New Protocol to the Canada U.S. Tax Treaty
September 2007
Release No: 07-04
On Friday, September 21, 2007, Finance Minister Jim Flaherty and his counterpart U.S. Treasury Secretary Henry M. Paulson Jr. signed the fifth Protocol to the Canada-U.S. Income Tax Convention, the first update to the treaty in 10 years. The Protocol contains a number of significant changes to the treaty. While some of the changes are beneficial to taxpayers, such as the elimination of withholding tax on interest, others will have a significant impact on cross-border structures.
The Protocol included two sets of diplomatic notes which contain details of binding arbitration procedures that are included in the new Protocol as well as notes that help to interpret some of the changes.
For the new Protocol to be effective, ratification procedures must be completed in both Canada and the U.S. If ratification procedures are completed in 2007, the new Protocol will come into force on January 1, 2008. If ratification procedures are not completed this year, the Protocol will come into force on completion of the ratification procedures. Changes with respect to withholding taxes will be effective two months after the Protocol enters into force.
The following is a summary of the changes in the new Protocol.
Elimination of Withholding Tax on Interest
As announced in the 2007 Federal Budget on March 19, 2007, the Protocol confirms that the withholding tax on interest under the treaty, currently 10%, will be eliminated. Interest income will only be taxable in the country where a taxpayer is resident. For example, a Canadian resident company which borrows from a U.S. lender will no longer have to withhold and remit Canadian tax on the interest payments.
This change applies to interest paid between arm’s length persons as of the second month after the Protocol enters into force. For interest paid on debt between related persons, such as a parent company and its subsidiary, the withholding tax rate will be reduced over three years starting with a reduction to 7% for the first year after the Protocol enters into force, 4% for the second year and finally elimination of the withholding requirement in the third year after the Protocol enters into force.
Withholding Tax on Dividends
Unfortunately, the treaty did not contain any reduction with respect to withholding tax on dividends, currently 5% for dividends paid to a resident of the other country where the beneficial owner of the dividend is a company that owns at least 10% of the voting stock of the company paying the dividend. However, the Protocol did amend this rule to require that, when determining whether the 10% test is met, a company that is resident of a contracting state is considered to own the voting stock owned by an entity that is considered to be fiscally transparent under the laws of that state and that is not a resident of the contracting state of the company paying the dividends for purposes of the treaty, in proportion to the company’s ownership interest in that entity. This amendment basically requires Canada to look through a fiscally transparent entity to its corporate members in determining whether these U.S. companies are considered to own 10% of the voting stock of the dividend payor.
Limited Liability Companies (LLCs) and Other Hybrid Entities
Hybrid entities are entities that are treated as a corporation under one country’s laws but are treated as transparent (i.e. a pass-through entity such as a partnership) under another country’s laws. For example, a U.S. LLC is considered to be a transparent entity under U.S. law, which means that its members (i.e. shareholders) pay U.S. tax on any income that the LLC earns. In Canada, LLCs are treated as corporations, which means that the LLC is subject to Canadian tax.
Under the current treaty, hybrid entities are not entitled to treaty benefits which causes problems. In order for an entity to be eligible for benefits under the treaty, such as reduced withholding taxes, an entity must be resident in one of the treaty countries and be liable for tax in that country. If an entity is a pass-through vehicle in its own country, such as an LLC, it is not eligible for benefits under the treaty as the entity itself is not liable for tax.
The Protocol contains measures to address this problem. Income earned by a resident of one country through a hybrid entity, such as an LLC, will be treated by the other country as having being earned directly by the resident in determining whether treaty benefits are available. For example, if U.S. resident investors use an LLC to invest in Canada (which is a corporation for Canadian purposes and a pass-through vehicle for U.S. purposes), any Canadian source investment income earned by the LLC will be eligible for reduced withholding taxes under the treaty because Canada will now treat the income as though it was paid directly to the U.S. resident investors in determining whether treaty benefits apply. Note, however, a corollary rule provides that if the hybrid entity’s income is not taxed directly in the hands of its investors, it will not be treated as having been earned by a resident and treaty benefits will not be available.
This change will apply for withholding tax purposes two months after the Protocol enters into force. The corollary rule applies after two years.
