Issue One Americas Region and PKF NAN February Chairman s Note

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1 Issue One Americas Region and PKF NAN February 2009 Chairman s Note Welcome to the first edition of the PKF International Tax Alert, a publication designed to summarise key tax changes from around the world. This publication will be issued three times per year in soft copy format only and can also be found on the PKF International website This version of the International Tax Alert only contains all the updates for the Americas Region and PKF NAN. To get tax alerts for other or all regions please download the alternative versions of the International Tax Alert available on Mark Pollock, Chairman, PKF International Tax Committee Mark.Pollock@pkf.com.au Tel: In this edition Argentina Tax Treaty with Austria Cr. Gustavo outlines the cessation of Tax Treaty with Austria. Canada US Canada Tax Treaty Bill Macaulay outlines the salient features of the US-Canada tax treaty, and the recently announced federal budget for Mexico New Taxes C P Mario Camposllera Garcia summarises two new taxes established in 2008, which affect the cost of company business. United States of America New changes to the US-Canada income tax treaty Rafael Carsalade comments on recent developments in the US-Canada tax treaty PKF International Tax Alert February

2 Argentina Tax Treaty with Austria revoked Argentina has given Austria a notice of termination of the Tax Treaty that had been in effect since The notice was sent through diplomatic channels on 26 June The Official Authority said that the notice of termination was sent due to the special treatment given to government securities issued by Austria. The convention ceased to have effect in respect for taxation years beginning after 31 December For more details, please contact: Cr. Gustavo Director P Villagarcía & Asociados Tel : +54 (11) Fax: +54 (11) gdirector@pkfargentina.com.ar PKF International Tax Alert February

3 Canada Canada-US Tax Treaty Amendments The Fifth Protocol amending the Canada-US Tax Treaty, signed in September 2007, entered into force on 15 December The Protocol contains a wide variety of provisions intended to improve the flow of commercial transactions between the two significant trading partners. Key changes introduced in the Protocol are: Elimination of the withholding tax levied on cross-border guarantee fees and arm s length interest payments. Phased elimination of withholding tax on interest payments between related parties (see details below). An increase in the withholding tax rate on contingent interest payments. The extension of treaty benefits to members of US limited liability companies. The limitation of treaty benefits on certain payments to hybrid entities such as Canadian unlimited liability companies. The expansion of the definition of permanent establishment to broaden the scope for the taxation of foreign service providers. The elimination of double taxation on emigrants gains. Clarification of the rules for taxing stock options exercised by cross-border employees. Harmonization of the treatment of pension contributions. Canada s adoption of a Limitation of Benefits provision for the first time. Introduction of a mandatory arbitration mechanism that allows taxpayers to require settlement of double tax disputes such as transfer pricing impasses. New residency rules for a company that continues its corporate existence from one country to the other. Reduction of the withholding tax on dividends paid to certain partnerships of US corporations to 5%. Reduction of US withholding tax on certain US REIT distributions. The timing for the transition into the new rules has many different effective dates: Changes relating to withholding tax (other than on interest payments) will be effective with respect to payments or credits made on or after the first day of the second month beginning after entry into force. This means the withholding tax changes will generally be effective on 1 February 2009 (eg, guarantee fees, certain dividends paid to partnerships). Canada introduced its own domestic law to exempt arm s length interest paid or credited to persons of all countries from withholding tax starting 1 January (See heading below.) Interest paid to a related party US resident is subject to the following withholding tax rates: For interest paid or credited during 2008, the rate is 7% (retroactive to 1 January 2008). For interest paid or credited during 2009, the rate is 4%. For interest paid or credited after 2009, the rate is 0%. Related party interest payments received by US residents in 2008 that were subject to 10% Canadian withholding taxes prior to the end of 2008 will be entitled to claim a refund for the 3% overpayment. The provisions applying to other taxes will apply for taxation years that begin after the calendar year in which the Protocol enters into force (ie, the taxpayer s taxation year that begins after 2008). The provision extending the definition of permanent establishment for foreign service providers will not apply until the third taxable year that ends after 15 December 2008 but in no event will the respective tax authorities count days and revenues prior to 1 January 2010 in applying the new test. PKF International Tax Alert February

