US/Canada Income Tax Treaty Update
The 5th protocol to the US / Canada income tax treaty which entered into force in December of 2008, provides for several changes with respect to cross-border transactions for US organizations doing business in Canda. Previously overlooked, many of these changes (both good and bad) may require action prior to January 1, 2010.
A few of the protocol’s highlights are listed below.
The Good:
- Source country withholding tax is eliminated on cross-border interest payments (some exceptions apply). The elimination of withholding tax is retroactive to January 1, 2008 for interest paid to persons unrelated to the payor, and is subject to phase in for arm’s-length interest paid to related persons:
Year |
Interest paid to unrelated party |
Interest paid to related party |
2007 |
10% |
10% |
2008 |
0% |
7% |
2009 |
0% |
4% |
2010 |
0% |
0% |
- Treaty benefits can now be extended to US limited liability companies by virtue of looking through the LLC to the member’s residency status. Canada will continue to allow treaty benefits to S corporations.
The Bad:
- The concept of a service permanent establishment (“PE”) is created. A business in the US, for example, without a fixed place of business in Canada can be deemed to have a PE in Canada if the US business performs services in Canada in excess of 183 days during any 12 month period. A US company with a PE in Canada will be subject to Canadian income tax on attributable profits.
- Beginning January 1, 2010, “hybrid” entities will be not be entitled to treaty benefits and will be subject to a 25% withholding tax on cross-border payments of interest and dividends. A hybrid entity is an entity that is not treated in the same manner by the US and Canada. For example, an entity treated as a corporation in Canada, but treated as fiscally transparent (i.e., a branch) in the US, is a hybrid entity. An unlimited liability company (“ULC”) in Canada is usually considered a hybrid entity.
The Ugly:
As a basic hybrid entity illustration, assume a US corporation owns a Nova Scotia ULC. The ULC pays a 30% corporate income tax in Canada on $100 of income, and then remits the remaining $70 as a dividend to the US parent. If the dividend is paid in 2009, the Canadian withholding tax will be at 5% ($3.50). If the dividend is paid after 2009, the Canadian withholding tax will be 25% ($17.50). Post 2009, the effective income tax rate will be 47.5% on $100 of income (US foreign tax credit will be limited).
The Opportunity:
US/ Canada cross-border clients with a hybrid or ULC entity should consider several possible fixes before the end of 2009 including the following:
- Continue operating as a hybrid, but eliminate intercompany debt by funding the ULC with capital rather than loans. Repatriation of capital is free of withholding tax.
- Incorporate the ULC for US purposes and eliminate hybrid status. Potentially bad if US parent is an S corporation as shareholder cannot receive “deemed-paid” foreign tax credits.
- Convert ULC to a branch for Canadian purposes and eliminate hybrid status. Eliminates US tax deferral on income earned by the Canadian business, but there will be reduced withholding tax upon repatriation.
- Pay a large dividend from the hybrid entity before the end of 2009.
- Insert a holding company (i.e., Luxembourg) to obtain lower withholding tax (adds additional administrative expense . . . could also be done at a later date).
- It is also possible that CRA (Canadian “IRS”) may soon provide a favorable ruling that will allow a ULC owned by an S corporation to use a paid-up-capital strategy to obtain a 5% withholding tax on dividends in spite of the protocol.
If you wish to discuss this change in law with respect to your specific situation,
or if you have additional questions, please contact Rob Whittall at (440) 205-4808 or rwhittall@cohencpa.com.
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