- New U.S.-Canada Treaty Protocol Will Affect both Inbound and Outbound Investments
- October 8, 2008
- Law Firm: Holland & Knight LLP - Tampa Office
On September 23, 2008, the United States Senate ratified the fifth protocol to the 1980 U.S.-Canada income tax treaty. It is safe to say that the protocol will have a significant impact on both investments into the U.S. from Canadian investors (“inbound investments”) as well as investments by U.S. investors into Canada (“outbound investments”). Some of the major changes included in the protocol include the tax treatment of payments made to and from a variety of hybrid entities (including U.S. LLCs and foreign reverse hybrids), the elimination of withholding tax on cross-border interest payments (the first income tax treaty signed by Canada to do so), and the extension of the limitation-on-benefits (LOB) provision to investors into Canada (it currently applies only to taxpayers investing in the U.S.).
U.S. Taxation of Foreign Persons, Generally
Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons, who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income:
- Certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP).
- Income that is effectively connected to a U.S. trade or business (ECI).
FDAP income is subject to a 30% withholding tax that is imposed on a foreign person’s gross income (subject to reduction or elimination by an applicable income tax treaty). ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.
Effect of Treaties
Although the statutory rate of withholding on U.S.-source payments of FDAP income to a foreign person is 30%, most (if not all) income tax treaties concluded with the U.S. reduce or even eliminate the U.S. withholding tax on payments of dividends, interest, and royalties. For a non-U.S. taxpayer to be eligible for treaty benefits, the taxpayer generally must be considered a “resident” of the particular treaty jurisdiction and must satisfy one of the LOB provisions in the treaty.
Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.” Similarly, under most “modern” income tax treaties a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that (1) is more than 50% owned by (a) citizens or residents of the U.S. or (b) residents of the jurisdiction where the corporation is formed and (2) not more than 50% of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed.
Major Changes Under the Protocol
As indicated above, significant changes in the protocol will, when they come into force, have an impact both from an inbound and an outbound U.S. tax perspective. Perhaps the most significant development will be the protocol’s effects on the treatment of payments made to and from a variety of hybrid entities, some of which are taxpayer favorable and some of which are not.
Treatment of Hybrid Entities – Paragraph 6(a): Effect on U.S. LLCs
A U.S. LLC is the classic hybrid entity. For U.S. federal income tax purposes, unless an election is filed to treat an LLC as a corporation, it is treated either as a partnership (if it has two or more members) or a disregarded entity (if it has a single member). Canada, however, treats a U.S. LLC like a corporation (i.e., a non-fiscally transparent entity).
Under the current treaty, a U.S. LLC is not a “resident” for treaty purposes because it is not “liable to tax” (unless it elected to be taxed as a corporation for U.S. federal income tax purposes). As a result, a U.S. taxpayer that invests in Canada through a U.S. LLC is not eligible for treaty benefits, despite the fact that it may be owned 100% by U.S. resident taxpayers. This causes interest, dividend, or royalty payments made to a U.S. LLC from Canada to be subject to a 25% Canadian withholding tax, rather than the reduced treaty rates, which range from zero to 15%. Another adverse tax consequence of not treating a U.S. LLC as a resident for treaty purposes is that LLCs which are carrying on business in Canada are subject to Canadian income tax even though the LLC may not have a permanent establishment (PE) in Canada.
Under paragraph 2 of Article 2 of the protocol, however, a new paragraph 6 would be added to Article IV of the treaty (the definition of resident) to provide as follows:
“An amount of income, profit or gain shall be considered to be derived by a person who is a resident of a Contacting State where:
(a) The person is considered under the taxation law of that State to have derived the amount through an entity (other than an entity that is resident of the other Contracting State); and
(b) By reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is the same as its treatment would be if that amount had been derived directly by that person.”
