Canada and the United States signed the fifth protocol of the new Canada-U.S. Tax Treaty on September 21, 2007. Canada ratified the treaty on December 14; U.S. ratification is expected in 2008. On the same day Canada ratified the treaty, it eliminated Canadian Part XIII withholding tax on interest paid or credited to most arm’s length non-resident lenders (other than interest paid on participating debt). This elimination of withholding tax applies to any interest paid or credited to arm’s length non-resident lenders on or after January 1, 2008, as promised in the March 2007 budget. No longer do Canadian taxpayers and their arm’s length non-resident lenders have to look to a treaty for an interest withholding tax exemption.
Canadian taxpayers are only reliant on the treaty for interest paid or credited to non-resident non-arm’s length lenders. The non-arm’s length lenders are referred to as “related lenders” in the United States, but Article IX of the treaty effectively expands the narrow relationship of “related” as it is known in Canadian income tax law to a non-arm’s length concept.
Withholding tax on interest paid or credited to non-arm’s length non-resident lenders will be reduced to seven per cent for the first year, four per cent for the second year, and zero per cent for subsequent years following the ratification. The Department of Finance has confirmed that if the United States ratifies the treaty in 2008, Canada and the U.S. shall take the position that January 1, 2008 will be the effective date of the seven per cent interest withholding tax reduction. As a corollary, Finance announced its intent to treat guarantee fees as interest. Historically, guarantee fees were deemed to be interest payments for the purpose of Part XIII Canadian withholding tax rules. But after the treaty is in force for two months, the protocol shall eliminate Canadian withholding tax on guarantee fees paid or credited by a taxpayer.
Cost Base Step-Up
When a Canadian emigrates to the U.S. there is a Canadian departure tax on most types of property held by the taxpayer. This departure tax triggers a deemed disposition at fair market value immediately prior to emigration, thereby triggering a Canadian income tax liability. For Canadian tax purposes, there is a reacquisition of the same property by the expatriate at its fair market value immediately prior to emigration. However, there is no step-up in the cost base of the property to reflect Canadian tax paid for U.S. tax purposes.
The potential for double taxation existed when the taxpayer sold the property after emigrating. On the actual disposition, the gain is triggered for U.S. tax purposes; however U.S. tax law does not recognize the step-up in cost base that occurred for Canadian tax purposes upon emigration from Canada. The cost base for U.S. tax purposes on the disposition would be the historical acquisition cost of the asset. Canada attempted to rectify this situation in 1996 by providing non-residents with a tax credit for departure tax paid upon emigration to any country once the property was sold in the new host country. The purpose of this tax provision is to eliminate double taxation on any cross border migration for Canadians.
The new Canada-U.S. treaty eliminates the need to rely on the Canadian tax credit for individuals emigrating to the United States. The treaty provides for situations in which a Canadian taxpayer is deemed to have disposed of a property upon emigration to choose to be treated in the United States as having sold and repurchased the property for fair market value consideration. This change was announced in September 2000 and once ratified, will be effective from September 17, 2000.
It is important that anyone contemplating any kind of cross border transaction consult with a tax advisor familiar with the intricacies of the treaty.
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