4 In the case of the amendments affecting the taxation of payments to Canadian unlimited liability companies and similar hybrids, the provisions will be effective 1 January US entities using Canadian unlimited liability company structures to carry on business in Canada will want to review their structures prior to 1 January The rules preventing the double taxation of individual s pre-migration gains have retroactive effect for emigrations after 17 September The residency rules applicable to corporate continuances are applicable to continuances effected after 17 September The provisions relating to mutual assistance in the collection of taxes will have effect for revenue claims finally determined by the country applying for assistance after 9 November Residents of countries with US subsidiaries carrying on business or investing in Canada will want to review their international structure in the light of the Limitation of Benefits provisions adopted by Canada in the Fifth Protocol. These rules came into force on 15 December US entities carrying on business in Canada and claiming that they do not have a permanent establishment will particularly want to review their business patterns and structures in advance of the new deemed permanent establishment rules become effective. The Protocol s amendment enshrines the temporal approach by introducing new time-based tests to deem the existence of a permanent establishment. The Protocol deems an enterprise to have a permanent establishment in the other country in either of the following two circumstances: Where services are performed in the other country by an individual who is present in the other country for an aggregate of at least 183 days in any 12 month period and, during that period or periods, more than 50% of the gross active business revenues of the enterprise consists of income derived from the services performed in that other country by that individual; or Where services are provided in the other country for an aggregate of at least 183 days in any 12 month period with respect to the same or connected project for customers who are either residents of the other country or maintain a permanent establishment in that other country and the services are provided in respect of that permanent establishment. Withholding Tax Exemption on Interest Paid to Arm s Length Persons of All Countries In addition to the changes to the Canada-US Tax Treaty discussed above, Canada introduced into its domestic law a broad-based withholding tax exemption for interest payments (other than in respect of contingent interest) to arm s length persons of all countries that generally parallels the initiative with US taxpayers under the Fifth Protocol. This change is now law and exempts arm s length interest paid or credited to nonresidents starting 1 January Federal Budget Measures Federal Finance Minister Jim Flaherty tabled his much-anticipated 2009 Budget on 27 January The tax initiatives of interest to international business include: The withdrawal of punitive interest deductibility rules for Canadian businesses on international investments that were scheduled to take effect in These rules were intended to attack double dip interest deductions taken in Canada and again in the foreign jurisdiction. Announcements concerning the review of certain measures affecting Canadian businesses ability to compete internationally, particularly the proposed amendments for taxation of foreign affiliates and the taxation of non-resident trusts and foreign investment entities. Customs tariff reductions for 214 tariff items to assist Canadian industry by lowering the costs of acquiring machinery and equipment from outside of North America. Enhancements to the accelerated capital cost allowance for eligible manufacturing and processing equipment acquired before 2012 and eligible new computers and systems software used in Canada acquired after 27 January 2009 and before February PKF International Tax Alert February

5 International Financial Centre British Columbia In 2008, qualifying activities under the International Financial Activity Program were expanded to include the following new activities: Head office activities Short-term Financial Instruments for Nonsecurities Corporations Hedging activities Exploitation of green-related patents. Under the International Financial Activity Program, companies registering an international financial business with the Province of British Columbia receive a refund of up to 100% of provincial taxes paid on income earned from a qualifying international business. With planned reductions in the federal income tax rate to 15% by 2012, the tax rate on qualifying income will be competitive with other finance centres such as Singapore and Hong Kong. Financial activities carried out for, with, or on behalf of a non-resident include loans and deposits, dealing in securities, providing financial advice, managing foreign exchange, managing investments, preparing financial research, factoring, leasing and insurance. The program extends beyond financial activities to include distributing film and television outside Canada; providing administrative support services related to an international financial activity; providing back-up services; and selling, assigning or licensing to a non-resident a life science or green-related patent, or selling to a non-resident a good or service whose sales revenue is principally derived from an invention for which a life science or green-related patent has been issued. For more details, please contact: Bill Macaulay Smythe Ratcliffe, Vancouver Tel: bmacaulay@smytheratcliffe.com PKF International Tax Alert February