Although not artfully worded, this provision seems to indicate that payments of interest, dividends, or royalties from Canada to a U.S. LLC that is wholly owned by U.S. taxpayers would be eligible for the reduced withholding rates under the treaty. This is because, as a fiscally transparent entity under the laws of the U.S., the treatment of the payment would be the same as it would have been if the amount had been derived directly by the U.S. owners. From a policy perspective this is clearly the correct result, and is a positive change that, when effective, will allow for U.S. taxpayers to invest in Canada through U.S. LLCs, a much more flexible entity than an S corporation, which currently is the vehicle of choice out of necessity.
Once this change becomes effective (which will be November 1, 2008, since the protocol provides that it becomes effective for amounts paid or credited after the first day of the second month that begins after the date on which the protocol enters into force), this will mean that:
(1) Dividends may be eligible for either the 5% or 15% withholding tax rate, as opposed to the 25% rate generally applicable in Canada.
(2) Interest may be exempt from withholding entirely.
(3) Royalties will be subject to a 10% withholding tax rate.
Under the current treaty, the 5% withholding tax rate on dividends is available only if the beneficial owner is a corporation that owns at least 10% of the voting stock of the dividend-paying company. A significant change under the protocol provides for look-through treatment that would allow corporate members of a flow-through entity (such as a U.S. LLC) to benefit from the 5% rate. Therefore, under the protocol a dividend paid from Canada to a U.S. LLC that is, for example, wholly owned by a U.S. corporation, would be eligible for the reduced 5% withholding tax, as opposed to the 25% withholding tax rate that currently applies.
Paragraph 7(a): Effect on Foreign Reverse Hybrids
In addition to the effect on domestic hybrids, such as U.S. LLCs, the protocol will have a major impact on U.S. corporate taxpayers that attempt to use foreign reverse hybrids to engineer a “double dip” (i.e., a deduction in both the U.S. and Canada).
A commonly used structure that accomplished such a result is known as a “synthetic nonresident-owned investment company” (NRO) structure. Under an NRO structure, a U.S. parent corporation and a newly formed U.S. subsidiary would form a Canadian limited partnership and elect to treat the partnership as a corporation for U.S. tax purposes. The limited partnership would be capitalized with the proceeds of a loan obtained by the U.S. parent from a third-party lender. The limited partnership would lend the funds invested in it to a Canadian operating subsidiary.
The benefits of this structure are that:
(1) An interest deduction is obtained both in the U.S. and Canada (i.e., a double dip).
(2) The interest paid from the Canadian operating company to the Canadian reverse hybrid (which is a controlled foreign corporation, or CFC) will not be treated as Subpart F income under the “same country exception.”1
(3) The interest paid by the operating company would be eligible for reduced rates under the treaty because it would be treated as derived directly by the U.S. corporate residents (given that Canada treats the interest as being paid to a fiscally transparent entity).
The protocol would deny treaty benefits with respect to the interest paid by the operating company in this situation. More specifically, paragraph 2 of Article 2 of the protocol would add a new paragraph 7(a) to Article IV of the treaty:
“An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State [i.e., the U.S.] where:
(a) The person is considered under the taxation law of the other Contracting State [i.e., Canada] to have derived the amount through an entity that is not a resident of the first-mentioned State [i.e., the U.S.], but by reason of the entity not being treated as fiscally transparent under the laws of that State [i.e., the U.S.], the treatment of the amount under the taxation law of that State [i.e., the U.S.] is not the same as its treatment would be if that amount had been derived directly by that person.” (Emphasis added.)
Again, not the easiest provision to read, but it appears that the interest paid by the operating company under the NRO structure would be subject to the 25% withholding tax rate in Canada, rather than the reduced treaty rate of 10%, because the treatment of the interest received by the Canadian reverse hybrid (which is a corporation for U.S. tax purposes) is not the same as the treatment that would result if the interest had been derived directly by the U.S. corporate partners.