Denial of Treaty Benefits to Certain Hybrid Entities
The Protocol contains provisions designed to deny treaty benefits to certain hybrid entities that are often used in cross-border planning. These changes are effective only on the first day of the third calendar year that ends after the Protocol enters into force, presumably to give taxpayers a chance to restructure arrangements that will be impacted by these changes. Any cross-border plans that use hybrid entities will have to be reviewed to determine the impact these changes will have.
Service Providers and Deemed Permanent Establishments
As a general rule, a service provider who is resident in one country is subject to income tax in the other country only if it provides services through a permanent establishment in the other country. (Note that some U.S. states impose tax based on nexus, as opposed to permanent establishments, and are not bound by the treaty.)
A permanent establishment is defined under the current treaty to include a fixed place of business, such as an office. In recent years, however, both the Canadian and U.S. authorities have been aggressive in arguing that service providers from the other country have permanent establishments in their country, and are therefore subject to tax there, even though it is not clear whether they are providing those services through a fixed base of business in their country.
To provide more certainty in this area, the new Protocol contains a new deemed permanent establishment rule for service providers. Basically, a service provider, resident in one country, will have a permanent establishment in the other country if those services are performed by an individual who is present in the other country for 183 days or more in any 12 month period and during that period, more than 50% of the gross active business revenue of the enterprise consists of income derived from the services performed by that individual in the other country. In addition, a service provider will have a deemed permanent establishment in the other country if services are provided in the other country for 183 days or more in any 12 month period with respect to the same or connected project for customers who are resident of the other country or who maintain a permanent establishment in that other country and the services are performed in respect of that permanent establishment.
This change will be effective as of the third taxable year that ends after the Protocol enters into force. However, it will not apply to services rendered or business revenues that occur or arise prior to January 1, 2010.
Deemed Cost Step-Up on Emigration
A change that was first announced just over 7 years ago has finally been codified. Under Canadian rules, when an individual becomes a Canadian resident, he or she will be deemed to acquire most capital properties at their value on entry into Canada for capital gains purposes. Similarly, an individual leaving Canada is deemed to dispose of most capital properties and will be subject to tax on the gains and losses that arise. In the U.S., individuals are taxed on gains realized on most properties based on their original cost. Therefore, for Canadians emigrating to the U.S., double tax can arise – on the deemed departure disposition for Canadian purposes and on a subsequent sale of the asset for U.S. purposes. To avoid this problem, emigrants historically sold their investments prior to taking up U.S. residency and reacquired them.
As first announced in 2000, the Protocol contains a change that will ensure that Canadians emigrating to the U.S. will not be subject to double tax. In particular, the individual can elect to sell and repurchase a property at an amount equal to its fair market value at the time immediately before becoming a non-resident of Canada. It appears this election can be made on a property-by-property basis. This change applies to properties that are deemed to have been disposed of after September 17, 2000. It should be noted that this change does not apply to assets held within an RRSP and certain other indirect holdings. Therefore, specific pre-emigration planning is still required to minimize U.S. tax exposure on these assets.
New Rules for Pension Contribution Deductions
Over the years, more and more employees work in one country but contribute to a pension plan in the other country. From a Canadian perspective, this would include individuals who live in Canada and commute to the U.S. daily to work and contribute to a U.S. pension plan. Another example would be a Canadian resident employee that works in the U.S. on a short-term basis and continues to contribute to a Canadian pension plan while resident in the U.S. Under current rules, there is no certainty that the employee can deduct the contributions made to the foreign plan.
Under the Protocol, a deduction for pension contributions in the other state will be allowed, subject to a number of conditions and limitations. One rule Canadian residents should remember is that the new U.S. pension plan contribution deduction will be limited to the taxpayer’s Canadian RRSP contribution limit, and the amount deducted will reduce their RRSP room for future years.
This change will apply for taxation years that begin after the calendar year in which the Protocol enters into force. However, if ratification is completed in 2007, the rule applies for taxation years that begin in 2008.
Double Tax Relief for Stock Options
The use of stock options as a form of remuneration for employees has become very common. The taxation of these options can be complicated, as realizing a cash benefit from a stock option is a three-step process – the option is granted by the employer, the option is exercised by the employee and ultimately, the underlying investment is sold. Under Canadian rules, exercising the stock option produces a benefit equal to the value of the stock at the time of exercise minus the exercise price and the amount (if any) paid by the employee to acquire the option. In certain circumstances, the benefit is reduced by one-half and it may be possible to defer this income inclusion.