6 Mexico New Taxes In the year 2008, two new taxes were established, the Flat Rate Business Tax and the Tax on Cash Deposits. These affect the cost of company business and, in order to fulfill with the tax requirement, the company has to withdraw funds to make such payments. The main features of these new taxes, the tax contributors with obligation to cover these taxes and the tax rate are described as follows: Flat Rate Business Tax (IETU) Features 1. It is considered a direct tax because it makes an impact on the contributors that generate an income which is subject to these taxes. 2. It will replace the tax assets. 3. The Flat Rate Business Tax encourages investment. 4. It is aimed at discouraging tax avoidance. 5. It is a complement to Income Tax. Example: If IRS > IETU pay IRS. If IETU > IRS pay IRS plus difference between both taxes. If IETU exists and IRS is 0, only pay IETU. Subjects and object of the tax Individuals and legal entities residing in the national territory, as well as residents abroad having a permanent establishment in the country are under the obligation to pay the Flat Rate Business Tax on the revenues they obtain, regardless of the place where the revenues are generated, for engaging in the following activities: The transfer of assets The granting of temporary use or enjoyment of assets. Residents abroad with permanent establishment Residents abroad having a permanent establishment in the country are under the obligation to pay the Flat Rate Business Tax for revenues that are attributable to said establishment that derive from the above mentioned activities. Computation of the tax and taxable base The Flat Rate Business Tax is calculated by applying the rate of 17.5% to the amount resulting from subtracting the deductions herein authorized from the aggregate revenues earned from the activities referred to in this article. This Law entered into force on 1 January Cash Deposit Tax Law Subject and object of the Law Individuals and legal entities are under the obligation to pay the tax provided for in this Law with respect to all cash deposits made in Mexican or foreign currency, made into any type of account in their name carried by the institutions of the financial system. Tax rate The cash deposit tax shall be computed by applying the rate of 2% to the total amount of the deposits subject to the tax hereunder. This tax rate is for amounts deposits to exceed $25,000 Mexican pesos. This Law entered into force on 1 July For more details, please contact C.P. Mario Camposllera GARCIA PKF Mexico Tel: mcamposllera@pkfmexico.com The rendering of independent services PKF International Tax Alert February

7 USA New changes to the US Canada Income Tax Treaty: A Look at Selected Provisions of the Fifth Protocol On 21 September 2007, the US and Canada signed the Fifth Protocol (the Protocol ) to the 1980 US-Canada Income Tax Treaty (the Treaty ) which was the result of nearly ten years of negotiations between the two countries. The changes to the Treaty resulting from this new Protocol are many and quite significant for crossborder business, especially when considering that in 2007 aggregate cross-border investment exceeded $140 billion and cross-border income flows have generally been in excess of $30 billion annually since 1995 (Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Canada, Joint Committee on Taxation, July 8, 2008). With so much cross-border income flow, the importance of the Protocol in further reducing the potential for double taxation and incentivizing trade is enormous. By briefly focusing on some of the Protocol provisions, namely the elimination of withholding taxes on cross-border interest payments, the look-through provision for dividends, and the treatment of LLCs and other hybrid entities, its significance to cross-border business can be better understood. Both Canada and the United States ratified the protocol before the end of Elimination of Interest Withholding Tax The elimination of withholding tax on cross-border interest payments is one of the most significant provisions in the Protocol, and is likely to be the one that will affect the most taxpayers in both countries. In most cases, Article XI of the current Treaty provides for a 10% withholding tax rate for interest paid across the border. Article 6 of the Protocol will modify Article XI so as to retroactively reduce that rate to zero for interest payments to unrelated parties as of 1 January 2008, and will begin phasing out the interest on related party interest over a period of three years. This phaseout will reduce the withholding rates to 7% (also retroactively) for 2008, then reduce it to 4% and zero in the two subsequent years. One exception is with regards to contingent interest as defined in 871(h)(4) which will be subject to a 15% withholding rate. Dividends Look-Through Provision Dividends withholding rates under the Protocol, unlike interest withholding and dividend withholding rates in the latest US treaties, will not be eliminated, reduced or gradually phased out. However, the look-through provision contained in article 5 of the Protocol (modifying Article X of the Treaty) will make the reduced 5% withholding rate available to corporate taxpayers who indirectly own corporations in either country where those shareholders would not have been able to do so before. The examples below illustrate situations where the 5% withholding rate would apply: Example 1 may be the most common where a Canadian Corporation (CanCo) is indirectly owned by a US corporation (USCo) through an entity that is considered fiscally transparent under US tax laws (US). In this case, USCo will be able to benefit from the 5% withholding rate as long as it owns at least 10% of the stock in CanCo through US. Example 2 provides an alternative scenario where shares in USCo are indirectly held by CanCo through its ownership in a partnership in a third country (3 rd Co LP). Since 3 rd Co LP is considered a fiscally transparent entity under tax laws in Canada (where beneficial owner CanCo resides), the 5% reduced withholding rate would apply to dividends paid by USCo to 3 rd Co LP. This remains true even in cases where in the US a check-the-box election was made to treat 3 rd Co LP as a corporation. In Example 3, the situation is reversed and the dividends paid by CanCo to 3 rd Co LP do not qualify for the 5% reduced withholding rate. Since 3 rd Co LP has checked the box to be treated as a corporation under US tax laws (where PKF International Tax Alert February

