Withholding Tax on Interest Payments

December 2007

Last March the Federal budget included what amounted to an update on the status of the talks between Canadian and US authorities regarding the Canada-U.S. Tax Convention ("the Treaty"). Officials on both sides of the border had agreed in principle on most of the key components of the next (5th) Protocol. Among the many measures, the next Protocol would eliminate withholding tax on arm's length interest. Further, and, subject to a phase-in period, withholdings on non-arm's length interest would also be eliminated. While many people got caught up in the Canada-US connotation, what many missed was that it was also announced that interest paid by a person resident in Canada to an arm's length non-resident, regardless of country of residence will be exempt from withholding tax (in the case of most types of debt) under the Canadian Income Tax Act ("the Act") as soon as the exemption under the Treaty was effected.

On September 21, 2007 the long awaited 5th Protocol to the Treaty was signed. As part of the Protocol (which contained many interesting tax changes), interest paid to arm's length non-residents was eliminated to be effective on the 2nd month following ratification of the Protocol.

On October 2, 2007 draft amendments to the Act were released implementing the March budget proposals. As part of the proposals, the withholding tax exemption was to apply once the Treaty was amended to exempt cross-border payments of interest to arm's length persons from withholding tax. However given the ratification to the Protocol requirement, there was no telling when the new exemption under the Act would be implemented. Consequently, on November 13, 2007, the Department of Finance released revised draft amendments which among other things, changed the effective date for the withholding tax exemption on arm's length interest. Under the updated proposals, the exemption in the Act will now apply after 2007 once the amendments are passed into Canadian law. As a result, the new exemption under the Act for all countries will no longer depend upon ratification of the Treaty. In fact they will take effect before the changes to the Treaty take effect.

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