Canadian 'anti-hybrid' rules: review agreements by January 2010.

• Author: Lysenko, Jonathan
• Position: INTERNATIONAL TAX

While the Canadian-United States Tax Treaty Protocol introduced significant changes that may improve cross-border cashflow between the U.S. and its top trading partner, Canada (such as 0 percent withholding tax on cross-border interest payments), the new "anti-hybrid" provisions of the protocol introduced an impediment that may require certain U.S. investors in Canada to restructure their operations.

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The anti-hybrid provisions of the protocol are scheduled to take effect in January 2010.

In essence, the protocol will apply a 25-percent withholding tax on interest and dividend payments to U.S. shareholders from Canadian hybrid entities. A hybrid is an entity--normally a Canadian unlimited liability company (ULC)--that is treated as a corporation for Canadian tax purposes, but as a flow-through for U.S. purposes.

It's particularly attractive to U.S. individuals and S Corporations because a hybrid can flow through the taxes paid in Canada to U.S. individual shareholders as a foreign tax credit, while a corporate entity cannot.

These significant new withholding taxes on hybrid entities may compel some U.S. shareholders to change their structure.

In considering a different structure, some common options include:

* Capitalize the ULC. Continue operating as a hybrid but fund it through capital rather than loans. When it's time to remit cash, capital can be repatriated free of withholding tax.

* Incorporate the ULC. Terminate hybrid status by electing corporate rather than flow-through treatment for U.S. purposes. The corporate election will mean more tax--full...