Adverse Canada-U.S. Treaty Rules Come into Effect January 1, 2010
On January 1, 2010, two sets of new rules that were introduced as part of the fifth protocol to the Canada-United States Income Tax Convention (Treaty) will come into effect. Both sets of rules could have a significant adverse impact on cross-border organizations. These organizations should carefully consider the potential application of these rules in their circumstances and determine whether restructuring transactions should be undertaken to minimize or eliminate any tax or administrative inefficiencies resulting from the application of these rules.
Hybrid Entity Rules
Beginning January 1, 2010, reduced rates of withholding tax under the Treaty will no longer apply to certain amounts derived through, or paid by, hybrid entities (i.e., entities that are treated as fiscally transparent in one of Canada or the United States but not in the other country). Common hybrid entities include Canadian unlimited liability companies and U.S. limited liability companies. Both of these hybrid entities are treated as corporations for Canadian tax purposes and, therefore, are not fiscally transparent for Canadian tax purposes; however, they may be treated as fiscally transparent in the United States (Disregarded ULCs and Disregarded LLCs, respectively).
For example, beginning on January 1, 2010, dividends or interest paid by a Disregarded ULC to its sole U.S. shareholder will be subject to withholding tax at a rate of 25%, rather than the withholding tax rates that would have otherwise applied under the Treaty (5% for dividends and 0% for interest). Similar payments by a U.S. hybrid partnership to a Canadian resident may also be subject to 30% U.S. withholding tax, rather than the reduced Treaty rates.
Deemed Permanent Establishment
The other provision of the Treaty that is coming into effect on January 1, 2010 and that may have an adverse impact on cross-border businesses is Article V(9). Article V of the Treaty sets out the circumstances in which an enterprise will be considered to carry on business through a permanent establishment in a jurisdiction. This determination is key for cross-border businesses; an enterprise that carries on business through a permanent establishment in a jurisdiction will become subject to taxation in that jurisdiction even though it is not resident in that jurisdiction for tax purposes.
New Article V(9) will deem an enterprise that does not otherwise have a permanent establishment in a jurisdiction to have a permanent establishment in that jurisdiction if it provides services in that jurisdiction that meet one of the following two thresholds:
- the services are performed in the jurisdiction by an individual who is present in the other state for 183 days or more in any twelve-month period and, during the time the individual is present in the jurisdiction, more than 50% of the gross active business revenues of the enterprise consists of income derived from such services; or
- the services are provided in the jurisdiction for 183 days or more in any twelve-month period with respect to the same or a connected project for customers who are either residents of the jurisdiction or who maintain a permanent establishment in the jurisdiction and the services are provided in respect of that permanent establishment.
In applying these threshold tests:
- only services that are physically provided from within the jurisdiction will be relevant;
- if individuals are present in the jurisdiction on a particular day, that day will count as one day (and not one day multiplied by the number of individuals present in the jurisdiction on that day) for purposes of the 183-day test;
- the twelve-month period referred to above may not necessarily be a calendar year; rather, it is any twelve-month period. Therefore, the threshold will need to be tested on an ongoing or rolling basis.
- Projects will be considered to be “connected” if they constitute a coherent whole, commercially and geographically.
The coming into effect of new Article V(9) will require cross-border businesses to carefully track, on a rolling twelve-month basis, the presence of their employees in the jurisdiction where the enterprise is not resident but carries on business. This requirement could pose a heavy administrative burden on some businesses.
Review of Cross-Border Structures and Organizations
Given the impending deadline for the increased rates of withholding tax and the deemed permanent establishment rule, cross-border structures and organizations should be reviewed to determine whether restructuring transactions should be implemented or changes need to be made to the manner in which these structures and organizations provide (or track the provision of) cross-border services.
U.S. Tax (IRS Circular 230): Any U.S. tax or other legal advice in this article is not intended and is not written to be used, and it cannot be used, by any person to avoid penalties under U.S. federal, state or local tax law, or promote, market or recommend to any person any transaction or matter addressed herein.