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

The protocol to amend the treaty was signed after almost a decade of negotiations on September 21, 2007 and enacted into Canadian law on December 14, 2007. On July 10, 2008, the US Treasury Department released its Technical Explanations to the protocol, which clarified several areas that were unclear or ambiguous with respect to the application of the protocol.

Prior to the US ratifying the treaty on September 23, 2008, Canada’s Minister of Finance, Jim Flaherty said that it “accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the Protocol” in a July 10, 2008 Department of Finance press release.

Ken Buttenham, Partner with PricewaterhouseCoopers LLP in Toronto says there remain a lot of “loose ends” and “one-off” situations that will have to be addressed at a later date. David Louis, Partner with Minden Gross LLP in Toronto adds that tax practitioners are hoping that there will be some sort of “limited protocol” that deals with unresolved issues, following ratification by the US.

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

While the Protocol deals with a wide range of cross-border tax issues the technical explanations provide clarification on specific issues. Below are highlights of some of the issues:

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, such as certain partnerships, US limited liability companies (LLC) and Canadian unlimited liability companies (ULC). A fiscally transparent entity is in general one which is taxed at the beneficiary, member or participant level and is defined by the tax laws of each country. Under the old treaty, Canada did not recognize a fiscally transparent US 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 which are corporations for Canadian tax purposes but fiscally transparent for US tax purposes.

The introduction of a limitation of benefits (LOB) provision which addresses the problem of “treaty shopping”, thereby ensuring that treaty benefits are only available to residents of Canada or the US, 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 misuse of tax treaties.

A new rule states a service provider may have a permanent establishment in either country even in the absence of a fixed place of business or agent, which was not the case in the past. 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, compared to 183 days in a calendar year.

New rules were also introduced with respect to treatment of benefits in qualifying retirement plans to facilitate 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 they work, for 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.

New rules on sourcing of employee stock option benefits and the consequent avoidance of double taxation as a significant benefit to individuals were also introduced. Generally, where 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 US, 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 the subsequent disposition. Under the existing treaty there is no specific rule that provides for the apportionment of stock option benefits.

One of the more significant changes clarified by the technical amendment deals with changes to the withholding tax regime. Some of these changes were previously announced in the Canadian 2007 federal budget. Subject to certain conditions defined in the LOB provisions, withholding tax on interest paid between Canadian and US resident persons that are not related will be eliminated two months after the date on which the protocol enters into force. On the other hand, withholding tax 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 with-holding tax exemption on interest is subject to certain exceptions. In the case of interest arising in Canada and paid to a beneficial owner that is a US 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 tax 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, in the case of interest arising in the US and paid to a beneficial owner that is a Canadian resident, to interest that would not qualify as portfolio interest under the US portfolio interest exemption because it is treated as contingent interest.

As well, the reduced interest with-holding tax rates do not apply to certain interest that exceeds an arm’s length rate, that is, interest paid to a person with 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 tax on guarantee fees with 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 the 2007 budget that, concurrent with the exemption from withholding tax on interest being implemented under the treaty, the Canadian Income Tax Act (ITA) will be amended to eliminate withholding tax 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, to also be exempt from Canadian withholding under the Canadian ITA. 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 withholding tax exempt interest will expand, the types of debt eligible for exemption will also expand to include short term or revolving debt.

Buttenham suggests that proposed changes in the form of withholding tax relief will have important implications for both lenders and Canadian borrowers, making potential cross-border financing arrangements simpler.

Dwarka Lakhan is the Editor of CRA Magazine. He is the President & CEO of the Caprion Group of Companies which provides integrated consulting services to the financial services industry. Phone 905-850-7715 Email dlakhan@caprion.ca Web www.caprion.ca