Although the change to the treaty is not welcome news for U.S. taxpayers engaging in similar financing structures in Canada, it is not all that surprising. Canadian tax authorities had previously announced that Canada was reviewing the treaty benefits extended to reverse hybrid entities in light of the recent OECD commentary on this issue. Furthermore, taxpayers should have sufficient time to restructure their operations in light of this new provision since it will not become effective until January 1, 2010.
Paragraph 7(a): Effect on U.S. LLCs
Paragraph 7(a) also may deny treaty benefits to a Canadian corporation investing in the U.S. through a disregarded U.S. LLC that earns trade or business income. In particular, a U.S. branch (conducted through a U.S. LLC) of a Canadian operating company may not be treated as a “resident” for treaty purposes, and therefore, may not be able to gain access to the business profits article or the branch profits tax article of the treaty.
This result may be obtained by a literal reading of paragraph 7(a) from an inbound perspective:
“An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State [i.e., Canada] where:
(a) The person is considered under the taxation law of the other Contracting State [i.e., the U.S.] to have derived the amount through an entity that is not a resident of the first-mentioned State [i.e., Canada], but by reason of the entity not being treated as fiscally transparent under the laws of that State [i.e., Canada], the treatment of the amount under the taxation law of that State [i.e., Canada] is not the same as its treatment would be if that amount had been derived directly by that person.” (Emphasis added.)
Applying this provision to the situation described above, it appears that the U.S. LLC would not be treated as a resident for purposes of the treaty because it is not fiscally transparent in Canada (where it is treated as a corporation). Therefore the treatment of the income earned by the LLC would not be the same as its treatment would be if that amount had been derived directly by the Canadian company. As such, the Canadian company would not be able to take advantage of the business profits provision (and therefore could not argue that it is not subject to U.S. federal income tax because it does not have a PE in the U.S.) or the reduced tax rate under the branch profits tax article.
Paragraph 7(b): Effect on Foreign Hybrids
In addition to the protocol’s effect on the treatment of foreign reverse hybrids, paragraph 7(b) of the residence provision of the treaty (Article IV) also will have an adverse effect on the treatment of foreign hybrid entities. As set forth in Article 2 of the protocol, new paragraph 7(b), which also will not be effective until January 1, 2010, provides:
“An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where: ...
(b) The person is considered under the taxation law of the other Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is not the same its treatment would be if that entity were not treated as fiscally transparent under the laws of that State.” (Emphasis added.)
This provision will have a detrimental impact in at least two situations.
First, as a result of paragraph 7(b), U.S. taxpayers that use Canadian unlimited liability companies (ULCs) (formed in either Nova Scotia or Alberta) as their operating entity in Canada will not be treated as residents for treaty purposes, if the ULC is treated as a flow-through entity for U.S. tax purposes. Therefore, interest, dividends, or royalties paid from Canada to the U.S. will be subject to the 25% withholding tax rate in Canada (rather than the reduced treaty rates). As noted above, the reason for this adverse tax treatment under paragraph 7(b) is that the ULC will be treated as fiscally transparent for U.S. tax purposes, thus changing the treatment of the payment for U.S. tax purposes.
A second structure that would be adversely affected by paragraph 7(b) is known as the “tower structure.” As discussed below, under paragraph 7(b) payments made by domestic reverse hybrid entities will no longer be eligible for treaty benefits.
Generally, under the tower structure Canadian corporate partners establish a U.S. limited partnership that they elect to treat as a corporation for U.S. federal tax purposes under the check-the-box rules (making that entity a domestic reverse hybrid). The U.S. partnership then borrows funds that it uses to make an equity investment through a disregarded Canadian ULC to a U.S. LLC. The U.S. LLC then may loan the funds to a U.S. operating company.
