On September 21, 2007, the United States and Canada signed the Fifth Protocol to the 1980 U.S.-Canada Income Tax Treaty, which was the result of nearly ten years of negotiations between the two countries. The changes to the treaty resulting from this new protocol are numerous and are quite significant for cross-border business, especially when considering that in 2007 aggregate cross-border investment amounted to more than $140 billion and cross-border income flows have generally exceeded $30 billion a year since 1995 (Joint Committee on Taxation, Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Canada 20 (JCX-57-08) (July 8, 2008)). With so much cross-border income flow, the importance of the protocol in further reducing the potential for double taxation and providing an incentive for trade is enormous.
This item focuses on protocol provisions that significantly affect cross-border business, namely the elimination of withholding taxes on cross-border interest payments, the lookthrough provision for dividends, and the treatment of LLCs and other hybrid entities.
Before diving into some of the provisions, some attention must be paid to the process that will put the new protocol into effect. The signed protocol will not enter into force until both the United States and Canada have separately ratified it through their internal governmental processes and the instruments of ratification have been exchanged. In Canada, the ratification process has already been completed (An Act to Amend the Canada-United States Tax Convention Act, 1984, 2007 S.C., ch. 32). In the United States, the protocol went through a hearing in the Senate Committee on Foreign Relations in July and was forwarded to the U.S. Senate for approval but was not considered before the Senate’s summer recess. Although there is much interest in the ratification of the protocol and its entry into force before the end of 2008, especially in light of some of the provisions discussed here, there is no certainty that the Senate will be able to do so before December 31, 2008.
Elimination of Withholding Tax on InterestThe elimination of withholding tax on cross-border interest payments is one of the most significant provisions in the protocol and likely the one that will affect the most taxpayers in both countries. In most cases, Article XI of the current treaty provides for a 10% withholding tax rate for interest paid across the border. Article 6 of the protocol will modify Article XI so as to retroactively reduce that rate to zero for interest payments to unrelated parties as of January 1 of the year the protocol enters into force and will begin phasing out the interest on related-party interest over a period of three years. This phaseout will reduce the withholding rates to 7% (also retroactively) for the first year the protocol enters into force, then reduce it to 4% and zero in the two subsequent years. One exception is for contingent interest, as defined in Sec. 871(h)(4), which will be subject to a 15% withholding rate.
The lack of certainty with respect to the protocol’s ratification and its entry into force is creating planning issues for taxpayers on both sides of the border. Because the current treaty provides for the 10% withholding rate on interest payments, taxpayers have been collecting those amounts and remitting them to the tax authorities. Should the protocol be ratified in 2008, it will provide a retroactive reduction in the rates (0% for unrelated parties and 7% for related parties) that may translate into significant tax refunds for taxpayers. Although no mechanisms are explicitly suggested in the protocol for dealing with such refunds, experiences with similar provisions in past protocols suggest that taxpayers may need to file actual tax returns with the other country’s authorities to claim a refund of the overwithholding based on the new protocol provisions.
Dividends Lookthrough ProvisionDividend withholding rates under the protocol, unlike interest withholding and dividend withholding rates in the latest U.S. treaties, will not be eliminated, reduced, or gradually phased out. However, the lookthrough provision contained in Article 5 of the protocol (modifying Article X of the treaty) will make the reduced 5% withholding rate available to corporate taxpayers who indirectly own corporations in either country where those shareholders would not have been able to do so before. Exhibit 1 illustrates situations in which the 5% withholding rate would apply.
Example 1 in the exhibit may be the cost common: A Canadian corporation (CanCo) is indirectly owned by a U.S. corporation (USCo) through an entity that is considered fiscally transparent under U.S. tax laws (US). In this case, USCo will be able to benefit from the 5% withholding rate as long as it owns at least 10% of the stock in CanCo through US.
Example 2 provides an alternative scenario in which shares in USCo are indirectly held by CanCo through its ownership in a partnership in a third country (3d Co LP). Since 3d Co LP is considered a fiscally transparent entity under tax laws in Canada (where beneficial owner CanCo resides), the 5% reduced withholding rate would apply to dividends paid by USCo to 3d Co LP. This remains true even when in the United States a check-the-box election was made to treat 3d Co LP as a corporation.
