International Tax Alert
On Friday, September 21, 2007, the United States and Canada signed a long-awaited Fifth Protocol (“Protocol”) amending the 1980 Convention between the United States of America and Canada with Respect to Taxes on Income (“U.S.-Canada Tax Treaty”). The U.S.-Canada Tax Treaty is among the most significant of U.S. tax treaties due to the tremendous cross-border investment and trade flows between the two countries, which, as U.S. Treasury Secretary Paulson noted, constitutes the “largest bilateral trade relationship in the world, with total exports and imports exceeding $530 billion in 2006.” The Treaty also is significant because of the high volume of tax disputes that have arisen between the two countries. The Protocol introduces a number of significant and positive changes that will affect companies with investment and trade flows between the United States and Canada, several of which are highlighted below. Although the timing of the ratification process is difficult to predict, there is some possibility that the Protocol will enter into force in 2008.
Elimination of Withholding Tax on Interest. The Protocol eliminates withholding tax on interest paid or credited between unrelated parties effective on or after the first day of the second month that begins after the Protocol enters into force. In addition, the withholding tax on interest paid between related parties is phased out over the three years after the Protocol enters into force, reduced to 7% in the first year that ends after entry into force and 4% in the second year that ends after entry into force before being eliminated altogether. See below for a discussion of the Protocol’s entry into force. The elimination of withholding tax on interest is unprecedented in Canadian tax treaties. These provisions will allow financial institutions greater flexibility in providing cross-border financing to customers, and ultimately will provide multinational companies greater flexibility in financing their operations in the United States and Canada.
Binding Arbitration of Tax Disputes. The Protocol introduces binding arbitration of tax disputes (at the election of the taxpayer) that the competent authorities have not been able to resolve within two years. In general, if the competent authorities are unable to resolve a dispute within two years and the taxpayer agrees not to disclose information received during the course of the arbitration, the dispute will be submitted to an arbitration board for resolution. The competent authorities will be bound by this resolution unless the taxpayer does not accept it. The diplomatic notes provide for detailed procedures that are similar to those included in the recent U.S. tax treaties with Belgium and Germany. The arbitration provision is very significant in the context of the U.S.-Canada Tax Treaty given the high volume of disputes that have arisen between the two countries. Cases that are pending at competent authority when the Protocol enters into force will be eligible for arbitration under this provision, but the two-year period will begin running only upon entry into force.
Tax Benefits to U.S. LLCs. The Protocol provides treaty benefits for dividends, interest, and royalties received by U.S. pass-through entities such as LLCs, partnerships, and S corporations so long as such income is treated under U.S. tax law as earned by U.S. owners and retains its character in the hands of such owners. The rule also applies to U.S. source income received by Canadian pass-throughs with Canadian owners. The language of this provision is somewhat different than that of analogous provisions in recent U.S. treaties and the 2006 U.S. Model tax treaty, but appears intended to reach the same result. In addition, the Protocol provides that corporations receiving cross-border dividends through pass-through entities are entitled to the lower rate of withholding tax applicable to dividends received by corporations. These provisions resolve significant issues under the current U.S.-Canada Tax Treaty, which was interpreted by Canadian authorities as not providing benefits to payments to U.S. LLCs treated as partnerships.
Source Taxation of Long-Term Service Activities. The Protocol provides that residents of one country who perform services in the other country for more than 183 days in a year may be subject to tax in the country in which the services are performed even if the service provider does not have a permanent establishment in that country. The current 12-month rule will continue to apply to construction and building activities. This provision is not consistent with established U.S. tax treaty policy and may force certain companies in the services sector to reorganize their businesses; therefore, it is likely to be controversial. It is noteworthy that this provision, which represents a significant concession on the part of the United States, comes into effect in the third taxable year that ends after the Protocol enters into force, on the same deferred timetable as the elimination of withholding tax on related party interest, which represents a significant concession on the part of Canada.
Reciprocal Limitation on Benefits Rules. The limitation on benefits rules of the current U.S.-Canada Tax Treaty apply only to the provision of treaty benefits by the United States. The Protocol amends the U.S.-Canada Tax Treaty to make the limitation on benefits rules reciprocal. This change in policy is particularly noteworthy given recent setbacks for the Canadian tax authorities in applying anti-abuse rules in the tax treaty context. See MIL (Investments) S.A.V.R., Fed. Ct. of Appeal (June 13, 2007) (upholding claim of treaty benefits under the Canada-Luxembourg tax treaty on gains from the sale of stock and rejecting efforts by CRA to read an inherent anti-abuse provision into the treaty). The provision also provides that its inclusion should not be construed as restricting in any manner the right of the two tax authorities to deny benefits in abusive contexts, presumably under applicable domestic anti-abuse rules. Finally, it is noteworthy that the LOB rules in the Protocol are less restrictive than those of recent U.S. tax treaties and the U.S. Model tax treaty; in particular, the Protocol does not include the rules restricting the regularly traded test found in the 2006 U.S. model tax treaty and recent U.S. tax treaties, and the Protocol has a very broad derivative benefits rule.
Additional Coordination of Pension and Retirement Plan Rules. Retirement Plan Rules. The Protocol amends the U.S.-Canada Tax Treaty to specifically include Roth IRAs and other similar arrangements in the definition of a “pension.” More significantly, the Protocol provides additional rules to address the tax treatment of contributions to, benefits accrued under, and distributions from pension, retirement, and other employee benefit plans. The Protocol specifies the circumstances under which a resident of one country who is a beneficiary of a plan of the other country may elect to defer taxation in the beneficiary’s country of residence with respect to any income accrued in, but not distributed by, the plan. It also specifies the circumstances under which contributions made to, or benefits accrued under, a plan in one country by or on behalf of an individual who is a resident of the other country shall be deductible or excludible in computing the individual’s taxable income in the other country. In all cases, treaty benefits described are not to exceed benefits generally applicable to and permitted for residents of the country under that country’s pension taxation laws.
Stock Options. The Protocol provides rules for sourcing stock option benefits. In general, benefits from stock options are considered compensation and are sourced on the basis of the individual’s principal place of employment between the time of grant and the time of exercise. This rule is similar to analogous rules in the 2001 U.S.-U.K. tax treaty and the 2003 U.S.-Japan tax treaty.
Entry into Force of Protocol. The Protocol generally will enter into force and become effective as of the later of: January 1, 2008, or the date of notification by each country that the Protocol has been ratified. That said, certain provisions of the Protocol have effective dates that differ from the general entry into force date specified. Such dates are noted, where applicable, in the discussion above.
Next Steps. The Protocol must now go through the ratification process in each country. In the United States, it must be transmitted to the U.S. Senate for advice and consent. Given that the Senate Foreign Relations Committee held a treaty hearing earlier this year in July and has a full agenda for the fall, it seems unlikely that the Protocol will be ratified this year, though ratification early next year is possible. In light of the substantial benefits provided by the Protocol, in particular the elimination of withholding tax on interest payments and the introduction of binding arbitration, ratification in the United States in early 2008 would be welcome.
For further information, please contact any of the following lawyers:
Rocco Femia, firstname.lastname@example.org, 202-626-5823
Marc Gerson, email@example.com, 202-626-1475