Tax Alert
November 2009
Authors:
Andrew H. Zuccotti
andrew.zuccotti@klgates.com
206.370.6680
Darcie L. Christopher
darcie.christopher@klgates.com
206.370.8173
K&L Gates is a global law firm with
lawyers in 33 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies,
entrepreneurs, capital market
participants and public sector entities.
For more information, visit
www.klgates.com.
Significant Changes to Canadian/U.S. Tax
Treaty Create Opportunities But Require
Action
The United States and Canada signed the Fifth Protocol (“Protocol”) to the United
States-Canada Income Tax Convention (the “Treaty”) on September 21, 2007, and
the Protocol was entered into force on December 10, 2008. The Protocol makes
several changes to the Treaty that present both planning opportunities and potential
obstacles for corporations that have operations in both the United States and Canada.
Because there are various effective dates for modifications set forth in the Protocol
(some of which are quickly approaching), taxpayers with Canadian/U.S. operations
need to review their operations now to ensure that such operations are structured
efficiently. Of particular significance is the fact that after January 1, 2010, U.S.
residents that earn income in Canada through a Canadian unlimited liability company
(a “ULC”) will no longer be eligible for Treaty benefits. Any such taxpayer should
seek counsel in light of this significant change to a common tax planning structure.
The purpose of this alert is twofold: (i) to provide a general overview of the
modifications made to the Treaty by the Protocol; and (ii) to provide a more detailed
description of some of the more key provisions in the Protocol and particularly those
which will soon become effective.
Overview of Modifications Made by the Protocol
•
Interest Withholding Taxes. The Protocol generally eliminates
withholding tax on most cross-border interest payments. The provisions
relating to related party interest are phased in over a two-year period so that
interest payments between related parties will be exempt from withholding
starting on January 1, 2010. Thus, with respect to cross-border loans
between related parties with interest payments due in December 2009,
taxpayers may benefit from delaying the actual payment of such interest
until after January 1, 2010. These provisions are discussed in more detail
below.
•
Rules Relating to Hybrid Entities. The Protocol provides for Treaty
benefits beginning January 1, 2009, relating to certain amounts derived
through or paid by hybrid entities that are fiscally transparent in one country
and not in the other county, (e.g. U.S. limited liability companies (“LLCs”)
and Canadian ULCs). The Protocol also provides anti-abuse rules relating
to the same, which become effective January 1, 2010. The anti-abuse rules
affect widely used structures involving investments in Canada through
ULCs. These provisions are discussed in more detail below.
•
Special Rules for Permanent Establishments of Service Providers. The
Protocol adds a new category of permanent establishment. This new
category of permanent establishment may apply to cause a service provider
with activities in the other contracting state to be subject to tax in that other
Tax Alert
state even where the service provider does
not have a fixed place of business or an
agent in that state. These rules become
effective on January 1, 2010 and are
discussed in more detail below.
•
•
Binding Arbitration. The Protocol adds a
new process requiring the tax authorities of
Canada and the U.S. to resolve certain
issues through arbitration that became
effective on December 10, 2008.
Previously, there was no mechanism to
compel the competent authorities to reach
an agreement to relieve double taxation,
which, in some cases, resulted in substantial
delays or the denial of relief. The
arbitration provision is intended to result in
resolution of cases within three years or less
and may, in many cases, induce the
competent authorities to reach negotiated
settlement at an earlier stage in the process.
Generally, the arbitration provision requires
a case to be submitted to binding arbitration
if the U.S. and Canadian authorities are
unable to completely agree on a case and
must begin within two years after the U.S.
and Canada have received the information
necessary to undertake substantive
consideration of a case. Notwithstanding
this, cases that were under review by the
U.S. and Canada at the time the arbitration
provision became effective are treated by
the Protocol as commencing on December
10, 2008, regardless of the information
submitted at that time. Thus, the Protocol
established a two-year waiting period until
December 10, 2010 for existing cases to
enter arbitration.
