Thanks to those intrepid treaty negotiators at the U.S. Treasury Department, there’s now a bright, shiny, new "Protocol" in effect between the United States and Canada.
The good news about this Protocol—an amendment to the U.S.-Canada tax treaty—is it eliminates some sneaky tax traps that made it tricky for Americans to invest in Canada using "pass-through" entities such as limited liability companies. (In a pass-through entity, the entity itself isn’t taxed—only its owners).
Essentially, the Protocol makes it easier for a U.S investor in a Canadian business to obtain both limited liability AND to qualify for a substantial reduction of the 25% withholding tax on interest, dividends, and royalties received from a Canadian source.
It does so by stipulating that a U.S. resident (an individual, partnership, corporation, etc.) earning Canadian income through a pass-through entity (such as a limited liability company) is entitled to a reduction in withholding tax. The "treaty rate" ranges from 0%-15%, and whatever tax is withheld can be applied against the U.S. tax liability of the U.S. resident. For this favorable situation to apply, the income derived through the entity must be taxed the same way by the IRS as it would have had the income been earned directly by the U.S. resident.
The situation is especially favorable with respect to interest payments. Canadian withholding tax on such payments in certain circumstances can now be reduced to zero.
The bad news is that this treaty severely restricts what was once a great tax-savings strategy: the ability of U.S. resident shareholders of a Canadian unlimited liability company to be treated as a disregarded entity for U.S. tax purposes. This status provided numerous opportunities for cross-border tax planning. For instance, it permitted businesses investing in Canada the opportunity to consolidate losses from a U.S. federal tax standpoint. It also maximized the availability of the U.S. foreign tax credit. Fortunately, the new rules on such "hybrid entities" don’t come into effect until Jan. 10, 2010, at the earliest.
There are a multitude of additional provisions in the Protocol, and it becomes effective over time, not right away. Nonetheless, it’s definitely a step toward normalizing bilateral tax relations between the United States and Canada.
Copyright © 2007 by Mark Nestmann
