Now that the US Senate has approved the Fifth Protocol to the Canada-US Tax Treaty, on Sept. 23, 2008, it looks as though the proposed changes to the treaty contained in the protocol will be ratified before the end of this year. The next step in the US ratification process requires the US president to sign the protocol. Some of the changes in the protocol will be of significant benefit to Canadians doing business in the United States, while others will require changes to current business and operating arrangements. While space does not permit a detailed explanation of the Fifth Protocol, we will outline some of the key provisions and the expected coming-into-force dates on the assumption that the protocol is ratified as expected.

Withholding on interest

Under the provisions of the protocol, withholding tax on interest paid between persons resident in Canada and the US will be eliminated. The elimination of withholding on interest (on a phased-in basis for related party interest) will apply on the following schedule:

• Interest paid to unrelated parties: no withholding on payments made on or after Jan. 1, 2008; and

• Interest paid to related parties:
  • 7% withholding on payments made in 2008,

  • 4% withholding on payments made in 2009;

  • 0% withholding on payments made in 2010 or later.

These changes are welcome and will facilitate cross-border financing arrangements. The timing of interest payments should be considered when entering into related party financing transactions given the phased-in elimination of withholding tax.

Permanent establishment services rule

The changes to the permanent establishment rules are less welcome. The treaty currently provides that business income is taxed in the source country where the business is operated through a permanent establishment. Therefore, if a Canadian resident earns business income in the US without having a permanent establishment in the US, it will be taxed in Canada, rather than in the US Alternatively, if the business income is earned through a permanent establishment in the US, it will be taxed in the US

The new rules will significantly impact many businesses that provide cross-border services. In particular, many service businesses will no longer be able to operate in the other country without creating a permanent establishment. In simple terms, the new rules may deem a permanent establishment to exist in a country if a business provides services in the other country through an individual who is present in the other country for a cumulative total of 183 days or more in any 12-month period.

These rules will come into force on Jan. 1, 2010. Service businesses would be well advised to review their operating systems and implement any necessary changes in advance of the effective date.

Treatment of hybrid entities

A significant number of cross-border structures make use of legal entities which may be considered to be corporations in one jurisdiction and disregarded entities in the other. In this area, the protocol delivers both good news and bad news for taxpayers. While it will extend treaty benefits to income earned by certain hybrid entities, such as US LLCs, it will also deny treaty benefits in the context of certain other types of tax planning structures which have been commonly used in the context of cross-border arrangements. The rules that provide relief will apply on the first day of second month that begins after the date the Protocol enters into force, while to benefit denial rules will be effective Jan. 1, 2010.

Treaty shopping

The limitation on benefits (LOB) article which is currently applicable only for US tax purposes will also become operative for Canadian tax purposes on Jan. 1, 2009. The comprehensive LOB article, designed to counter "treaty shopping" abuses, is a significant development in the Canadian tax landscape and could operate to deny treaty benefits in many situations where treaty entitlement had never come under question, and even where treaty shopping was not a factor.

Personal tax measures

The protocol contains a number of measures of particular interest to internationally mobile individuals. Changes to deductible pension contributions will benefit short-term assignees remaining in their home country pension plan. Cross-border commuters who participate in a pension plan based in their country of employment rather than their country of residence will also benefit, as will US citizens resident in Canada.

An individual emigrating from Canada is taxed on accrued but unrealized gains on certain assets owned when ceasing Canadian residency. Double taxation can arise if there is no corresponding increase in tax basis in the country of immigration at the time of departure. The Protocol will allow an election to create a deemed disposition for US tax purposes, where the individual leaves Canada to take up residence in the United States.

Conclusion

While the Fifth Protocol creates certain risks that may necessitate the restructuring of cross-border arrangements, it also presents planning opportunities. Contact your Ernst & Young adviser for more information.

By:

Dave Walsh, CA, CPA (Illinois)

Partner

613-598-4331

Dave.g.walsh@ca.ey.com

Darrell Bontes, CA

Senior Manager

613-598-4364

darrell.bontes@ca.ey.com

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