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104th Congress Exec. Rept.
SENATE
1st Session 104-9
_______________________________________________________________________
REVISED PROTOCOL AMENDING THE TAX CONVENTION WITH CANADA
_______
August 10 (legislative day, July 10), 1995.--Ordered to be printed
_______________________________________________________________________
Mr. Helms, from the Committee on Foreign Relations, submitted the
following
R E P O R T
[To accompany Treaty Doc. 104-4, 104th Congress, 1st Session]
The Committee on Foreign Relations, to which was referred
the revised protocol amending the Convention between the United
States and Canada With Respect to Taxes on Income and on
Capital signed at Washington on September 26, 1980, as amended
by the Protocols signed at Washington on June 14, 1983, and
March 28, 1984 (the revised protocol was signed on March 17,
1995), having considered the same, reports favorably thereon,
without amendment, and recommends that the Senate give its
advice and consent to ratification thereof, subject to one
declaration as set forth in this report and the accompanying
resolution of ratification.
I. Purpose
The proposed revised protocol further amends the current
treaty, as amended by the first and second protocols, and
replaces the protocol signed on August 31, 1994. The principal
purposes of the proposed revised protocol are to modify the
treaty to continue to promote close economic cooperation
between the two countries and to eliminate double taxation of
income earned by residents of either country from sources
within the other country, prevent evasion or avoidance of
income taxes of the two countries and to eliminate possible
barriers to trade caused by overlapping taxing jurisdictions of
the two countries. It is also intended to enable the countries
to cooperate in preventing avoidance and evasion of taxes.
II. Background
The proposed revised protocol to the income tax treaty
between the United States and Canada was signed on March 17,
1995 (see Treaty Doc. 104-4). The proposed revised protocol
amends the current income tax treaty between the two countries
that was signed in 1980 and modified by protocols signed in
1983 and 1984. The proposed revised protocol revises and
replaces the original third protocol which was signed on August
31, 1994, and which was pending before the Senate Committee on
Foreign Relations at the time of its replacement.
The proposed revised protocol was transmitted to the Senate
for advice and consent to its ratification on April 24, 1995.
The Senate Committee on Foreign Relations held a public hearing
regarding the proposed revised protocol on June 13, 1995.
III. Summary
Some provisions of the proposed revised protocol are
similar to those in other recent U.S. income tax treaties, the
1981 proposed U.S. model income tax treaty (the ``U.S.
model''),\1\ and the model income tax treaty of the
Organization for Economic Cooperation and Development (the
``OECD model'') and from the existing treaty with Canada.
However, the proposed revised protocol contains certain unique
provisions as well as deviations from those models. A summary
of the principal provisions of the proposed revised protocol,
including some of these differences, follows:
\1\ The U.S. model has been withdrawn from use as a model treaty by
the Treasury Department. Accordingly, its provisions may no longer
represent the preferred position of U.S. tax treaty negotiations. A new
model has not yet been released by the Treasury Department. Pending the
release of a new model, comparison of the provisions of the proposed
treaty against the provisions of the former U.S. model should be
considered in the context of the provisions of comparable recent U.S.
treaties.
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(1) Article 1 of the proposed revised protocol expands the
categories of Canadian income taxes generally covered by the
treaty to include the taxes imposed under all parts of the
Canadian Income Tax Act, and not simply, as under the existing
treaty, the income taxes imposed under the general income tax
portion of the Act and under the portions addressing Canadian
income of nonresidents and foreign corporations carrying on
business in Canada. The proposed revised protocol expands the
categories of U.S. taxes generally covered to include U.S.
estate taxes, to the extent described more fully below. For
purposes of the nondiscrimination and exchange of information
provisions of the existing treaty, the proposed revised
protocol expands the categories of Canadian tax covered to
include all such taxes, not simply (as under the existing
treaty) those imposed under the Canadian Income Tax Act. With
these expanded provisions, the proposed revised protocol brings
the existing treaty into closer conformity with the U.S. model
treaty.
The existing treaty, like other U.S. treaties, also has a
provision addressing the applicability of the treaty to taxes
that may be imposed by either country in the future, where
``the future'' means any date after the treaty was signed in
1980. The proposed revised protocol makes this provision apply
to taxes imposed after March 17, 1995, the date that the
proposed revised protocol was signed.