Pursuant to this structure, the Canadian corporate resident would receive a payment from the U.S. limited partnership (taxed as a corporation for U.S. tax purposes). For U.S. tax purposes the payment would be treated as a dividend, whereas for Canadian tax purposes the payment would be treated as a partnership distribution. As a result of paragraph 7(b), that payment will not be eligible for the reduced treaty rates under the dividend article because the U.S. limited partnership is treated as fiscally transparent under the laws of Canada. Therefore the treatment of the amount of income in Canada is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of Canada. Accordingly, a 30% withholding tax will apply when a distribution (which will be treated as a dividend for U.S. tax purposes) is made from the U.S. limited partnership to the Canadian partner, clearly not a taxpayer-friendly result.
Another significant change that would be made by the protocol is the reduction of withholding tax on interest under the treaty. As noted above, non-U.S. taxpayers generally are subject to a 30% withholding tax on U.S.-source interest, whereas Canada imposes a 25% withholding tax on interest under its local law. The current treaty reduces these rates to 10%, which is currently the lowest rate of withholding tax on interest paid under any of the treaties entered into by Canada.
An important exception to the U.S. withholding tax exists for “portfolio interest.” For this purpose, portfolio interest is defined as any interest (including OID) that is paid on a note that is either (1) in registered form or (2) that is not in registered form, if there are arrangements reasonably designed to ensure that the note will be sold only to non-U.S. persons and certain other conditions are satisfied. There are, however, exceptions to portfolio interest. It does not include:
(1) Interest received by a “10% shareholder.”
(2) Interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.
(3) Interest received by a controlled foreign corporation (CFC) from a related person.
(4) Contingent interest.
Under the protocol, withholding tax on interest paid to unrelated persons would be eliminated effective November 1, 2008. This would represent the first treaty entered into by Canada that completely eliminates the withholding tax on interest.
Regarding interest paid or credited to related persons2, the protocol phases out the 10% withholding tax as follows:
(1) 7% during the first calendar year that ends after entry into force (i.e., 2008).
(2) 4% during the second calendar year that ends after entry into force (i.e., 2009).
(3) Zero for subsequent years (i.e., 2010).
Similar to the limitations on portfolio interest, any interest that is considered contingent interest for U.S. tax purposes will not be eligible for the zero rate on interest. Rather, contingent interest will be taxed at a 15% rate, which is still lower than the statutory 30% rate under the Code.
The significance of eliminating the withholding tax on interest payments under the treaty is that non-U.S. taxpayers who previously were unable to qualify for the tax-free portfolio interest exception (e.g., because they were a 10% shareholder) will now be able to achieve a similar result under the treaty. This will likely lead to increased lending activities by Canadian investors into the U.S. (and vice versa), as well as a preference towards debt rather than equity investments in U.S. subsidiaries by Canadian multinationals.
Unlike many of the recently enacted protocols to U.S. tax treaties, such as those with Belgium, Denmark, Finland, Germany, and Sweden, that provide for zero withholding tax on dividends, the U.S.-Canada protocol does not provide for a similar reduction in the withholding tax on dividends paid between the U.S. and Canada. One notable change, however, was introduced with respect to the reduction of withholding tax on dividends paid by real estate investment trusts.
Under Article X, paragraph 7(c) of the current treaty, only individuals who owned not more than 10% of a U.S. REIT could benefit from the reduced withholding tax of 15% on dividends. Under Article 5, paragraph 5 of the protocol, however, a new paragraph 7(c) is added to Article X of the treaty, extending the 15% rate to:
(1) Dividends paid with respect to a class of publicly traded stock, so long as the person holds an interest of not more than 5% in any class of the REIT’s stock.
(2) Dividends paid to a beneficial owner of the REIT who does not own more than 10% of the REIT, so long as the REIT is “diversified.”3
This provision is consistent with many of the newer protocols regarding the withholding tax on dividends paid by REITs, such as the U.S. treaties with Belgium, the U.K., Japan, as well as the 2006 U.S. Model Treaty.
