specific matters. Among these are new rules for hybrid entities that either allow or deny treaty benefits for certain amounts derived through or paid by hybrid entities that are considered to be fiscally transparent in one country but not the other. That includes certain partnerships, U.S.-based limited liability companies and Canadian unlimited liability companies.

A fiscally transparent entity, in general, is one that is taxed at the beneficiary, member or participant level and is defined by the tax laws of each country. Under the former treaty, Canada did not recognize a fiscally transparent U.S. LLC as being separate from its members.

Louis says that one of the adverse changes in this area is the denial of treaty benefits to ULCs that are corporations for Canadian tax purposes but are fiscally transparent for U.S. tax purposes.

The protocol also introduces a “limitation of benefits” provision, which addresses the problem of “treaty shopping.” It tries to ensure that treaty benefits are available only to residents of Canada or the U.S., subject to certain tests such as the “active business” test, which establishes a connection between income and an active trade or business. Up until now, Canada has generally relied on its general anti-avoidance rule to prevent the misuse of tax treaties.

Another new provision stipulates that a service provider may have a permanent establishment in either country, even in the absence of a fixed place of business or agent. An enterprise could also be deemed a permanent establishment if services are provided in the host country for one or more periods during any 12-month period, vs 183 days in a calendar year under the old rules. (See “A place in the sun,” B14.)

New rules were also introduced with respect to the treatment of benefits in qualifying retirement plans. The goal is to facilitate the movement of people on work assignments between the two countries. Subject to certain conditions, individuals who live in one country and work in the other may deduct the contributions they make to a retirement plan in the country in which they work for source-country tax purposes. As well, individuals who move to either country for work may deduct, for source-country tax purposes, their contributions to a retirement plan in the first country for up to five years.

Wayne Bewick, a tax advisor with Toronto-based accounting firm Trowbridge Professional Corp., sees the new rules on sourcing of employee stock-option benefits and the consequent avoidance of double taxation as a significant benefit to individuals. Generally, when an employee is granted an option to acquire shares or units of an employer or a mutual fund trust, the income arising from the exercise of the option will be considered to have been derived in Canada or in the U.S., proportionately based on the number of days that the individual’s principal place of employment was in either country, during the period between the date of the grant of the option and its subsequent disposition. Under the existing treaty, there is no specific rule that provides for the apportionment of stock-option benefits.

@page_break@One of the more significant treaty changes deals with changes to withholding taxes. Some of these changes were previously announced in the 2007 federal budget. Subject to certain conditions defined in the LOB provisions, withholding taxes on interest paid between Canadian and U.S. residents that are not related will be eliminated two months after the date on which the protocol comes into force. On the other hand, withholding taxes on interest paid between related persons will be reduced to 7% during the first calendar year in which the protocol becomes effective, then reduced to 4% in the following calendar year and eliminated altogether in subsequent years.

A related person is generally determined under domestic law and is considered to be someone who is related to another person if either person participates directly or indirectly in the management or control of the other, or if any third person or persons participate directly or indirectly in the management or control of both.

As with all changes clarified by the technical amendments, the withholding tax exemption on interest is subject to certain exceptions. In the case of interest arising in Canada and paid to a beneficial owner who is a U.S. resident, certain “participating interest” — such as amounts determined by reference to income, profits or cash flow of the debtor, and dividends or similar distributions paid by the debtor — will be effectively treated as dividends, and be subject to withholding taxes, not exceeding the 15% rate generally applicable under the treaty to dividend payments. Incidentally, the existing 15% withholding tax on dividends has not been changed under the new protocol.

The same treatment will apply for interest arising in the U.S. and paid to a beneficial owner who is a Canadian resident, to interest that would not qualify as “portfolio interest” under the U.S. portfolio interest exemption, because it is treated as “contingent interest.”

As well, the reduced withholding tax rates on interest do not apply to certain interest that exceeds an arm’s-length rate — that is, interest paid to a person in a special relationship with the borrower in excess of what would have otherwise been paid in the absence of that special relationship.

The protocol will also eliminate withholding taxes on guarantee fees, taking effect from the same date as the exemption for interest becomes effective.

In addition to the clarifications by the technical amendments, the Canadian federal government announced in its 2007 budget that, concurrent with the exemption from withholding taxes on interest being implemented under the treaty, the Canadian Income Tax Act will be amended to eliminate withholding taxes on interest paid to all arm’s-length non-residents of Canada, regardless of their country of residence. This change should also cause certain lending-related fees paid to arm’s-length non-residents, such as guarantee fees, and commitment and stand-by fees, also to be exempt from Canadian withholding taxes under the Canadian Income Tax Act. However, the associated Canadian legislation is not yet finalized.

Under existing rules, the withholding tax exemption generally applies only to interest payable by Canadian corporations on debt with a term of at least five years that complies with certain other requirements. The category of Canadian borrowers eligible to pay interest exempt from withholding taxes will expand; the types of debt eligible for exemption will also expand to include short-term or revolving debt.

PWC’s Buttenham suggests that the proposed changes, in the form of relief from withholding taxes, will have important implications for both lenders and Canadian borrowers, making cross-border financing simpler. IE