On September 21, 2007, the U.S. and Canada jointly released the Fifth Protocol to the Canada-U.S. Income Tax Convention (the "Protocol").
Entry into Force
The Protocol will enter into force on the later of January 1, 2008 or the date that both governments ratify the Protocol. It is likely that the Protocol will enter into force after January 1, 2008.
Withholding Tax on Interest - Non-Arm's Length
If interest is paid to a non-arm's length person, the rate of withholding tax will be reduced as follows:
By January 1, 2010, there will be no withholding tax on interest payments between Canadian and U.S. residents.
In the past, tax advisors have attempted to avoid withholding tax by using the provisions of subparagraph 212(1)(b)(vii) of the Income Tax Act, which eliminated withholding tax for 5-year loans with certain principal repayment restrictions. This provision will now become unnecessary where there are transactions between residents of Canada and of the U.S. The Canadian Government has also announced that the elimination of withholding tax will apply to interest payments by Canadian residents to all non-residents, effective at the date that the similar provisions of the Protocol become effective.
This exemption from withholding tax is subject to a few new exceptions. A withholding tax rate of 15% will still apply to:
Where interest exceeds an arm's length amount, and there is a special relationship between the payer and the beneficial owner, the amount of the interest will be subject to 15% withholding tax. A "special relationship" is not defined in the Protocol. It is interesting that the rules do not include the phrase "non-arm's length". Instead, the Protocol reflects the use of a new term.
Canadian taxpayers should still be aware of the thin capitalization rules, which limit the amount of interest deductible in non-arm's length situations. None of these changes made by the Protocol affects the ability to deduct excess interest under the thin capitalization rules. Once the provisions of the Protocol are in effect, the only negative implication of the thin capitalization rules will be the disallowance of a portion of interest expense.
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