Limitation on Benefits. Previously, the
Treaty contained a limitation on benefits
article that generally limited Treaty benefits
to Canadian individuals and companies with
U.S. activities. However, Canada chose not
to apply the limitation on benefits article
under the prior Treaty and instead relied on
its ability to prevent treaty shopping
through its general anti-avoidance rules.
The Protocol adds a new limitation on
benefits article that is similar to the previous
article, except that Canada intends to apply
the new limitation on benefits article set
forth in the Protocol.
•
Pensions. The Protocol adds new rules
addressing pension contributions and
accrued pension benefits in cross-border
employment situations.
•
Stock Options. The Protocol adds new
rules apportioning the taxation of stock
option benefits between Canada and the
U.S. in cross-border employment
situations.
Zero Rate of Withholding on Interest
•
Interest Withholding Generally. Under
U.S. and Canadian law, the statutory
withholding rate on interest paid to nonresidents is 30% and 25%, respectively.
Prior to the changes made by the Protocol,
the withholding rate in respect of interest
under the Treaty was 10%.
•
Relief for Interest Payments to
Unrelated Parties. The Protocol, subject
to potential application of the limitation on
benefits provision, generally eliminates the
withholding tax on interest (other than
certain participating interest in Canada or
contingent interest in the United States) that
is paid to an unrelated resident of the other
country.
o
•
Refund Opportunity #1: Because the
Protocol eliminates, retroactive to
January 1, 2008, the 10% withholding
on interest paid to unrelated parties,
taxpayers may claim refunds in respect
of interest payments made during 2008.
Relief for Interest Payments Between
Related Parties. The Protocol gradually
eliminates withholding on interest (other
than certain participating interest in Canada
or contingent interest in the United States)
paid to related parties with a complete
exemption taking effect for interest
payments made after January 1, 2010.
The withholding rate for interest paid in
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Tax Alert
2009 is 4% and in 2008 the withholding rate
was 7%.
o
Refund Opportunity #2: Because the
Protocol eliminates the 10%
withholding rate on interest under the
Treaty, the reduced withholding rates
applicable to interest paid in 2008 and
2009, which are lower than the Treaty
withholding rate of 10%, present a
refund opportunity for taxpayers.
o
For this purpose, the term “related
party” generally refers to individuals or
entities that are owned or controlled
directly or indirectly by the same
interests and for U.S. purposes is
defined by reference to the term
“related” as it is defined under Section
482 of the Internal Revenue Code of
1986, as amended.
reason of the LLC being a fiscally
transparent entity. More specifically,
under the Treaty as revised by the
Protocol, an amount of income is
treated as earned by a person who is a
resident of the United States if: (i) the
person is treated under U.S. tax law to
have derived the amount through an
entity that is not a resident of Canada;
and (ii) because the entity is fiscally
transparent under U.S. tax laws, the tax
treatment of the income is the same as
it would have been had it been earned
directly by that person. For U.S.
purposes, transparent entities include
partnerships, investment trusts, and
grantor trusts. For Canadian purposes,
transparent entities include
partnerships and bare trusts, but do not
include grantor trusts.
o
No Restriction to U.S. or Canadian
Entities. It should be noted that
fiscally transparent entities are not
limited to U.S. or Canadian entities.
Thus, U.S. interest holders of an entity
organized in a third jurisdiction that is
disregarded for U.S. tax purposes may
obtain benefits under the Treaty as
amended by the Protocol.
o
Effective Date. These provisions are
effective beginning January 1, 2009.
Treatment of Fiscally Transparent
Entities
•
Treaty Benefits Allowed to Members of
LLCs and Other Fiscally Transparent
Entities.
o
o
The Protocol extends Treaty benefits to
U.S. residents that derive Canadian
source income through LLCs that are
treated as flow-through entities (e.g.,
fiscally transparent entities) for U.S.
federal income tax purposes.