(2) Article XXIV (Elimination of Double Taxation) 2 of
the treaty (as it now exists and as it would be amended by the
proposed revised protocol) uses the terms ``Canadian tax'' and
``United States tax'' to specify those taxes deemed generally
creditable. Under the proposed revised protocol, however, not
all of the existing, generally covered Canadian taxes are taxes
the United States regards as creditable income taxes. Article 2
of the proposed revised protocol modifies the definition of
``Canadian tax'' in Article III (General Definitions) to ensure
that the taxes deemed creditable under the elimination of
double taxation article of the existing treaty are only those
generally covered Canadian taxes that are in fact taxes on
income.
\2\ Articles numbered by roman numeral are articles of the existing
treaty, unless otherwise specified. Articles numbered by Arabic numeral
are articles of the proposed revised protocol, unless otherwise
specified.
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The proposed revised protocol also modifies the definition
of ``United States tax'' in Article III (General Definitions).
The modification is intended to conform Article III to the
protocol's rearrangement of the references to U.S. taxes in
Article II (Covered Taxes), without changing the significance
of the term ``United States tax'' as it is used in Article XXIV
(Elimination of Double Taxation).
(3) Article 3(1) of the proposed revised protocol adds
citizenship in a treaty country to the list of factors that
would qualify an individual for treaty benefits as a resident
of that country. However, similar to several existing U.S.
income tax treaties, the proposed revised protocol provides
that a nonresident of Canada who is a U.S. citizen or green-
card holder is treated as a U.S. resident only if the
individual has a substantial presence, permanent home, or
habitual abode in the United States, and the individual's
personal and economic relations are closer to the United States
than to any third country.
The proposed revised protocol adds language to the treaty
to confirm the Contracting States' interpretations of the
existing treaty, under which organizations such as governments,
certain pension plans, and nonprofit organizations are treated
as residents of the United States or Canada.
Article 3(2) of the proposed revised protocol amends the
existing treaty language under which an otherwise ``dual
resident company'' is treated as a resident of only one country
if it was originally created under the laws of that country.
Under the proposed revised protocol, such a company will be
deemed to be a resident of the other country if it is
``continued'' in that other country. The Treasury Department's
Technical Explanation of the Protocol Amending the Convention
Between the United States of America and Canada with Respect to
Taxes on Income and on Capital Signed at Washington on
September 26, 1980, as Amended by the Protocols Signed on June
14, 1983 and March 28, 1984 (``Technical Explanation'')
indicates that the term ``continuation'' under Canadian law
refers to the local incorporation of an entity that is already
organized and incorporated under the laws of another country.
(4) Like some other U.S. treaties (such as those with
Mexico and Finland), but unlike the OECD and U.S. models, the
existing treaty allows each country to impose a time limit on
taxpayer claims for refund or other adjustments that arise from
(and hence ``correlate'' to) adjustments previously imposed on
a related person by the tax authorities of the other country.
The time limit under the existing treaty allows the first
country to reject the claim for a correlative adjustment if its
tax authority was not notified of the other country's
adjustment within 6 years from the end of the taxable year to
which the adjustment relates. Furthermore, if the notification
is not timely and the taxpayer was not notified by the other
country of the adjustment at least 6 months prior to the end of
the 6-year period, then (absent fraud, willful default or
neglect, or gross negligence) the existing treaty requires the
other country to refrain from making its adjustment to the
extent that the adjustment would give rise to double taxation.
Article 4 of the proposed revised protocol allows the
competent authorities to agree that the first country may waive
the 6-year notification requirement if the correlative
adjustment would not otherwise be barred by its own time or
procedural limitations. In addition, the proposed revised
protocol eliminates the obligation of the other country to
refrain from making its original adjustment, and instead simply
permits the competent authority to provide relief from double
taxation ``where appropriate.''
(5) Article 5 of the proposed revised protocol generally
lowers the existing treaty's 10-percent tax rate on direct
investment dividends (i.e., dividends paid to companies
resident in the other country that own directly at least 10
percent of the voting stock of the payor) and branch profits
taxes. The lower rate under the proposed revised protocol is 7
percent in 1995, 6 percent in 1996, and 5 percent (as in the
U.S. model treaty and numerous other U.S. treaties) thereafter.
