The fact that the 2007 Protocol to the Canada-U.S. Tax Treaty finally took effect on Dec. 15, 2008, may, at first blush, seem to be merely an arcane fact. But for just about anyone involved in a cross-border commercial transaction–and Canada and the U.S. do about $600 billion in trade annually–nothing could be further from the truth.
The protocol’s main feature is the elimination or phasing out of nonresident withholding tax on the vast majority of cross-border interest payments. This change should stimulate the inflow of American and other foreign capital to Canada (see “Securitization Impetus”).
“The withholding tax has been one of the main impediments to U.S. investment in Canada,” says Patrick Marley, a partner at Osler, Hoskin & Harcourt. “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, and the complicated requirements under existing exemptions will disappear.”
The protocol will bring a sea change in financial transactions, according to Professor Vern Krishna of the University of Ottawa’s Faculty of Law.
“Where there’s a withholding tax, whoever pays interest to a nonresident must deduct the tax from the payment and remit it to the government,” he says. “If applicable treaties are in place, the tax is offset against taxes payable by the recipients in their home country. In most but not all cases, especially where Americans are involved, the taxpayer gets credit for the tax withheld. The advantage of the amendment is that it eliminates the entire process.”
In the past, for example, a nonresident in Canada subject to a withholding tax of 10 percent on a $100 payment would receive only $90 and wait until the end of the year to file for a refund.
“Under the new rules, the cash flow timing is much better because the nonresident gets the full $100 up front and doesn’t have to wait for his $10 until the end of the tax year,” Krishna explains.
In other words, the procedural morass that previously existed should become a nonissue.
The protocol extends the exemption to trusts and other entities, meaning corporations and a narrow range of partnerships are no longer the only borrowers eligible.
In addition, debt obligations no longer need to comply with the “5/25″ rule to qualify for an exemption. The rule made eligible only arm’s length loans where no more than 25 percent of the principal was repayable within five years.
Finally, the protocol will apply to U.S. lenders that are “related” to Canadian borrowers, bringing parent-subsidiary and other group corporate transactions that are not arm’s length in nature within the withholding tax exemption.
The non-arm’s length exemption, however, will be phased in. The previous withholding tax rate of 10 percent on interest paid between related persons will drop to 7 percent during the first calendar year in which the exemption applies, 4 percent in the next year and will be eliminated for subsequent years.
The protocol was generally effective as of Feb. 1. In the case of interest payments, the elimination of withholding tax is retroactive to Jan. 1, 2008.
Because the changes apply without regard to the residence of the nonresident lender, the removal of the withholding tax will discourage treaty shopping, which occurs when lenders set up intermediaries in countries whose treaties with Canada or the U.S. feature favorable withholding tax rates.
It will also reduce borrowing costs in Canada and the U.S.
“Formerly the borrower rather than the foreign lender bore the cost of the tax through a gross-up clause in the lending agreement,” Marley says.
Another provision of the protocol ensures that the treaty applies to monies received through hybrid entities like limited liability companies.
“American limited liability companies did not formerly get treaty benefits such as capital gains protection and the reduced withholding rate,” Wach says. “But they will now, at least to the extent the limited company is in the hands of qualifying U.S. residents.”
The protocol is also of interest to employment lawyers. It contains rules to govern pension benefits in cross-border employment situations and for apportioning the taxation of stock option benefits between Canada and the U.S. in cross-border situations.
It also adds provisions relating to arbitration of double taxation issues.
Previously, if treaty rules didn’t provide for a resolution to a double taxation problem, it was up to the revenue authorities to resolve it–at their own glacial pace, of course. And if they couldn’t resolve the matter, there wasn’t anything to do about it. Transfer pricing (the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division’s profit and loss separately) is an area in which these types of problems frequently occur, largely because of the cross-border flow of goods and services to and from U.S. parents and subsidiaries.
But now, taxpayers can elect binding arbitration in which the revenue authorities must participate–and the rule applies retroactively.
But it’s not all good news.
The protocol features enhanced information exchange provisions, making cross-border information more accessible to tax authorities in Canada and the U.S.
“Previously, each contracting jurisdiction was required to provide to the other information that was relevant to the administration of the tax laws of the jurisdiction receiving the request,” Marley says. “The protocol goes further by adding specific provisions empowering each jurisdiction to obtain taxpayer information situated beyond its borders.”
So now, authorities from one jurisdiction can enter the other for interviews and to examine documents. Authorities can no longer withhold information on the basis that a financial institution, nominee, agent or fiduciary holds the information, nor can they do so on the basis that the information relates to ownership interests. Finally, neither Canada nor the U.S. can deny information to each other on the basis that the state receiving the request does not need the information in order to administer its own tax laws.
By the same token, none of this will impact the core of the protocol: an increased flexibility to structure cross-border loans without triggering withholding tax.