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April 16, 2024

Tax Tips

5th Protocol - Canada-US Income Tax Convention - Interest Withholding Tax - Non-Arm's Length
Subject: 5th Protocol
Number: 07-16
Date: 12/14/2007
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

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:

  1. To 7% for the period from the date of ratification of the Protocol until the end of the calendar year in which the Protocol is ratified. For example, if the Protocol is ratified in 2008, the 7% rate will apply from the date it is ratified until December 31, 2008.
  2. To 4% for interest paid or credited during the second calendar year after the ratification of the Protocol. Assuming that the Protocol is ratified in 2008, the 4% rate will apply to interest payments made or credited in 2009.

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:

  • "Contingent interest" arising in the U.S. that does not qualify as portfolio interest under the U.S. portfolio interest exemption; and
  • "Participating interest" that arises in Canada. Participating interest is considered to be interest determined with reference to receipts, sales, income, or profits.

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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The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.