Traditionally, although Canada treats an
LLC as a corporation rather than a
fiscally transparent entity, because
LLCs do not pay tax in the United
States, Canada did not treat an LLC as a
resident of the United States for
purposes of the Treaty. Thus, prior to
amendment by the Protocol, LLCs were
not entitled to Treaty benefits in respect
of Canada.
The Protocol generally revises the
Treaty so that an owner of an LLC (or
other transparent entity) is entitled to
Treaty benefits where, under U.S. law,
the owner of the LLC is treated as
deriving the income of the LLC by
•
Anti-Abuse Provisions.
o
In a provision that affects the
widespread use of Canadian ULCs for
Canadian investments, the Protocol
provides anti-abuse provisions that will
generally deny Treaty benefits to a
U.S. resident for amounts earned
through a hybrid entity that is
recognized by Canada, but that is
disregarded in the United States.
These provisions are effective
beginning January 1, 2010. Thus, after
January 1, 2010, U.S. residents that
earn income in Canada through a ULC
will no longer be eligible for Treaty
benefits. Taxpayers who have
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Tax Alert
Canadian ULCs as part of their tax
planning structure should seek counsel
to provide tax advice regarding the
most tax-efficient methods for
restructuring such investments in
advance of this deadline.
o
o
income derived from the services
performed in the host country by that
individual amounts to more than 50%
of the enterprise’s gross active business
revenues during that 183+ day period.
This provision is most likely to apply
to self-employed individuals or to
enterprises providing services through
a small number of key employees.
Unlike the test described below for
large project services, the residence of
the customer is not relevant under this
test.
In addition, the anti-abuse provisions
added to the Treaty by the Protocol
would deny Treaty benefits to a
Canadian resident that earns income in
the United States through a U.S.
partnership for which U.S. corporate
status has been elected through the
filing of a Form 8832.
o
Effective Date. The anti-abuse
provisions in respect of hybrid entities
will become effective on January 1,
2010.
Permanent Establishment Arising
From the Provision of Services
•
•
The Protocol adds a new category of
permanent establishment – a “services
permanent establishment.” Under this new
category of permanent establishment, a
service provider may be deemed to have a
permanent establishment in a contracting
state even if the service provider does not
have a fixed place of business or an agent
present in that contracting state.
Generally, the Protocol provides that an
enterprise of Canada or the United States
that does not otherwise have a permanent
establishment in the other country (the “host
country”) will have a permanent
establishment in the host country if the
enterprise provides services in the host
country and it meets any one of two
thresholds:
o
Key Person Services. This first
threshold applies if services are
performed in the host country by an
individual who is physically present in
the host country for one or more
periods totaling 183 days or more
during any 12-month period, and the
Large Project Services. The second
threshold applies where services are
provided in the host country for an
aggregate of 183 days or more in any
12-month period with respect to the
same or connected projects for
customers who either are host-country
residents or who maintain a permanent
establishment in the host country for
which services are provided.
•
Relation to Other Permanent
Establishment Categories. In certain
cases, a permanent establishment is created
under the Treaty with respect to a building
site or construction or installation project
lasting more than 12 months. The new
category of permanent establishment
relating to services is “subject to” the above
category and, thus, does not create a
permanent establishment where
construction services are provided for more
than 183 days, but less than 12 months.
•
Effect of Application. If a service
provider is treated as having a permanent
establishment by reason of services
provided in the host country, the services
are taxed on a net basis under Article
VII(1) (Business Profits) of the Treaty.
Thus, taxation is limited to the profits
attributable to the activities carried on in
performing the services.
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Tax Alert
•
Effective Date. The addition of this new
category of permanent establishment applies
beginning January 1, 2010.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal
tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used,
for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to
another party any transaction or matter addressed herein.
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participants and public sector entities. For more information, visit www.klgates.com.
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