Bill S-2, An Act to amend the Canada–United States Tax Convention Act, 1984, was introduced in the Senate by the Leader of the Government in the Senate, the Honourable Marjory LeBreton, P.C., and received first reading on 18 October 2007. The bill received third reading in the Senate on 21 November 2007. It was introduced in the House of Commons on 22 November 2007 and was referred to the Standing Committee on International Trade on 26 November 2007. It received third reading in the House of Commons on 13 December 2007, and on 14 December 2007 received Royal Assent.(1)
The Canada–United States Tax Convention Act, 1984 ratifies the current tax treaty or convention between Canada and the United States involving taxes levied by each country on income and capital (Canada–US Tax Treaty).(2) The main purpose of a tax treaty is to prevent double taxation by splitting the total amount of tax payable between two jurisdictions according to the residency of the individual or the location of the income being generated. To achieve this purpose, a treaty will contain general rules which work in tandem with domestic tax legislation. The amount of tax payable in each jurisdiction is usually unequal due to tax rate disparities. There is growing awareness in the international tax community that at least one country should be able to tax an item of income and this should be one of the goals in coordinating national tax laws through tax treaties.(3) Tax treaties also aim to simplify compliance with two national taxation systems and try to prevent tax evasion.(4)
Two model tax treaties have been developed to aid in the standardization of bilateral tax treaties – the Organisation for Economic Cooperation and Development Model Tax Convention (the “OECD model”) and the United Nations Model Double Taxation Convention (the “UN model”).(5) The OECD model predates the UN model and is primarily used for bilateral treaties between developed nations. The UN model, on the other hand, is used for agreements between developing and developed nations. The Canada–US Tax Treaty is a hybrid treaty that does not completely follow either the OECD or UN model, but is instead based on the “U.S. model treaty” and portions of the OECD model.(6)
Canada’s first comprehensive tax treaty or convention with the United States was concluded in 1942, expanding on a more summary agreement first entered into in 1928.(7) The 1942 agreement was overhauled, modernized and replaced by a new comprehensive treaty in 1980.(8) Since 1980 the treaty has been amended, upgraded and fine-tuned by protocols on four occasions, namely in 1983, 1984, 1995 and 1997.
Bill S-2 contains the fifth amending protocol (“fifth protocol”). Its purpose is to implement in Canada the fifth such protocol together with two exchanges of diplomatic notes which deal with very technical issues. The fifth protocol was concluded after nearly 10 years of negotiations aimed at modernizing and improving the 1980 convention for the betterment of individuals, families and business on both sides of the border.(9)
A unique feature of tax treaty ratification is that it represents the culmination of previous negotiations between two nations. Therefore, the resulting treaty is not subject to amendment by the normal process in Parliament.(10) In the US, the fifth protocol is currently being examined in Congress by the Joint Committee on Taxation and is expected to be ratified by the end of 2008.(11)
Due to the unique character of the tax treaty ratification process, clauses 3 and 4 of the bill merely import the two schedules described below by adding them as a schedule to the existing Canada–United States Tax Convention Act, 1984 (“Act”). Clause 1 changes the definition of “convention” in the existing Act to include the additional schedules. Clause 2 amends the existing convention to change the notification requirements of the minister of Finance: now, in addition to requiring that the minister publish notification in the Canada Gazette of the convention’s entry into force, the new legislation obligates the minister to publish notification of the termination of the convention. The notifications must be published within 60 days of the entry into force or the termination of the convention. Similarly, clause 5 contains a requirement that, within 60 days of the entry into force of the two new schedules, notice of this occurrence must be published.
The bulk of the bill consists of two schedules. The first takes the form of diplomatic letters between the then Minister of Foreign Affairs and International Development, Maxime Bernier, and United States Ambassador to Canada, Terry Breese; the second contains revised or new articles to the existing treaty as agreed upon by James M. Flaherty, Minister of Finance, for the Government of Canada and Henry M. Paulson, Jr., Secretary of the Treasury, for the Government of the United States of America. More specifically, the first schedule outlines the procedure for coordinating and resolving tax disputes (Annex A) and the agreed upon interpretation of the amendments to the current treaty (Annex B). The second schedule contains the actual amendments to the existing tax treaty between Canada and the United States. Together, schedules 1 and 2 are called the fifth protocol.
During second reading in the Senate, debate was limited to background information on tax treaties and the evolution of the fifth protocol. At the Standing Senate Committee on Banking, Trade and Commerce, debate focused on the elimination of the withholding tax(12) for cross-border interest payments and how this elimination will aid investment in Canada by lowering the cost of borrowing for Canadian businesses. Another beneficial effect that was discussed was the anticipated increase in trade between Canada and the United States. Due to these beneficial effects, the bill was adopted by the Senate without any significant delay.