Canada provides special tax benefits to so-called ``non-
resident-owned investment corporations.'' Such a corporation is
subject to a lower rate of statutory income tax than the
general corporate rate (25 percent vs. 38 percent), and is
exempt from tax on non-Canadian capital gains. Under Article
5(2) of the proposed revised protocol, Canada is permitted to
impose the existing 10-percent rate, rather than the lowered
rate, on a direct investment dividend paid to a U.S. resident
by a non-resident-owned investment corporation.
As under other U.S. treaty provisions adopted since 1988,
the proposed revised protocol permits the United States to
impose tax at the rate applicable to ``portfolio dividends''
(i.e., dividends other than direct investment dividends), in
the case of any dividend from a regulated investment company (a
``RIC'') or real estate investment trust (a ``REIT''). Under
the existing treaty, the portfolio dividend tax rate is 15
percent and generally is not altered by the proposed revised
protocol. However, the proposed revised protocol provides that
the general limitation on taxation of portfolio dividends does
not apply to a dividend paid by a REIT, except for a dividend
that is beneficially owned by an individual holding an interest
of less than 10 percent in the REIT (treating as an individual
any estate or testamentary trust that acquired its interest in
the REIT as a consequence of an individual's death within the
previous 5 years).
(6) Article 6(1) of the proposed revised protocol lowers to
10 percent the existing treaty's generally applicable 15-
percent limit on source-country taxation of interest. Article
6(2) of the proposed revised protocol broadens the existing
exemption from source country withholding in the case of the
sale of equipment, merchandise or services on credit. Article
6(3) of the proposed revised protocol conforms to U.S. internal
law that requires 30-percent withholding on an excess inclusion
of a foreign person with respect to a residual interest in a
real estate mortgage investment conduit (a ``REMIC''), without
reduction under the treaty.
(7) The existing treaty contains a 2-tier limitation on
source-country taxation of royalties. Only the residence
country may tax royalties and similar payments in respect of
the production or reproduction of literary, dramatic, musical
or artistic work, if such payments are not in respect of motion
pictures or works for use in connection with television.
Royalties that do not qualify for the exemption may be taxed by
the source country at a rate not to exceed 10 percent. Article
7(1) of the proposed revised protocol expands the class of
payments that qualify for the exemption to include payments for
the use of, or the right to use, patents and information
(unless provided in connection with a rental or franchise
agreement) concerning industrial, commercial or scientific
experience, and clarifies that computer software royalties are
also included in the exempt class. The proposed revised
protocol permits the treaty countries to agree to add
additional payments to the exempt category (by an exchange of
diplomatic notes without additional treaty ratification
procedures), if they are payments with respect to broadcasting.
The existing treaty includes a source rule for royalties
that, similar to U.S. internal law, sources royalties primarily
by place of use. Article 7(2) of the proposed revised protocol,
by contrast, introduces a new source rule under which the
royalties are sourced primarily by reference to the residence
of the payor or the location of a permanent establishment or
fixed base of the payor.
(8) To the extent that the existing treaty provides the
competent authority of one country the discretion to defer the
recognition of the gain or other income on the alienation of
property in the course of a corporate organization,
reorganization, amalgamation, division or similar transaction,
Article 8 of the proposed revised protocol provides similar
discretion in the case of a comparable transaction involving
noncorporate entities. One practical effect of this change is
explicitly to authorize the exercise of discretion in the case
of a reorganization of a Canadian mutual fund organized as a
trust.
(9) The existing treaty has a provision limiting source-
country taxation of pensions. Article 9(1) of the proposed
revised protocol makes a slight change in the definition of the
term ``pensions.'' The protocol clarifies that the definition
of pensions includes, for example, payments from a U.S.
individual retirement account (an ``IRA''), and provides that
the definition of pension includes, for example, payments from
a Canadian registered retirement savings plan (a ``RRSP'') or
registered retirement income fund (a ``RRIF'').
The existing treaty has provisions giving sole taxing
jurisdiction over social security benefits to the residence
country (if paid by the other country), and limiting the taxing
jurisdiction of the United States over Canadian social security
benefits received by a Canadian resident who is a U.S. citizen.
