The new deal signed by Canada and the U.S., which updates the tax treaty between the two countries, will help North American businesses access capital more easily and eliminate some of the barriers that have discouraged investment in the respective countries, tax experts say. It will also make life easier for Canadians and Americans who work part or all of the year on the other side of the border.

Tax advisors are generally happy with the changes and suggest that, if anything, they were overdue. “It’s been a while coming,” says Bill Holms, Canadian leader of international tax services for PricewaterhouseCoopers in Vancouver.

The Fifth Protocol to the Canada-U.S. Tax Convention, signed in September, represents the first changes to the agreement since 1997. Several of the issues dealt with in the protocol address long-standing difficulties affecting both corporations and individuals.

“A number of these provisions make it easier and more tax-friendly to invest in one country or the other,” says Paul Carenza, tax partner at Ogilvy Renault LLP in Toronto.

The protocol will come into force in the second month after the agreement is ratified by Parliament and the U.S. Senate. However, there are different start dates for the various provisions of the protocol, all of which are contingent on the ratification of the deal. Although it is widely expected that the protocol will pass eventually, no one knows how long that process will take.

Roughly speaking, there are six main areas of change in the protocol, three of which are more likely to affect corporations rather than individuals, and three of which will affect individual taxpayers:

> Corporate Issues

> Withholding tax eliminated. The change that has received the most attention is the elimination of the 10% withholding tax charged on interest paid by the residents of one country on loans from an arm’s-length resident of the other country. This will make it easier for businesses to borrow from cross-border lenders, which will provide more opportunity to find better rates and terms.

For “related parties,” such as a parent firm and its subsidiary, there will be a phased-in elimination of the cross-border withholding tax. The rate will be reduced to 7% in the first year the protocol is in force, to 4% in the second year and reduced entirely by the third.

In addition to this provision, Canada’s Department of Finance introduced draft legislation on Oct. 2 that would see the withholding tax on interest paid to all arm’s-length non-residents from any country eliminated, not just from U.S. residents. This will come into effect at the same time as the protocol’s elimination of the withholding tax on interest.

These provisions and proposals are seen as positive for Canadian companies and their subsidiaries. “Multinational companies generally have agreements with a syndicate of banks around the world that enable them to get the lowest-cost borrowing, the greatest flexibility,” says Holms. “What this protocol allows is that a multinational’s Canadian subsidiary can borrow directly from that syndicate.”

This provision will come into force in the second month after the protocol does.

> Limited liability company owners to enjoy treaty benefits. In the U.S., the LLC structure has been very popular over the past decade or so, especially with private-equity funds. That is because this structure provides liability protection for its owners while exposing owners to just one level of taxation instead of both corporate and individual tax rates.

Prior to the protocol, a U.S. LLC investing in Canada did not enjoy treaty benefits, as Canadian tax authorities regarded the structure as a hybrid entity (a corporation in Canada and a partnership in the U.S.). As the LLC entity itself is not liable for U.S. taxes — only its owners are -— Canada did not extend treaty benefits to it. This created tax and administrative barriers for U.S. investment in Canada using an LLC.

The protocol will now allow U.S.-based owners of U.S.-based LLCs to enjoy treaty benefits — including the elimination of withholding taxes on interest paid. It’s important to note that the LLC itself will not enjoy treaty benefits — only its U.S. owners.

Tax experts believe the provision should encourage more U.S. investment in Canada, particularly from private-equity funds, although issues still need to be addressed regarding how the provision will be administered.

@page_break@A corollary rule in the protocol says that if a hybrid entity’s income is not taxed directly in the hands of its investors, it will be treated as not having been earned by a resident and, therefore, is not eligible for treaty benefit. This is to discourage certain hybrid entities that allow investors to avoid taxes on the entity’s income in either country.

This provision will come into force in the second month after the protocol comes into force with respect to withholding taxes on payments to LLCs, with the corollary rule kicking in two years after that.

> Mandatory arbitration process introduced. The protocol has introduced a mandatory arbitration process, largely to address issues concerning double taxation resulting from disagreements over transfer pricing. When a company in one country sells a product or service to a related company in the other, a disagreement can arise between the Canada Revenue Agency and the U.S. Internal Revenue Service over what the transfer price should be and what taxes are owed. When this happens, a company can face the possibility of double taxation.

The current system of appealing to the “competent authority” -— Finance in Canada and Treasury in the U.S. — is slow and does not always yield a resolution. Now taxpayers can compel the CRA and the IRS to resolve their dispute in binding arbitration. “What this does is to provide certainty that something will be decided,” Holms says.

After ratification of the protocol, all cases currently under consideration, as well as future ones, will enjoy mandatory arbitration rights.

> Individual Issues

> Pension contributions recognized in either country. Currently, no rule exists to cover pension contributions made by an individual who resides in one country and contributes to a pension plan in the other. Also, no rule exists for someone who moves to one country for a short-term work assignment but continues to make contributions to a pension plan at home.

This provision will allow, subject to certain conditions, a person to make a contribution in the country in which he or she works and take the deduction in the country in which he or she resides. It will also allow contributions to a pension plan in the original country to be deducted in the country in which one works.

If the protocol is ratified this year, this provision will apply in 2008. If not, the provision will apply in the calendar year after the protocol is ratified.

> Double taxation on capital gains eliminated. Under current rules, when a taxpayer emigrates from Canada to the U.S., he or she is liable for the capital gains on properties owned at the time, whether they are sold or not. If the properties are sold later on while the owner is a resident in the U.S., the IRS will charge taxes on the total gain in value of the property from the time it was first acquired. Essentially, the taxpayer is taxed twice on part of the property’s gain.

This provision will allow a taxpayer to make an election at the time of emigration essentially to raise the cost base of the property to market value. Although the taxpayer is still on the hook to the CRA for gains earned in Canada at the time of his or her emigration, the taxpayer will now pay taxes to the U.S. only on post-emigration gains when a property is sold. “It’s a welcome change and something that has been expected for quite a long time,” says Jennifer Horner, executive director with Ernst & Young LLP in Kitchener, Ont.

The provision will apply retroactively to all emigrations after September 2000.

> Stock options tax treatment clarified. Confusion exists regarding which country has the right to tax stock options granted to an employee in one country but which are later exercised by the employee after he or she has moved to the other country to work for a related company.

The protocol provides for the apportioning of the income derived from the exercise of the stock option between each country, based on the time spent working in each country during the period between the granting of the option and its exercise. So, if a taxpayer spent half the time between the granting of the option and its exercise in one country and half in the other, then both countries would have the right to tax half the income.

This provision will enter into force when the protocol does. IE