When the treaty was enacted in 1980, a corporation was deemed to be a resident of a particular jurisdiction only if it was incorporated in such jurisdiction. The possibility arose, however, of companies being formed in one jurisdiction (such as Delaware) and moving to another jurisdiction (i.e., Canada) through a “corporate continuance.” Accordingly, the 1995 protocol added a provision to paragraph 3 of Article IV of the treaty stating:
“Notwithstanding the preceding sentence, a company that was created in a Contracting State, that is a resident of both Contracting States and that is continued at any time in the other Contracting State in accordance with the corporate law in that other State shall be deemed while it is so continued to be a resident of that other State.”
Essentially, what this provision did was to allow a dual-resident corporation that was created in one country but continued in another country to be treated as a resident of only the country in which it is continued. This was seen by the IRS as a potential opportunity for a U.S. corporation to avoid U.S. taxation since it entitled the corporation to relief from U.S. tax under the treaty.
In September of 2000, U.S. Treasury Release No. LS-883 stated: “The revised [Treaty] provision will clarify that a company incorporated in one country that continues into the other will still be treated as a resident of [the U.S.] unless that country’s internal law no longer treats it as such. For example, a U.S. corporation that continues into Canada but retains its status as a U.S. corporation, will, under the treaty, become a Canadian resident while remaining a U.S. resident. Such a corporation will not be entitled to any benefits under the U.S.-Canada treaty except to the extent agreed upon by the competent authorities of the two countries.”
This is essentially what the new protocol provides. Under the protocol, a company that is resident of both contracting states would be treated as a resident of the contracting state in which it is created. In any other case, the competent authorities of the contracting states will settle the question of residency by mutual agreement, and if they are unable to settle such dispute, the company will not be treated as a resident of either contracting state. This provision will be effective with respect to corporate continuances effected after September 17, 2000. Therefore, it is possible under this provision that a dual-resident corporation will not be entitled to treaty benefits in either the U.S. or Canada if the competent authorities are unable to come to a mutual agreement.
A New Bilateral LOB Provision
Perhaps one of the more significant changes made by the protocol, at least from a Canadian perspective, is the replacement of the existing LOB provision with an entirely new provision. In general, LOB provisions are designed to prevent treaty shopping, defined by Treasury as the “use, by residents of third states, of legal entities established in a Contracting State with a principal purpose to obtain the benefits of a tax treaty between the United States and the other contracting State.” As noted above, LOB provisions accomplish this result by generally restricting treaty benefits to entities (1) that are owned to a sufficient degree (typically more than 50%) by citizens or residents of the U.S. or residents of the particular treaty jurisdiction, and (2) that do not erode their residence country tax base through deductible payments made to third-country residents.
Under Article XXIXA of the current treaty, the LOB provision is one-sided, i.e., it applies only to the granting of treaty benefits by the U.S. This is the only U.S. treaty to have such a unilateral provision. Canada historically took the position that it did not want to rely on technical rules for protection against “treaty shopping.” Instead, Canada chose to rely on its general anti-avoidance rules (GAAR).
Canada has now reversed its position on relying on an LOB provision to prevent treaty shopping. In particular, the LOB provision will now specifically apply from both a U.S. and a Canadian tax perspective. As a result of the protocol, the U.S.-Canada income tax treaty is Canada’s first comprehensive income tax treaty that contains a bilateral LOB provision, which means that a U.S. taxpayer attempting to claim treaty benefits with respect to investments into Canada will be required to satisfy one of the strict tests under the new LOB provision.
Creation of a PE by Service Providers
Another significant change made by the protocol (in Article 3, paragraph 2) is the revision of paragraph 9 in Article V (the PE provision) of the treaty. Generally, a U.S. taxpayer that provides services in Canada will be subject to Canadian income tax, only if those activities rise to the level of a PE in Canada. In that event, the service provider will be subject to Canadian tax on its profit attributable to such PE.
