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The long-awaited Protocol to the Canada-U.S. Income Tax Convention was finally signed today by the Canadian Minister of Finance, James Flaherty, and the U.S. Treasury Secretary, Henry Paulson, Jr. Canada and the United States also released Diplomatic Notes as Annex A and Annex B to the Convention in order to provide guidance in interpreting the Protocol changes and existing provisions.

While the Protocol contains a number of relieving measures that were expected, it also contains a large number of changes that were unexpected, some of which may have adverse consequences for certain taxpayers. Due to the large number of changes, we have summarized the highlights in this Alert and will follow up with more detailed analysis.

The Protocol will enter into force on the later of January 1, 2008, and the date of ratification by both countries. While it is possible that the Protocol could be ratified this year, it is considered to be unlikely at this time. Assuming that the Protocol is not ratified this year, most of the proposed changes will be effective for taxation years of a taxpayer which begin the year after the Protocol is ratified. With respect to taxes withheld at source, like interest paid to non-residents, the Protocol will apply to amounts paid or credited on or after the first day of the second month after the Protocol is ratified. For example, if the Protocol is ratified in March 2008, the withholding tax reductions will begin in May 2008 and most other changes will begin to apply in 2009 for calendar year taxpayers.

Corporate tax provisions

Interest paid to non-residents
The Protocol will result in the elimination of withholding tax on interest paid to unrelated non-resident lenders. It was stated in the March 2007 federal budget that the government intends to amend Canadian domestic law such that withholding tax will be eliminated on interest paid to all unrelated non-resident lenders, regardless of their country of residence, effective as of the same date.

For interest paid to related non-resident lenders, the maximum withholding rate will be reduced to 7%, 4%, and 0% for the first (calendar) year, second year and third and subsequent years respectively following the entry into force of the Protocol.

In certain cases where interest is contingent or dependent on factors such as profitability, the interest may be treated as a dividend distribution rather than an interest payment for purposes of determining the applicable rate of withholding tax.

In a related change to the Other Income article, the Protocol will eliminate withholding tax on guarantee fees. Guarantee fees paid to a non-resident are currently treated as interest and taxed accordingly.

Treaty benefits for limited liability companies (LLCs)
The Protocol also provided for the much anticipated extension of treaty benefits to LLCs that are treated as fiscally transparent entities for U.S. tax purposes. The residence article of the treaty will be amended to provide that a member of a LLC, for example, shall be considered to derive an amount of income, profit or gain of the LLC where the member is considered to derive the amount through the LLC under U.S. tax law and, by reason of the LLC being fiscally transparent, the treatment of the amount is the same as it would have been if the member had received it directly. If the member is a resident of the United States, the member will be eligible for treaty benefits in respect of the amount received. Benefits under the treaty will not be available in respect of members who are not resident in the United States.

In determining the applicable withholding tax rate on dividends paid to a LLC, the shares held by the LLC will be considered to be held by a member of the LLC in the same proportion as the member’s interest in the LLC, thereby providing for a possible reduction in the withholding tax rate.

The benefits of the application of the treaty in respect of amounts paid to a LLC for which tax is withheld at source, such as dividends, interest and royalties, would be available at the same time as other measures in the Protocol with respect to withholding taxes. Other benefits of the change, such as relief in respect of capital gains, would be effective for the same taxation year that the changes to the Protocol are generally effective.

The changes also appear to provide relief in respect of a long-standing issue involving dividends paid to a partnership of non-residents. Previously, the 15% rate of withholding applied in respect of dividends paid on shares owned by a partnership of U.S. corporations, rather than the 5% rate that would have applied if the shares were owned by the partners directly.

Loss of treaty benefits for payments to and from certain other hybrid entities
While LLCs will soon be able to obtain treaty benefits, certain other structures involving hybrid entities appear to lose treaty benefits.