In Example 3, the situation is reversed and the dividends paid by CanCo to 3d Co LP do not qualify for the 5% reduced withholding rate. Since 3d Co LP has checked the box to be treated as a corporation under U.S. tax laws (where beneficial owner USCo resides), it is not considered a fiscally transparent entity in the United States and therefore the lookthrough provision does not apply.
One curious result of this lookthrough provision under the protocol is that it effectively requires the dividend-paying corporation to become acquainted with the tax laws of its indirect owners’ countries of residence to determine if under those laws the intermediary entities would be treated as fiscally transparent and therefore eligible for the reduced withholding rate. This requirement to look into the other country’s laws to determine if an entity is considered to be fiscally transparent is also specifically mentioned in Article 2 of the protocol, which modifies Article IV of the treaty dealing with definitions of tax residence under the treaty.
Fiscally Transparent and Hybrid EntitiesThe issue of treaty benefits applied to fiscally transparent and hybrid entities was a major aspect of the protocol, and the results in some cases will not be good for some U.S.-owned businesses in Canada operating under the common check-the-box Canadian unlimited liability company (ULC) structure. Under U.S. check-the-box regulations, a U.S. taxpayer (USCo) would elect to treat the Canadian ULC, normally formed under Nova Scotia or Alberta laws, as a partnership for U.S. tax purposes. The result is an entity, the ULC, that is a 100% owned partnership and so is effectively disregarded for U.S. tax purposes but is still treated as a corporation for Canadian tax purposes (see Exhibit 2).
The provision contained in Article 2 of the protocol (modifying Article IV of the treaty, on residence) determines that in such a case, USCo would not be eligible for benefits under the treaty. USCo would thus be subject to the full Canadian withholding tax rate of 25% on payments (i.e., dividends, interest, rents, royalties) it receives from the ULC. Since the ULC is disregarded for U.S. tax purposes, the payments from it to USCo are also disregarded, and the payments would not constitute foreign source income to USCo with which it could claim the Canadian withholding tax as a foreign tax credit to reduce its U.S. taxes.
Although the operating income generated by the ULC would provide foreignsource income for the year in which the withholding taxes would be assessed and so potentially would allow for the use of the foreign tax credit, a possible mismatch of the amount of foreign-source income and foreign taxes could result due to timing differences in the recognition of the withholding taxes and distributions made.
The good news is that the provisions in the protocol dealing with the disallowance of benefits under the treaty for such structures will enter into force at the earliest in 2010, provided that the protocol is ratified before the end of 2008. This gives taxpayers some time to properly plan to adjust their structures to reflect the new treaty provisions.
Other ProvisionsOther significant provisions in the protocol not discussed here include a reduced U.S. withholding rate on dividends received by companies from real estate investment trusts in some cases, the elimination of withholding tax on cross-border guarantee fees, the requirement for mandatory arbitration, the extension of limitation of benefits provisions to apply to Canadian residents, changes to pension and annuities withholding, changes to determination of permanent establishment for personal services, consequences to other structures involving fiscally transparent and hybrid entities, and others. (For more on the protocol, see Sardella, “Commentary on the Canada-U.S. Tax Treaty’s Fifth Protocol,” 39 The Tax Adviser 150 (March 2008).)
The protocol will bring significant changes to the treaty and require that companies from both sides of the border seriously consider the effects of these changes on their businesses. Some of the changes will have an immediate impact, mostly positive, as soon as the protocol enters into force. For some of the more significant changes, which include some with potentially harmful effects, the uncertainty as to the timing of the protocol’s ratification by the U.S. Senate and the phase-in of many of the significant changes provide a window for companies and advisers alike to properly plan for their impact. The key is to begin the process early.
Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.
Unless otherwise noted, contributors are members of or associated with PKF North American Network.
For additional information about these items, contact Mr. Reilly at (703) 385-8809 or firstname.lastname@example.org.