Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
The Fifth Protocol (the Protocol) to the Canada-United States Income Tax Convention (the Treaty) was released with much fanfare on September 21, 2007. Canada and the U.S. have independently entered into a multitude of bilateral tax treaties that tend to follow the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention. However, it is evident that the unique relationship of Canada and the U.S. as important trading partners has resulted in the Treaty being a very unique agreement that deviates in many ways from both the OECD Model Tax Convention and the U.S. Model Tax Convention even without regard to the Protocol. The Protocol was a heavily negotiated long-term work in progress. These negotiations culminated in a very unusual and complex agreement that contained some very unique provisions. A number of these provisions were drafted in a confusing manner and some of these provisions appeared to be questionable from a tax policy perspective. Leaving aside the substantive provisions in the Protocol, the effective dates applicable to the various provisions also raised a great deal of confusion.
As noted in the report prepared by the U.S. Joint Committee of Taxation that was delivered to the U.S. Senate Committee on Foreign Relations, the traditional objectives of U.S. treaties have been the avoidance of international double taxation and the prevention of tax avoidance and evasion. Unfortunately, some of the shortcomings of the Protocol are to potentially cause or increase double taxation to Canada-U.S. cross-border trade and investment where no double taxation previously existed.
With this backdrop in mind, the tax community greatly anticipated the release of the Technical Explanation to the Protocol (TE) by the U.S. Treasury Department and there was a fairly high level of optimism that much of the uncertainty surrounding the Protocol would be cleared up.
The TE was released by the U.S. Treasury Department on July 10, 2008. The TE was prepared entirely by the U.S. Treasury Department and is an official United States guide to the Protocol. However, the Canadian Minister of Finance issued a press release that indicated that the TE "accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the Protocol."
The TE is important in that it provides an explanation from the U.S. government on how the Protocol is intended to apply. However, it should be borne in mind that as stated by the Federal Court of Appeal in Kubicek Estate in relation to the U.S. Technical Explanation to the 1984 protocol to the Treaty, "the Technical Explanation is a domestic American document. True, it is stated to have the endorsation of the Canadian Minister of Finance but, in order to bind Canada, it would have to amount to another convention, which it does not. From the Canadian viewpoint, it has about the same status as a Canada Revenue Agency interpretation bulletin of interest to a court but not necessarily decisive of an issue."
Although the TE clears up some of the uncertainty in relation to the Protocol, it clearly does not resolve all of it. Moreover, the TE clearly does not resolve any of the problems associated with the controversial rules that will apply to certain hybrid entity structures and it does not address some significant omissions in the limitation on benefits provision. The TE is only an interpretive aid; it cannot correct errors or omissions in the Protocol itself. Consequently, it appears that a further agreement will be required to fix the errors and omissions contained in the Protocol.
Canada completed all the domestic requirements to ratify the Protocol on December 14, 2007 when Bill S-2 received royal assent. However, the Protocol will only come into force once it has been ratified by the U.S. and the two countries have formally notified each in writing of the ratification.
The Protocol has not yet been ratified by the U.S. Congress. The Protocol was introduced to a hearing of the U.S. Senate Committee on Foreign Relations on July 10, 2008, which is the first step in the U.S. approval process. It is worth noting that certain aspects of the Protocol are controversial and that there is no certainty of ratification by the U.S. Congress in 2008 or at all.
If the Protocol enters into force, it will generally be effective:
- in respect of withholding taxes (such as on dividends and
royalties), other than on interest payments, two months after
it enters into force; and
- in respect of other taxes, although particular timing
applies to certain provisions (such as delayed implementation
to January 1, 2010 for the new denial hybrid entity and the
permanent establishment rules if the Protocol is in force in
2008), for taxation years that begin in the calendar year
after the Protocol enters into force.