For example, U.S. residents frequently finance their Canadian operations through “reverse hybrid” partnerships which are treated as partnerships for Canadian tax purposes and as corporations for U.S. tax purposes. The Protocol will deny treaty benefits in respect of amounts paid to such partnerships since the partners are not subject to tax on the payments due to the fact that the partnership is not fiscally transparent for U.S. tax purposes.

Another provision applies in respect of amounts paid by hybrid entities. The provision may apply where a person receives an amount from an entity that is viewed as fiscally transparent under the tax laws applicable to the recipient.

The implications of these changes may require taxpayers to reassess the viability of certain hybrid arrangements. Fortunately, these measures will not be applicable until the first day of the third calendar year that ends after the Protocol enters into force.

Permanent establishments of service providers
The Protocol contains changes to the definition of permanent establishment that will deem a non-resident to have a permanent establishment in the other country if services are provided in the other country for an extensive period. A permanent establishment will be deemed to arise if either:

• the services are performed by an individual who is present in the other country for 183 days in aggregate in a 12-month period and more than 50% of the gross revenues of the enterprise are derived from those services, or
• the services are provided for 183 days in aggregate in a 12-month period with respect to the same or a connected project for customers who are residents of that country or have a permanent establishment there.

This measure, which will have a very significant impact on consultants and other service providers, will not generally be effective until the third taxation year of a taxpayer that ends after the Protocol comes into force.

Status of dual-resident corporations
In news releases issued on September 18, 2000, Canada and the United States indicated that the residency provisions of the Convention applicable to companies that continue from one country into the other would be amended. It was stated that the revised provision would clarify “that a company incorporated in one country that continues into the other will still be treated as a resident of the first country unless that country’s internal law no longer treats it as such.” The Protocol includes a change to the residence article, applicable to corporate continuations effected after September 17, 2000, which provides that a dual resident company that is created under the laws of one country but not under the laws of the other country shall be deemed to be a resident only of the first-mentioned country. In other cases, the competent authorities must settle the question of residency. The meaning of the term “created” is somewhat unclear in this context, and further clarification of this measure will be required.

Individual taxation

Employee stock options
Annex B of the Diplomatic Notes provides long-awaited guidance with respect to the taxation of stock option income received by an individual who has been employed by a corporation or a mutual fund trust in both Canada and the United States. The apportionment of taxing rights between Canada and the United States is to be determined based on the individual’s “principal place of employment” during the period from the date of grant to the date of exercise or disposal of the options. The choice of exercise date as opposed to vesting date is somewhat of a surprise, given that the United States adopted grant to vesting sourcing in 2005, and it was the Canadian rules that were ambiguous. No guidance has been provided as to the determination of principal place of employment.

Taxpayer emigration and double taxation
The Convention currently provides a rule intended to coordinate the taxation of gains where an individual is treated as having disposed of a property for purposes of one jurisdiction, but not the other. This rule provides that such an individual may elect to also be taxable in the other jurisdiction as if he or she had disposed of and reacquired the property at the same time. The result of such an election is a step-up in the cost basis of the property, thereby avoiding double taxation of the gain upon eventual sale.

The difficulty with the existing rule is that an individual must be subject to tax in the second jurisdiction at the time of the deemed disposition. The Protocol therefore extends this election to individuals deemed to dispose of a property in one jurisdiction, regardless of their residency status in the second jurisdiction. Unfortunately, given the mechanics of the foreign tax credit system in both countries, this change will still not avoid double taxation in certain circumstances.

Taxation of employment income
Former Article XV (Dependent Personal Services) is now “Income from Employment.” Changes have been made in determining when a resident of one country is subject to tax by the other country on employment income earned in that other country.

Previously, a resident of one country (i.e. Canada) who exercised employment in the other country (i.e. the United States) would only be taxed in his or her country of residence on such employment income if:

(a)  the individual’s employment income earned in that other country (i.e. the United States) did not exceed $10,000; or

(b)  the individual employee was present in the other country (i.e. the United States) for 183 days or less in a year and the employment income was not borne by an employer who was a resident of that other country or by a permanent establishment or a fixed base which the employer had in that country.