Historically, it was unclear under Canadian law whether the provision of services satisfied the definition of a PE under the treaty. Under Article V of the current treaty, a PE is defined as “a fixed place of business through which the business of a resident of a Contracting State is wholly or partly carried on,” including:
(1) A place of management.
(2) A branch.
(3) An office.
(4) A factory.
(5) A workshop.
(6) A mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
(7) A building site or construction or installation project only if it lasts more than 12 months.
(8) A person acting in a contracting state on behalf of a resident of the other contracting state – other than an agent of an independent status – if such person has, and habitually exercises in that state, authority to conclude contracts in the name of the resident.
Based on a Canadian Federal Court of Appeals decision (The Queen v. William A. Dudney, 2000 DTC 6169), it was determined that a non-Canadian-resident consultant providing services at a client’s premises in Canada for more than 300 days in one of the calendar years in question did not rise to the level of a PE in Canada. It is apparent that Article V of the Treaty was amended to prevent service providers from relying on Dudney as support for the position that their activities do not rise to the level of a PE. Article 3 of the protocol provides in paragraph 2:
“Subject to paragraph 3, where an enterprise of a Contracting State provides services in the other Contracting State, if that enterprise is found not to have a permanent establishment in that other State by virtue of the preceding paragraphs of this Article, that enterprise shall be deemed to provide those services through a permanent establishment in that other State if and only if:
(a) Those services are performed in that other State by an individual who is present in that other State for a period or periods aggregating 183 days or more in any twelve-month period, and, during that period or periods, more than 50 percent of the gross active business revenues of the enterprise consists of income derived from the services performed in that other State by that individual; or
(b) The services are provided in that other State for an aggregate of 183 days or more in any twelve-month period with respect to the same or connected project for customers who are either residents of that other State or who maintain a permanent establishment in that other State and the services are provided in respect of that permanent establishment.”
It seems that this new provision will have the biggest impact on service providers that are not involved in a building, construction, or installation project but yet are present in Canada or the U.S. for a significant time without creating a PE. If there is any good news about this change, it is that by setting forth a 183-day safe harbor in this provision, the U.S. and Canada have given taxpayers an opportunity to manage, where practical, the amount of time spent in the other country to minimize the possibility of creating a PE under the protocol.
The changes made under the protocol will have a significant impact on cross-border payments made between the U.S. and Canada. Clearly, the most positive changes made by the protocol include the elimination of withholding tax on cross-border interest payments and the ability of U.S. taxpayers to claim treaty benefits when investing in Canada through U.S. LLCs. Also notable is the inclusion of a bilateral LOB provision, representing the first time that Canada has attempted to prevent treaty shopping other than through the use of its GAAR.
It will be interesting to see whether the provisions that deny treaty benefits to a variety of hybrid entities will be the new standard when the U.S. is negotiating future treaties or protocols, or whether these provisions will be limited to the protocol with Canada.
1 In general, under Section 957 of the Internal Revenue Code (the “Code”), a CFC is a foreign corporation that is more than 50% owned by 10% U.S. shareholders. Typically, interest received by a CFC is treated as Subpart F income, and therefore subject to current U.S. federal income tax in the hands of the CFC’s U.S. shareholders, regardless of whether any distributions are made. An important exception is available for interest received from a company that is formed in the same jurisdiction as the recipient CFC and has a substantial part of its assets used in its trade or business located in that same foreign jurisdiction; see Section 954(c)(3)(A)(i). It also may be possible for the interest not to be treated as Subpart F income in the hands of the recipient CFC under the temporary Section 954(c)(6) look-through rule.
2 For purposes of this provision, a person is deemed to be related to another person if either person participates directly or indirectly in the management or control of the other, or if any third person or persons participate directly or indirectly in the management or control of both. See Article IX(2) of the treaty.
3 A REIT generally is considered to be “diversified” if the value of no single interest in real property exceeds 10% of its total interests in real property.