Canada-US Tax Treaty

On Friday, the Finance Minister and the Treasury Secretary signed the Fifth Protocol of the Canada-US Income Tax Convention. The Canadian government lined up several business organizations in advance to provide endorsements, which have dominated the media coverage. One of these organizations, the C. D. Howe Institute, made the case for the amended treaty through an op-ed in Saturday’s Financial Post.

The two main changes are the elimination of withholding taxes on cross-border interest payments and the exemption of American “limited liability companies” (LLCs) from Canadian corporate tax. Both changes are promoted as facilitating more US investment in Canada.

At first glance, the end of withholding taxes on interest seems like a relatively inexpensive tax cut ($250 million for two fiscal years) that may slightly reduce borrowing costs. What the press has not yet mentioned is that Canada already had criteria through which interest paid on arm’s-length debt (e.g. bank loans) from the US could gain exemption for the withholding tax, which is why this tax raises such modest revenues.

The Fifth Protocol’s effect is to exempt interest on loans that do not meet these criteria. In particular, it will be easier for Canadian public-private partnerships to access American financing.

Withholding tax on non-arm’s-length interest payments will be phased-out over three years. For example, if a subsidiary operating in Canada borrows from its US parent company, the interest payments are deducted from the subsidiary’s taxable Canadian profits and added to the parent’s taxable American profits. However, since the payments are determined internally by the corporation rather than by market interest rates, it can use them to shift taxable profits across the border however it wants. Currently, the withholding tax on non-arm’s-length loans mitigates such activity. The amended treaty’s cost, in terms of lost revenue, could be appreciably higher after this tax is fully phased-out.

Because corporate taxes are generally lower in Canada than in the US, the incentive may usually be for corporations to shift profits north of the border. However, the treaty’s general thrust is clearly to reduce corporate tax payments to both countries.

Regarding LCCs, the C. D. Howe Institute explains:

Until now, Canadian tax rules have treated U.S. limited liability companies as corporations, even when they are really partnerships that pass their earnings through to partners, to be taxed in partners’ hands. The new agreement will recognize LLCs as partnerships, or flow-through vehicles, rather than as corporations, so that they will not face double taxation.

However, the Canadian government did not accept this argument with respect to income trusts and rightly opted to tax them as corporations. Exempting LCCs operating in Canada from Canadian corporate tax seems to contradict the income-trust decision, but I admittedly know very little about how LCCs work.

The C. D. Howe Institute’s overall argument is that harmonizing tax rules will encourage efficient decision-making based on real economic variables rather than based on tax differences. The most meaningful way to achieve this objective would be to raise Canadian corporate taxes to match US corporate taxes. Of course, the Institute only favours harmonization that leads to lower corporate taxes. In fact, its op-ed on the tax treaty again calls for even lower corporate-tax rates in Canada.