Protocol changes part (b) of the test in two respects. First, the 183 days test must now be met in “any 12-month period commencing or ending in the fiscal year concerned.” In practice, this tends to be a more difficult period for individuals to track. Second, a further requirement is added that the employment income must also not be paid by, or on behalf of a person who is a resident of that other country. (i.e. the United States). 

Taxation of pensions
The Protocol sets out new rules with respect to the treatment of contributions to qualifying pension and other retirement plans. The rules also clarify that benefits accruing under these plans are not taxable. These rules will affect cross-border commuters and individuals on temporary work assignments of up to five years. While these rules do provide greater flexibility and certainty to employees and employers, they are quite complex and many administrative questions remain.

Canadian qualifying plans include: registered pension plans, deferred profit sharing plans, group and individual registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) that are funded solely through the rollover of contributions from one or more of the preceding plans. U.S. qualifying plans include 401(k) plans, certain individual retirement plans, qualified annuity plans, qualified pension plans, certain thrift plans and certain individual retirement accounts that are funded exclusively by rollover contributions from one or more of the preceding plans.

In general, the new rules would permit cross-border commuters to deduct, in their country of residence, the contributions they make to the pension or retirement plans of their work country. Similarly, individuals on short-term assignments would be able to deduct contributions made to their home country’s retirement or pension plan for tax purposes of their country of residence. For example, a Canadian on assignment in the United States could continue to accrue and contribute to the registered pension plan of his Canadian employer and deduct such contributions for U.S. tax purposes.

There are a number of conditions that must be met by the individual in order for contributions to be tax deductible and benefits to accrue tax free.  In addition, limits are imposed. The purpose of these limits is to ensure that the individual does not obtain a tax advantage. For example, a U.S. citizen on short-term assignment in Canada would, in general, be able to deduct for Canadian tax purposes contributions to his U.S. employer’s retirement plan to the extent the contributions did not exceed the individual’s RRSP limit for the year.

Lastly, if a number of conditions are met, employers may claim a corporate tax deduction for contributions made to qualifying pension or retirement plans on behalf of such individuals.

General Provisions

New arbitration measure
The Protocol institutes a new arbitration provision that should be of substantial assistance in ensuring that taxpayers are not subject to double taxation. Arbitration will generally be available to taxpayers at their request.  Decisions of the arbitration board will be binding on the two countries unless the taxpayer opts not to accept the determination. The process will utilize what is commonly referred to as "baseball" arbitration - each country presents their position in writing, and the arbitration board selects from one of the two positions. Arbitration will generally be available only for issues relating to an individual's residency determination, the determination of and attribution of profits to a permanent establishment, transfer pricing, and certain issues relating to royalties. Timelines are laid out that should result in a determination being rendered within a year of the commencement of the arbitration proceedings. The new provision will be available for any case that is in the system when the Protocol comes into force.

This is a very positive development for taxpayers. The existence of the provision should reduce any inclination by either competent authority to take extreme positions in any particular case and should also have the effect of reducing the time to reach settlements.

Limitation on benefits changes
The Protocol contains several changes to the limitations on benefits (LOB) article. First, the LOB article will apply to the application of the Convention by Canada whereas previously it was only for application by the United States. This will give rise to new compliance burdens on payments to the United States from Canada. Although the Protocol retains the right of a contracting state to deny benefits where provisions of the treaty have been abused, this change may also have implications in perceived “treaty shopping” cases. Second, the conditions for “qualified person” status of publicly-traded entities have been modified to recognize share trading on more than one stock exchange, provide additional guidance on the term “principal class of shares” and disqualify entities that have outstanding, for example, tracking stock. Lastly, certain exempt organizations that are not currently eligible under Article XXI will become qualified persons.

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