The Canada U.S. Income Tax Convention (Treaty) currently in force was first established in 1980, and since that time there have been five major alterations, or "protocols" adopted at various times. The latest, Fifth Protocol, contains some major changes, which could change the way in which tax law is interpreted in Canada and the United States, and could be used to modify the way in which tax planning is carried out. The Fifth Protocol, unless otherwise stated, is effective on January 1, 2008. Download our article covering Fifth Protocol Highlights, which addresses practical applications for business transacted across the Canada United States border. A summary of changes effective on January 1, 2010 is available here.
Here are the highlights of the changes:
- Elimination of withholding tax on interest payments. The former 10% withholding tax rate applied to payments of interest between unrelated parties has been eliminated. Interest not related to a "permanent establishment" in the other state will be taxable only in the country of residence. This facilitates cross border investment transactions.
- "Mandatory" arbitration of provisions. Currently in matters where there is a possibility of double taxation, each country may voluntarily participate in arbitration, which may resolve the issue. Under the new rules, each country must go to arbitration if an agreement cannot be reached (although a taxpayer may elect to invoke this procedure). This article should increase confidence that double taxation can be eliminated.
- "Departure Tax" capital gains - double taxation eliminated. Under current rules, a person departing from Canada was (and continues to be) required to declare capital gains and losses arising from "deemed dispositions" on departure from Canada, based on the fair market value of capital properties held on the date of departure. Under the new rules, the taxpayer can elect to have realized his gain before becoming a resident of the U.S. and therefore the U.S. would only tax capital gains on changes in value from the date of entry onward. (Certain U.S. citizens returning to the U.S., however, may be taxable on capital gains based on their world income.)
- Changes in the treatment of "Limited Liability Companies" and other hybrid entities. Currently certain entities which are disregarded for income tax purposes in the United States, or which are considered "flow through" entities are considered corporations in Canada. This gives rise to many tax problems related to the recognition of foreign tax credits (especially since the hybrid entity is not considered taxable in the U.S.) Under the new rules, income, which is treated as being earned by a member or shareholder of such an entity, who is a resident of the U.S., will be deemed to be earned by the recipient in Canada. The intent of the Fifth Protocol is to provide relief for U.S. LLC's making investments in Canada. NOTE: However, a Canadian resident member of a U.S. LLC who receives a distribution is considered to have received a dividend, and can take a foreign tax credit under subsection 126(1) (15%) and deduct excess tax under subsection 20(11). If the LLC does not make a distribution of income in the year it is earned, any U.S. tax can only be deducted under subsection 20(12) and no foreign tax credit would be available. (A corollary rule to take effect in two years provides that if income is NOT to be recognized by the individual member in the country of origin, it will NOT be taxable in the country of residence.) This will also coordinate with the interest withholding rules noted above. If a U.S. LLC earns interest income in Canada, the new rules will presume that the U.S. residents earned the income, and will thus eliminate withholding taxes on the income in Canada.
- Mutual Recognition of RRSP’s and IRA's. In this major change, cross border workers may be able to deduct contributions to pension plans made abroad in their country of residence. This means that if a Canadian works in the U.S. and contributes to a U.S. retirement plan, that deduction would be allowable on his Canadian return (as well as in the U.S.) to the limit of his RRSP contribution room. Similarly, U.S. citizens working in Canada and making RRSP contributions or pension plan contributions will be able to deduct the contributions on their U.S. returns.
- Stock option benefit - apportionment of taxation. Currently it is not clear how income tax will apply in situations where an employee becomes entitled to a stock option in one country and then moves to the other country before exercising or disposing of the stock. Under the new rules, taxation will be proportionate to the amount of time spent working (and earning the option) in each country.
The following are of particular interest to companies and individuals providing consulting or other personal services in the state they are not resident in:
- "Permanent Establishment" defined. The definition of "permanent establishment" was subject to much interpretation in the former Treaty. Under the new rules, the application of benefits in many cases is tied to whether a person or company has a permanent establishment in a contracting state. A permanent establishment is now created where an individual spends more than 183 days in the other state and during that time more than 50% of the gross revenue generated by the business is derived from services rendered in the other state by that individual. A permanent establishment may also be created where services are provided in the other state for more than 183 days in any 12-month period with respect to a project for a resident of the other state.
- Former Treaty Article XIV - "Independent Personal Services" deleted. Consistent with changes in the definition of "permanent establishment" mentioned above, the blanket exemption from taxation available to individuals or businesses providing business services in the other state (but not through a permanent establishment) has been repealed. Now, "business profits" are taxable in each state on a basis proportional to the activity carried out through a permanent establishment in each state. This change will affect the taxability of Canadian corporations and individuals providing services in the U.S. and U.S. entities providing services in Canada.
- Former Treaty Article XV - "Dependent Personal Services" continued and renamed "Income from Employment". Employment income will continue to be taxable only in the country of residence, unless the income was earned from services performed in the other country and if the employee spends more than 183 days in the other country, and earns more than $10,000 while on foreign assignment. The income will also be taxable in the other country if the salary is "borne by" a resident of the other country. (This last provision extends the Treaty benefit to short term employees transferred to the other country by their employer in the country of residence.)
Watch this site for further analysis of these important developments and their impact on the provision of personal services in the other state. Although these rules are not to be implemented for three years from the date the Fifth Protocol is ratified, strategic changes are currently recommended since the changes are being effectively administered by Canada Revenue Agency at this time.
Download the full text of technical details.