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The Protocol to the Canada-U.S. Income Tax Convention, which was signed on September 21, 2007, includes a provision that will eliminate the current 10% withholding tax on interest paid by a resident of one country to an unrelated lender resident in the other country. The Protocol also provides for the phased reduction of withholding tax on interest paid to related party lenders, with the withholding tax rate to be reduced to 7% in the first year in which the Protocol is effective, then to 4% in the second year and 0% in subsequent years. 

The Canadian government stated in its March 2007 budget that it would eliminate withholding tax under Canadian domestic law in respect of interest paid to all non-resident lenders who deal “at arm’s length” with the Canadian payer, regardless of the lender’s country of residence. The Protocol uses the term “related” but the concepts are similar since related persons are deemed not to deal with each other at arm’s length under Canadian law.  Draft legislation was released on October 2, 2007, which provided that this amendment would be effective on the same date as the elimination under the Protocol of withholding tax on interest paid to unrelated U.S. lenders. However, the legislation was revised when it was tabled in the House of Commons on November 13, 2007, to provide that domestic withholding tax on such arm’s-length payments will be eliminated as of January 1, 2008, regardless of the effective date of the Protocol.

The change in the effective date of the amendment is helpful since there has been some uncertainty as to whether the withholding tax elimination (in the case of unrelated party interest) or reduction (in the case of related party interest) in the Protocol was intended to be retroactive to January 1, 2008 in the event that the Protocol was ratified in 2008. Under an alternative interpretation of the Protocol, the provisions would not be effective until the second month after the Protocol is ratified by both countries. 

However, at a hearing yesterday before the Senate Standing Committee on Banking, Trade and Commerce, Ted Menzies, M.P., the Parliamentary Secretary to the Minister of Finance, stated that Canada and the U.S. agree that these provisions of the Protocol are intended to be applied retroactively. Department of Finance officials have confirmed this agreement. Assuming this interpretation is reflected in the Technical Explanation to the Protocol and the provisions are administered in this manner by the revenue authorities of the two countries, if the Protocol is ratified in 2008 as anticipated the elimination of withholding tax on interest paid to unrelated parties and the reduction to 7% on interest paid to related parties should both be effective as of January 1, 2008.

Officials also testified at the hearing that they are hopeful that the Technical Explanation to the Protocol may be available next month.

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