In some situations, stock option remuneration will be covered by the general rules in Article XV of the existing trust. However, where this isn’t the case and where an employee enters or leaves Canada between the day on which the option is granted and when the option is exercised, it is not always clear whether Canada or the foreign country has the right to tax the option benefit given that one must try to determine whether the benefit was derived from employment in Canada or the foreign country. This can be difficult when the employee remains employed within the same economic entity.
As part of an exchange of diplomatic notes as opposed to a treaty change, a new test will apply to determine which country can tax the option benefit. The stock option benefit will generally be considered to have been derived in a country to the extent that the individual’s principal place of employment was in that country during the time between the granting of the option and its exercise. It would appear that this rule will apply where the employee is employed by the same employer or related employers on each side of the border.
The Department of Finance cited an example where an employee of a U.S. company is granted a stock option on January 1, 2009. On January 1, 2010, the employee is moved from the company’s U.S. head office to its Canadian subsidiary. On December 31, 2011, the employee disposes of the option, giving rise to an income inclusion. Except in unusual circumstances, the taxation of the stock option benefit will be prorated – one third of the resulting benefit will be deemed to have been derived in the U.S. and two thirds will be deemed to have been derived in Canada. This change will enter into force at the same time as the Protocol.
New Mandatory Arbitration Rule
Under the current version of the treaty, various rules apply to determine which country can levy tax, and when these rules do not eliminate double taxation, the final point of relief is a mutual agreement between tax authorities of both countries on who will tax the item in question. However, this doesn’t guarantee that such an agreement will in fact be reached and therefore, double tax may still arise.
Under the Protocol changes, a new rule will be available to taxpayers. If the tax authorities of both countries fail to reach an agreement on a double tax issue and if a taxpayer so elects, he or she can ask for arbitration of the issue. The notes to the Protocol indicate that arbitration is available for disputes which involve Article IV (but only as it applies to the residence of an individual), Article V (permanent establishment), Article VII (business profits attributable to a permanent establishment), Article IX (related persons) and Article XII (royalties, but only in certain circumstances), or any other issue which the competent authorities decide, on an adhoc basis, that binding arbitration shall be used. However, it would appear that arbitration on an issue can be denied if both countries agree, before the date on which arbitration proceedings would otherwise have begun, that the issue is not suitable for determination by arbitration. This change applies to cases that are, when the Protocol enters into force, already under consideration under the treaty’s mutual agreement procedure, as well as cases that subsequently come under consideration.
Other Changes
Determination of Profits Under Article VII – Canada and the U.S. have agreed to adopt the approach for attributing profits to a permanent establishment that is being promoted by the OECD, which uses transfer pricing principles to ensure that profits allocated reflect the capital employed, risks assumed and the activities performed by the permanent establishment.
Limitation of Benefits Clause – For the first time, a Canadian tax treaty will contain a comprehensive limitation of benefits clause. This clause is designed to prevent residents of other countries from “treaty shopping” (by setting up structures to take advantage of the provisions of the Canada-U.S. tax treaty) by ensuring that these benefits are only available to residents of Canada and the U.S.
Guarantee Fees – Under the new Protocol, guarantee fees with respect to debt will only be taxable in the recipient’s country of residence, unless the fees are business profits attributable to a permanent establishment in the other country. This change effectively eliminates the withholding tax on these fees and will be effective for taxable years that begin after the calendar year in which the Protocol enters into force.
Corporate Continuations – Under the new Protocol, where a corporation is resident in both contracting states due to a corporate continuation, a two part rule applies. First, if the corporation was created under the laws in force in one country, but not under the laws in force in the other, the corporation will be resident in the first-mentioned country only. In any other case, both countries will try to settle the issue of residency and how the treaty will apply by mutual agreement. If no agreement is reached, the corporation will not be considered a resident of either country for the purposes of the treaty. For example, a U.S. corporation that continues into Canada but retains its status as a U.S. corporation will, under the treaty, become a Canadian resident while remaining a U.S. resident. Such a corporation will not be entitled to any benefits under the treaty except to the extent agreed upon by the competent authorities of the two countries. This change applies to continuances effected after September 17, 2000.
For more information on how these rules will affect you, contact your BDO advisor.
Please note: this material is general in nature and should not be relied upon
to replace the requirement for specific professional advice. © September 2007, BDO Dunwoody LLP