|
TREATY PROVISION |
SUBJECT MATTER OF PROVISION |
EFFECTIVEDATE |
|
Article IV Residence (par.3) |
Continuance / dual resident companies |
Retroactive to September 17, 2000 |
|
Article IV Residence (par.6) |
Hybrid entities – relieving rules for LLCs and other fiscally transparent entities |
For source withholding tax purposes, on the first day of the secondmonth after the Protocol enters into force For other income tax purposes, for taxable years commencing after the calendar year in which the Protocol enters into force |
|
Article IV Residence (par.7) |
Hybrid entities - denial rules for fiscally transparent entities |
On the first day of the third calenr year that ends after the Protocol enters into force |
|
Article V Permanent Establishment (par.9) |
Deemed permanent establishment for service providers |
For the third taxable year after the Protocol enters into force 1 |
|
Article VII Business Profits |
Approach to taxation of business profits attributed to a permanent establishment |
For taxable years beginning after the calendar year in which the Protocol enters into force |
|
Article XI Interest 2,3 |
Related party interest 4 |
For interest paid or credited during the first calendar year that ends after the Protocol comes into force, the rate is 7% if the Protocol is ratified in 2008, retroactive to January 1, 2008 For interest paid or credited during the second calendar year that ends after the Protocol comes into force, the rate is 4% For interest paid or credited during the third calendar year that ends after the Protocol comes into force, the rate is 0% |
|
Article XIII Gains (par.7) |
Individual's pre-emigration and post-immigration – cost base step-up election |
Retroactive to September 17, 2000 for dispositions of property that occur after September 17, 2000 |
|
Articles XV, XXIV Income from Employment, Elimination of Double Taxation |
Employee stock options – apportionment of taxing rights |
For taxable years beginning after the calendar year in which the Protocol enters into force |
|
Article XVIII Pensions and Annuities |
Guarantee fees 5 |
For source withholding tax purposes, on the first day of the second month after the Protocol enters into force For other income tax purposes, for taxable years commencing after the calendar year in which the Protocol enters into force |
|
Article XXII Other Income |
Mandatory and binding arbitration |
For arbitration cases that are currently under consideration by the competent authorities and for arbitration cases that come under consideration after the date the Protocol enters into force, as of the date on which the Protocol enters into force |
|
Article XXVI-A Assistance in Collection |
Assistance in respect of a taxpayer's claim and collection of revenue |
Applicable for revenue claims finally determined by an applicant state after November 9,1985 |
|
Article XXVII Exchange of Information |
Enhancement of exchange of information rules |
For taxation years beginning after the calendar year in which the Protocol enters into force |
|
Article XXIX-A Limitation on Benefits |
Reciprocal comprehensive limitation on benefits rules |
For source withholding tax purposes, on the first day of the second month after the Protocol enters into force For other income tax purposes, for taxable years commencing after the calendar year in which the Protocol enters into force |
Footnotes:
1 Assuming the Protocol is ratified in 2008, for a calendar year taxpayer, this provision would be effective on January 1, 2010. Moreover, only those (i) days present, (ii) services rendered and (iii) gross business revenues that occur or arise or after January 1, 2010 would be taken into account.
2 As of January 1, 2008, pursuant to Canadian domestic tax law, withholding tax is eliminated in respect of interest paid to arm's-length non-residents (other than on participating debt interest). The U.S. has a similar but not identical domestic exemption in respect of "portfolio interest" (other than for contingent interest).
3 The Protocol provides that withholding on interest paid to an unrelated resident of the other state (save for participating interest in Canada or contingent interest in the U.S.) will be generally eliminated. If the Protocol is ratified in 2008, this rule would be effective as of January 1, 2008.
4 Reference to paragraph 2 of Article IX (Related Persons) of the Treaty and, generally, to the domestic law applicable to the payer should be made to determine whether persons are related or deemed to be related.
5 The Protocol provides that guarantee fees are taxable only in the residence state unless they are attributable to a permanent establishment in the other state, in which case they may be taxable under Article VII (Business Profits). Canada normally exempts guarantee fees from withholding tax under domestic tax law by treating such fees as interest, provided they are paid to an arm's-length non-resident. The Canadian Department of Finance recently suggested that Article XXII (Other Income) of the Protocol should generally apply to exempt guarantee fees paid to related persons from Canadian withholding tax irrespective of the phase-in of the related persons interest withholding tax exemption under Article XI (Interest).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
