A new Protocol to the Canada-U.S. Tax Treaty was recently signed and is expected to enter into force in the near future, causing substantial changes to the taxation of cross-border transactions with the U.S. Changes include the elimination of withholding taxes on cross-border interest payments and the extension of treaty benefits to U.S. limited liability corporations ("LLCs"), as well as the denial of treaty benefits for certain "hybrid" entities.

Withholding tax on cross-border interest

Until recently interest paid by a Canadian resident to a U.S. resident was subject to a 10% withholding tax. The U.S. has a broadly available exemption from such tax; but Canada's main exemption is often highly impractical for borrowers to access, resulting in higher cost of capital for Canadian borrowers.

The Protocol proposes to completely eliminate the 10 per cent withholding tax. This change has motivated the Canadian Government to change Canada's general tax laws to eliminate Canadian withholding tax on interest to arm's length non-residents of all countries, which it did effective at the start of 2008. Accordingly, the only difference for payments of interest to the U.S. will be in respect of payments to non-arm's length recipients, for whom the elimination is to be phased in over three years.

Treaty benefits for LLCs

The Canada Revenue Agency has long taken the position that LLCs (if they elect not to be taxable in the U.S.) are not "resident" in the U.S. for the purposes of the Treaty because they are not subject to tax in the U.S. As a result, treaty benefits such as reduced withholding tax or the exemption from Canadian tax on Canadian-source gains are not available.

The Protocol introduces a new rule under which income earned by U.S. residents through an LLC will in certain cases be treated in Canada as having been earned by a U.S. resident, therefore enabling treaty protection in respect of that income. However, as of two years after the Protocol coming into force, if income of the LLC is not taxed directly in the hands of its investors, the income will be treated as not having been earned by a U.S. resident.

The Protocol therefore removes serious impediments to cross-border investment. U.S. private equity funds with U.S. investors investing into Canada may now be structured as LLCs (as U.S. fund managers often prefer) rather than partnerships, and U.S. tax leakage will be eliminated.

However, LLCs will not be attractive to non-U.S. investors, who will not be entitled to this "look-through" treatment, and will not be entitled to benefits of tax treaties between Canada and their own countries of residence. U.S. private equity funds with international investors will likely continue to structure as partnerships.

Limitation of Benefits and Hybrid Entities

Not all of the provisions of the Protocol are beneficial. A new "limitation of benefits" provision applicable to Canada forms part of the Protocol, the first time Canada has adopted such a provision in a tax treaty. As a result, not all U.S. taxpayers will be entitled to the benefits of the treaty, or their benefits may be restricted. For example, a U.S. subsidiary of a foreign parent corporation will see its entitlement to treaty benefits restricted.

As well, treaty benefits will be denied to certain "hybrid" entities (being, in general terms, an entity that is treated as being taxable in either Canada or the U.S., but as being a "pass through" for tax purposes in the other country). This change will apply possibly as early as Jan. 1, 2010. This change will dramatically affect tax structuring between the two countries. At particular risk are ULCs, which are currently a favourite tool of planners to facilitate U.S. investment into Canada due to their treatment under U.S. law; they are eligible to be treated as fiscally transparent in the U.S., allowing losses to flow through to shareholders and permitting other planning opportunities including so-called "push down" or "reverse hybrid" structures. Existing ULC structures will need to be reviewed in advance of the application of this provision of the Protocol.

Binding arbitration

Finally, there is one exciting provision for arbitrators and ADR practitioners in the Protocol. A new provision allows taxpayers to elect for binding arbitration to resolve double taxation issues. Participation is mandatory for the revenue authorities. This will prove particularly important in cases of transfer pricing audits by Canada or the U.S.

Going forward

The Protocol has been approved by Parliament as Bill S-2, receiving Royal Assent on Dec. 14, 2007. However, before its entry into force the Protocol must be approved by the U.S. Senate Committee on Foreign Relations, and then by the Senate itself. The treaty was referred to the Senate by President Bush on March 13, 2008; there is no current timeline for Senate consideration. Tax practitioners in Canada therefore await action by the U.S. before planning on the basis of the Protocol can commence.