Article 9(2) of the proposed revised protocol, like most other
treaties negotiated since the Social Security Amendments of
1983, eliminates those provisions and gives sole taxing
jurisdiction to the source country.
In addition, under present law, certain Canadian retirement
plans that are qualified plans for Canadian tax purposes do not
meet U.S. internal law requirements of qualification. The
existing treaty, however, permits a U.S. taxpayer who is a
beneficiary of an RRSP to obtain U.S. tax deferral
corresponding to the deferral that the RRSP provides under
Canadian tax law, to the extent that income is reasonably
attributable to contributions made to the plan by the
beneficiary while he was a Canadian resident (see Rev. Proc.
89-45, 1989-2 C.B. 872). The proposed revised protocol expands
the class of retirement or other employee benefit arrangements
favored by Canadian law with respect to which the United States
will grant corresponding deferral of U.S. tax, and confirms
that Canada will provide reciprocal treatment to a Canadian
taxpayer who is a beneficiary under a pension plan or other
arrangement that qualifies for deferral of U.S. tax under U.S.
law.
(10) The existing treaty provides that each country
generally exempts dividends and interest from source-country
taxation when earned by a trust, company, or other organization
constituted and operated exclusively in connection with certain
employee benefits, such as pensions. Article 10(1) of the
proposed revised protocol modifies the provision to exempt
dividends and interest from source-country income taxation, and
modifies the description of the payees that are exempted under
this provision to refer to a trust, company, organization, or
other arrangement, generally exempt from income tax, and
operated exclusively to administer or provide employee
benefits. This is intended to clarify that IRAs, RRSPs, and
RRIFs, for example, are intended to benefit from the provision.
The existing treaty provides that a U.S. resident may take
a U.S. tax deduction for a charitable contribution to a
Canadian organization that could qualify to receive deductible
contributions if it were itself a U.S. resident. Article 10(2)
of the proposed revised protocol extends this benefit to a
Canadian corporation that is taxed by the United States as a
U.S. corporation under internal U.S. law (e.g., by virtue of an
election under Code section 1504(d)).
The existing treaty provides that a Canadian resident must
be allowed a Canadian tax deduction for a gift to a U.S.
organization that could qualify to receive deductible gifts if
it were itself created or established and resident in Canada.
Canadian law was changed, since the existing treaty was last
amended, to provide a credit, rather than a deduction, for
certain gifts. The proposed revised protocol confirms that
Canada is required to provide the appropriate relief--that is,
deduction or credit--where a gift is made by a Canadian
resident to a U.S. organization that could qualify in Canada as
a registered charity, were it created or established and
resident in Canada.
(11) A nonresident alien individual or foreign corporation
generally is subject to U.S. tax on gross U.S. source gambling
winnings, collected by withholding. In general, no offsets or
refunds are allowed for gambling losses (Barba v. United
States, 2 Cl. Ct. 674 (1983)). On the other hand, a U.S.
citizen, resident, or corporation may be entitled to deduct
gambling losses to the extent of gambling winnings (sec.
165(d)). In Canada, an individual is subject to tax on income
derived from gambling only if the gambling activities
constitute carrying on a trade or business (e.g., the
activities of a bookmaker). Whether gambling activities rise to
the level of a trade or business is determined on the facts and
circumstances of each case.
Article 11 of the proposed revised protocol adds a
provision not found in any other U.S. treaty or the model
treaties, under which the United States must allow a Canadian
resident to file a refund claim for U.S. tax withheld, to the
extent that the tax would be reduced by deductions for U.S.
gambling losses the Canadian resident incurred under the
deduction rules that apply to U.S. residents.
(12) Under internal law allowing a credit for foreign
income tax, the United States has in the past provided a credit
for Canada's social security tax (Rev. Rul. 67-328, 1962-2 C.B.
257). Article 12(1) of the proposed revised protocol obligates
Canada to give a foreign tax credit for U.S. social security
taxes paid by individuals (other than taxes relating to
unemployment insurance benefits). This rule may have great
significance in the case of Canadian residents who commute
across the border to employment in the United States.
The proposed revised protocol makes a number of changes to
the article requiring the United States and Canada to provide
credits for taxes imposed by the other country or (in Canada's
case) corporate tax exemptions for income from U.S. affiliates,
generally prompted by changes to U.S. and Canadian internal law
since the last amendments to the existing treaty were adopted.