8 beneficial owner USCo resides), it is not considered a fiscally transparent entity in the US and therefore the look-through provision does not apply. One curious result of this look-through provision under the Protocol is that it effectively requires the dividend paying corporation to become acquainted with the tax laws of its indirect owners countries of residence to determine if under those laws the intermediary entities would be treated as fiscally transparent and therefore eligible for the reduced withholding rate. This requirement to look into the other country s laws to determine if an entity is considered to be fiscally transparent is also specifically mentioned in Article 2 of the Protocol which modifies Article IV of the Treaty dealing with definitions of tax residence under the Treaty. Fiscally Transparent and Hybrid Entities The theme of Treaty benefits applied to fiscally transparent and hybrid entities was a major aspect of the Protocol, and the results in some cases will not be good for some US-owned businesses in Canada operating under the common check-the-box Canadian unlimited liability company (ULC) structure (see example below). Under US check-the-box regulations, a US taxpayer (USCo) would elect to treat the Canadian ULC, normally formed under Nova Scotia or Alberta laws, as a partnership for US tax purposes. The result being an entity, the ULC, which is a 100% owned partnership and so effectively disregarded for US tax purposes but still treated as a corporation for Canadian tax purposes. The provision contained in Article 2 of the Protocol (modifying Article IV of the Treaty on residence) determines that, in such case, USCo would not be eligible for benefits under the Treaty. The result would be that USCo would be subject to the full Canadian withholding tax rate of 25% on payments (ie dividends, interest, rents, royalties) it receives from ULC. Since the ULC is disregarded for US tax purposes and, consequently, so are the payments from it to USCo, the payments would not constitute foreign source income to USCO with which it could claim the Canadian withholding tax as a foreign tax credit to reduce its US taxes. Although the operating income generated by the ULC would provide foreign source income for the year in which the withholding taxes would be assessed, and so, potentially, allow for the use of the foreign tax credit, a possible mismatch of the amount of foreign source income and foreign taxes could result due to timing differences in the recognition of the withholding taxes and distributions made. The good news is that the provisions in the Protocol dealing with the disallowance of benefits under the Treaty for such structures will enter into force at the earliest on 2010, provided that the Protocol is ratified before the end of This gives taxpayers some time to properly plan to adjust their structures to reflect the new Treaty provisions. Other Provisions Other significant provisions in the Protocol not discussed here include: PKF International Tax Alert February

9 reduced US withholding rate on dividends received by companies from REITs in some cases elimination of withholding tax on crossborder guarantee fees requirement for mandatory arbitration extension of limitation of benefits (LOB) provisions to apply to Canadian residents changes to pension and annuities withholding changes to determination of permanent establishment (PE) for personal services consequences to other structures involving fiscally transparent and hybrid entities. The Protocol will bring significant changes to the Treaty and require that companies from both sides of the border seriously consider the effects of these on their business. Some of the changes will have an immediate impact, mostly positive, as early as the Protocol enters into force. For some of the more significant changes, some with potentially harmful effects, the uncertainty as to the timing of the ratification of the Protocol by the US Senate and the phase-in of many of the significant changes provide a window for companies and advisers alike to properly plan for their impact. The key is to begin the process early. For more details, please contact: Rafael Carsalade, CPA, PKF Texas Tel: RCarsalade@pkftexas.com PKF International Tax Alert February

10 Disclaimer No person, entity or corporation should act or rely upon any matter or information as contained or implied within this publication without first obtaining advice from an appropriately qualified professional person or firm of advisors, and that such advice specifically relates to their particular circumstances. This publication should not be regarded as offering a complete explanation of the taxation matters that are contained within this publication. This publication has been sold or distributed on the express terms and understanding that the publishers and the authors are not responsible for the results of any actions which are undertaken on the basis of the information which is contained within this publication, nor for any error in, or omission from, this publication. The publishers and the authors expressly disclaim all and any liability and responsibility to any person, entity or corporation who acts or fails to act as a consequence of any reliance upon the whole or any part of the contents of this publication. PKF International Limited is an association of legally independent member firms. PKF International Tax Alert February