In the House of Commons, debate on the bill was limited to the over-taxation of American pensioners living in Canada when compared with pensioners living in the United States. The second pension-related issue was the prohibition of tax deductions for pension contributions made by Canadians working in the United States.(13) The fifth protocol will change this situation by allowing pension contribution deductions for Canadians who work in the US and vice versa. Concern was also voiced over the use of tax havens by large Canadian businesses to lower tax payable in Canada. Since the US is not a tax haven, the bill does not specifically address this problem. The Liberals supported the bill since it was negotiated when their party formed the government. The Bloc Québécois also approved of the bill and felt that the new mandatory arbitration procedure will help individuals unfamiliar with the current tax appeal process. Generally, all parties supported the bill at second reading in the House.
At committee stage in the House of Commons, the NDP voiced concern over the lack of an economic impact analysis to determine the amount of lost tax revenue for Canada.(14) The remaining debate was similar to that which occurred in the Standing Senate Committee on Banking, Trade and Commerce, and, overall, the parties supported the bill.
The media have been generally supportive of the bill since economists believe that it will decrease barriers to trade by eliminating the withholding tax on cross-border interest payments.(15) An indirect benefit is that the elimination of the withholding tax may also increase competition and lower lending rates in Canada. The treaty also eliminates double taxation on limited liability companies (LLCs) resident in the United States. Since American venture capital firms operate as LLCs, this change could increase the availability of funding for new Canadian businesses and technologies.(16)
Since this bill implements the fifth protocol and is technical fine-tuning of the existing Canada–US tax treaty, the following analysis will focus only on major changes to the treatment of income and expenses incurred by entities in Canada and the United States.(17)
The fifth protocol eliminates the withholding tax on cross-border interest payments. The withholding tax currently paid by Canadian entities on interest payments made to a US resident entity is 10%. This new rule eliminating the withholding tax applies only to un-related parties or arm’s-length parties (i.e., it does not apply to parent companies and their subsidiaries). For related parties, the withholding tax will be reduced to 7% in the first calendar year after ratification of the Convention. This is reduced to 4% in the second year and is eliminated in subsequent years. The elimination of the withholding tax between unrelated parties should enable Canadian borrowers to access the US debt market more easily and reduce their borrowing costs when it is not possible to comply with the existing rules for preferential treatment of short- and medium-term debt.(18) This is especially true for short-tem debt.
Historically, the Canada Revenue Agency (CRA) has denied treaty benefits to US LLCs that were not taxed in the United States. Further, the CRA did not provide treaty benefits to US members of LLCs. The fifth protocol amends the residency provisions of the fourth protocol so that tax treatment of LLC members will resemble that of LLCs. Thus, US resident members of US LLCs doing business in Canada will be granted treaty benefits in Canada.
The fifth protocol also introduces new rules to deny treaty benefits to certain hybrid entities commonly used in cross-border financing transactions. This change prevents an entity from using the benefit of treaty provisions and the national tax laws regarding residency to decrease the amount of withholding tax on interest paid. A second related rule applies to the income, profit or gain received by the creditor.
The limitation-on-benefits provision in Article XXIX A of the existing convention tries to prevent “treaty shopping.” (19) The existing provision prevents a resident of a third state from using Canada as a conduit for the purpose of obtaining a US treaty benefit. The fifth protocol amends this article to deny treaty benefits to US residents unless they satisfy a new test based on actual business activity (new Article XXIX A). This will provide the CRA with a new alternative for preventing treaty abuses.
The fifth protocol introduces a new definition of “permanent establishment” for service providers (Article V). It is now easier to be deemed a permanent establishment in the US or Canada and thus be liable for income tax in either country (see paragraph 9 of Article V).
The fifth protocol introduces a new binding arbitration procedure to resolve difficult disputes between the competent authorities of Canada and the US. The taxpayer has the option to use the arbitration result in judicial proceedings in either jurisdiction.
The stock options and consequent taxation of employees who change residence due to employment will be apportioned according to the amount of time spent in the US or Canada (see diplomatic notes in Annex B). The fifth protocol implements mutual recognition of contributions to a pension plan (new paragraph 8 of Article XVIII). This will allow income tax deductions by taxpayers in either country for pension contributions in the other country. A similar deduction is available for employers. This will facilitate movement of personnel between Canada and the US. The fifth protocol introduces a provision to prevent the double taxation of pre-emigration gains (new paragraph 7 of Article XIII). This new provision will allow a taxpayer to elect to be treated in the other country as having reacquired the property at the time of changing residence. This will prevent taxation of gains in the other country after being taxed in the country of origin due to tax rules that deem a person to have disposed of all capital property prior to leaving the country.
© Library of Parliament
