Fifth protocol: proposed amendments to United States-Canada Income Tax Treaty.

• Author: Cornett, J. Michael

Almost twenty-seven years to the day after the Convention between the United States of America and Canada with respect to Taxes on Income and on Capital (Treaty) was signed (September 26, 1980), officials in the two countries executed (September 21, 2007) the Fifth Protocol to this Treaty (2007 Protocol). (1) The 2007 Protocol will enter into force on the date that Canada (2) is notified of the U.S. Senate's ratification of the 2007 Protocol. (3) Optimally, this will happen in 2008.

The negotiations for the 2007 Protocol lasted for more than a decade and began with a provision found in the 1995 protocol, mandating negotiations regarding the interest withholding tax within three years of the signing of the earlier protocol. (4) Most commentators view the 2007 Protocol as beneficial for both countries, but there are some who believe that the detriment to U.S. businesses, especially those in the service industry, outweigh the benefits provided by the 2007 Protocol. (5) This article addresses the Protocol's significant amendments to the Treaty. (6)

Reduction of Withholding Tax on Interest to Zero

First and foremost, the 2007 Protocol reduces the withholding of tax on interest payments from 10 percent, as currently provided in the Treaty, to 0 percent. Specifically, the 2007 Protocol states "[I]nterest arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed only in that other State." (7) This language effectively eliminates the withholding tax on interest. The effective date of this provision, however, depends on whether the interest payment is made to an unrelated person or a related person.

If the interest payment is made to an unrelated person, the reduction of the withholding rate to zero is effective for interest paid or credited on or after the first day of the second month that begins after the date of the 2007 Protocol's entry into force. (8) In the case of interest paid or credited to related persons, the reduction in the withholding tax rate is phased in over a three-year period. Specifically, in the first calendar year ending after the 2007 Protocol enters into force, the withholding rate on interest paid or credited between related persons is 7 percent, and for the second calendar year ending after entry into force, the withholding rate is reduced to 4 percent for interest paid or credited in the second calendar year. In the third calendar year and thereafter, the withholding rate is zero. (9)

There is some uncertainty whether the reduction in withholding rates for related person interest applies from the date of the 2007 Protocol's entry into force or from the first day of the second month after the 2007 Protocol enters into force. Presumably, this will be clarified before the 2007 Protocol enters into force. If the payment of interest can be deferred (for both unrelated and related persons), it may be possible to claim the lower withholding rate at the time of payment even though the interest expense was accrued in a period before the 2007 Protocol entered into force.

Treaty Benefits on Payments to United States Limited Liability Companies

Before the 2007 Protocol, Canada did not grant treaty benefits to a U.S. resident that invested in Canada through a U.S. limited liability company (LLC). This occurred because Canada did not view the LLC as a U.S. resident entitled to treaty benefits for purposes of the Treaty. (10) Under the 2007 Protocol, Canada will provide treaty benefits to a U.S. resident that is a member of an LLC if (i) the U.S. resident is considered to derive the income through the LLC, and (ii) the amount of the income of the LLC is treated the same as the treatment such income would receive if earned directly by the U.S. resident. (11) Thus, U.S. resident members of a LLC that is treated as fiscally transparent for U.S. federal income tax purposes can claim treaty benefits for their proportionate share of dividend, interest, and royalty payments made to the LLC. (12) For payments subject to withholding taxes, this provision will be effective for amounts paid or credited after the first day of the second month that begins after the date the 2007 Protocol enters into force. (13) For taxes other than withholding taxes (i.e., income tax and capital gains), the provision will be effective for taxable years that begin after the calendar year the 2007 Protocol enters into force. (14)

Provisions Involving Hybrid or Reverse Hybrids Entities

Even though the 2007 Protocol provides welcome relief for payments made to LLCs, the 2007 Protocol contains provisions that may deny treaty benefits for payments made in structures that involve a hybrid or reverse hybrid entity. Specifically, Article 2(7) of the 2007 Protocol provides two rules that will have to be considered when structuring a...