United States-Canada Income Tax Treaty Update

By Wolfish, Richard G. | The CPA Journal, October 2008 | Go to article overview

United States-Canada Income Tax Treaty Update


Wolfish, Richard G., The CPA Journal


On September 21, 2007, U.S. Secretary of the Treasury Henry M. Paulson, Jr., and Canadian Minister of Finance Jim Flaherty signed the Fifth Protocol to the United States-Canada Income Tax Treaty. This agreement is the result of nearly 10 years of negotiations. In order for the protocol to be put into force, it must be approved by the respective governments. The protocol was ratified by the Canadian Parliament in December 2007. On March 14, 2008, it was referred to the Senate Foreign Relations Committee and is awaiting hearing. There are many significant changes included in the protocol.

Benefits for U.S. Residents Holding Hybrid Entities

Hybrid entities like the limited liability company (LLC) can be transparent for U.S. tax purposes, unless the LLC has elected to be taxed as a corporation A hybrid entity is a corporation formed under legal statutes but is one that is taxed as a disregarded entity, corporation, or partnership at the election of the entity members. The United States Model Income Tax Convention, Article 1, General Scope, Paragraph 6, states:

An item of income, profit or gain derived through an entity that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a State to the extent mat the item is treated for purposes of the taxation law of such Contracting State as the income, profit or gain of a resident.

Differences between the US. tax system and that of other countries have often created complications for investors as well as officials of taxing jurisdictions whose policies often create obstacles to investment, like the double taxation of earnings. Such is the case with the Canada Revenue Agency (CRA) and its view of U.S. hybrids like the LLC. Prior to the protocol, the CRA considered an LLC as a hybrid or disregarded entity or partnership for U.S. tax purposes - that is, as a corporation not subject to U.S. taxation and, therefore, denied income tax treaty benefits to the LLC. Lost treaty benefits included reduced cross-border withholding rates and permanent establishment limitations, and often meant double taxation to members of the hybrid. Under the new protocol, however, hybrid members that are US. residents will now be entitled to treaty benefits. A caveat is that, to be eligible, the United States must treat the income the same as if the income had been earned directly by the member. If eligible, Canada generally will treat Canadian-source income earned by a hybrid U.S. LLC as having been earned by its members, and the treaty benefits-such as reduced withholding, permanent establishment limitations, and various other privileges-will apply, generally ending double taxation on operating hybrid investments. The protocol will take effect on January 1, three years after the year it is ratified.

Adverse Changes to Populer Holding end Finance Structures

The new protocol denies treaty benefits for a common holding structure used by many U.S. and Canadian investors, the Canadian Unlimited Liability Company (ULC). A ULC is a Canadian corporation that is treated as a corporation for Canadian tax purposes, but treated as a hybrid for U.S. tax purposes. The ULC has been a common form of holding structure for US. investors seeking a flow-through vehicle for US. tax purposes. The flow-through treatment allows investors to recognize income, deductions, and foreign taxes on the US. tax return. In the process, the foreign tax credits are recognized as "direct" tax credits for flowthrough investors and avoid the double taxation that would otherwise be created when a Canadian corporation is necessary for investment.

The Fifth Protocol denies treaty benefits where the hybrid entity is treated as a separate entity under the tax system of the source country (Canada) and as a flowthrough in the other country. The protocol will deny treaty benefits for cash distributions from these structures, effectively increasing the withholding rate to 25% of the distribution. …

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