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Fifth Protocol to the Canada-U.S. Income Tax Treaty

By Mark G. Janulewicz, CPA

Lumsden & McCormick, LLP

The fifth Protocol to the Canada - U.S. Income Tax Treaty entered into force on December 15, 2008, amending the existing income tax treaty between the U.S. and Canada. The Protocol is generally effective for tax years beginning on or after January 1, 2009, although certain provisions have different effective dates.  A number of substantial changes to the tax treaty are contained in the fifth Protocol and while some will benefit individuals and businesses on both sides of the border, there are certain provisions that could have adverse tax effects.

The Protocol contains provisions that provide for the elimination of withholding tax on interest payments, treaty benefits to owners of U.S. LLCs doing business in Canada, denial of treaty benefits for certain hybrids, and revisions relating to deductions for pension contributions for cross border individuals.

Withholding Tax on Interest Payments

Currently, the Canada-United States Income Tax Treaty reduces the standard withholding rate of 30% in the United States and 25% in Canada to 10% on cross-border interest payments. The new Protocol will provide a total phase out of withholding tax on interest payments. The phase out of the withholding is as follows:

Retroactive to the beginning of 2008, the rate drops to 7%, which could result in refund opportunities
For 2009, the rate drops to 4%. 
For 2010 and beyond, the withholding on interest payments will no longer be required.
Tax professionals should monitor the interest deduction limitation and earnings stripping rules of each country, which could limit the current tax deduction between related entities.

Benefits for U.S. Residents Holding Hybrid Entities

Although Canada has treated the U.S. LLC as a corporation (and not a transparent entity), Canada has treated the LLC as not being a resident of the U.S. because U.S. LLCs do not pay tax and therefore are not entitled to Treaty benefits.

Provisions in the Protocol attempt to eliminate these and other problems. An amount of income is now considered earned by a person who is a resident of the U.S. if

The person is considered under the U.S. tax law to have derived the amount t   through an entity that is not a resident of Canada and;
Because the entity is fiscally transparent under the U.S. tax laws, the tax treatment of the income is identical as though it had been earned directly by that person. 
This provision is helpful to U.S. residents investing in an LLC doing business in Canada. The U.S. tax law treats an owner of an LLC as deriving the income as a conduit entity, therefore the owner of the LLC is entitled to treaty benefits on that income.

Changes to Holding and Finance Structures

The new protocol denies treaty benefits for a common holding structure used by many U.S. and Canadian investors, the Canadian Unlimited Liability Company (ULC). A ULC is a Canadian corporation that is treated as a corporation for Canadian tax purposes, but treated as a hybrid for U.S. tax purposes. The ULC has been a common form of holding structure for U.S. investors seeking a flow-through vehicle for U.S. tax purposes. The flow-through treatment allows investors to recognize income, deductions, and foreign taxes on the U.S. tax return. In the process, the foreign tax credits are recognized as "direct" tax credits as a flow through for investors and avoids the double taxation that would otherwise be created when a Canadian corporation is necessary for investment. The Fifth Protocol denies treaty benefits where the hybrid entity is treated as a separate entity under the tax system of the source country (Canada) and as a flow through in the other country (U.S.). The protocol will deny treaty benefits for cash distributions from these structures, effectively increasing the withholding rate to 25% of the distribution. The effective date for this provision is January 1, 2010, so there is time to unwind these structures.

Pension Contributions

The Protocol contains new rules with respect to contributions to and benefits accrued in qualifying retirement plans. The new rules apply to individuals residing in one country and working in the other who contribute to a qualifying retirement plan in the country where they work. These individuals may deduct, in their resident country, the contributions made to a qualifying retirement plan in the country where they work. The new rules under the Protocol allow an individual who moves from their resident country to work in another country for less than five years to continue to contribute to a qualifying retirement plan in their resident country.

There are also new rules relating to binding arbitration, limitations on benefits, emigrants' gains and revisions to the permanent establishment rules which should be examined closely.

The Fifth Protocol to the United States-Canada Income Tax Treaty provides important clarifications and opportunities for planning on both sides of the border.

** In accordance with Internal Revenue Service Circular 230, please be advised that unless otherwise expressly stated, any discussion of a federal tax issue in this communication or any attachments to this communication is not intended to be used, and it cannot be used, for the purpose of avoiding tax penalties that may be imposed on any taxpayer.**