The proposed revised protocol clarifies, for example, that even
where the treaty exempts income or capital from taxation in a
particular country, that country is nevertheless entitled to
take the exempt income or capital into account for purposes of
computing the tax on other income or capital.
(13) The existing treaty provides that in computing taxable
income, a treaty country must permit a resident to take a
deduction for a dependent resident in the other country to the
same extent that would be allowed if the dependent resided in
the first country. Since the last amendment to the treaty was
adopted, the Canadian law dependent deduction was converted to
a dependent credit; that is, a deduction in computing tax, as
opposed to taxable income. Article 13(1) of the proposed
revised protocol confirms that each country is required provide
the appropriate deduction--whether from taxable income or
simply from tax--for a dependent residing in the other country.
Article 13(2) of the proposed revised protocol expands the
categories of Canadian taxes covered by the nondiscrimination
article to include all taxes, including for example excise and
goods and services taxes, rather than only (as under the
existing treaty) those imposed under the Income Tax Act.
Extension of the nondiscrimination rule to all taxes imposed by
a treaty country will also apply to the United States under the
proposed revised protocol, although this is in general already
true under the existing treaty, because the existing article
applies to all taxes imposed under the Internal Revenue Code
(the ``Code'').
(14) Like the U.S. treaties with Germany, the Netherlands,
and Mexico, Article 14(2) of the proposed revised protocol
provides for a binding arbitration procedure to be used to
settle disagreements between the two countries regarding the
interpretation or application of the treaty. The arbitration
procedure can only be invoked by the agreement of both
countries. As is true under the treaties with the Netherlands
and Mexico, the effective date of this provision is delayed
until the two countries have agreed that it will take effect,
to be evidenced by a future exchange of diplomatic notes.
(15) Article 15 of the proposed revised protocol adds a
treaty provision requiring each country to undertake to lend
administrative assistance to the other in collecting taxes
covered by the treaty. The assistance provision is
substantially broader than the corresponding provisions in the
U.S. model treaty and the existing treaty. Although collection
assistance provisions like that in the proposed revised
protocol appear in the U.S. treaty with the Netherlands, and to
some extent in the present (and proposed) treaties with France
and Sweden, entry into a provision such as the one in the
proposed revised protocol, with a country that presently has no
similar provision in a treaty with the United States, is a
departure from U.S. treaty policy of recent years.
(16) In a departure from the model treaties and other U.S.
treaties, Article 16 of the proposed revised protocol entitles
either treaty country to share information it received from the
other country with persons or authorities involved in the
assessment, collection, administration, enforcement, or
appeals, of state, provincial, or local taxes substantially
similar to the taxes covered generally by the treaty as amended
by the proposed revised protocol. This change is in some ways
similar to, although significantly narrower than, the proposed
additional protocol with Mexico.
The proposed revised protocol expands the categories of
Canadian taxes covered by the exchange of information article
to include all taxes, including excise and goods and services
taxes, rather than (as under the existing treaty) only those
imposed under the Income Tax Act. As is true in the case of the
nondiscrimination article, application of the exchange of
information article to all taxes imposed by a treaty country
also applies to the United States under the proposed revised
protocol, although this is in general already true under the
existing treaty, because the existing article applies to all
taxes imposed under the Code.
(17) Article 17 of the proposed revised protocol modifies
the provision of the existing treaty relating to miscellaneous
rules.
Under U.S. and Canadian internal law, corporate earnings
generally are taxed to shareholders only upon distribution.
However, a limited class of U.S. small business corporations
may elect, under subchapter S of the Code, to have their income
taken into account by their shareholders, rather than
themselves (whether or not the income is distributed), and to
exempt from tax their distributions of earnings. In some cases
it may be possible for a Canadian resident to be a shareholder
in a so-called ``S corporation.'' Article 17(2) of the proposed
revised protocol adds a new provision under which the Canadian
tax authorities may agree to impose Canadian income tax on the
shareholder using essentially the same timing rules as the U.S.
S corporation rules, providing foreign tax credits for the U.S.
tax imposed under those rules.
The multilateral trade agreements encompassed in the
Uruguay Round Final Act, which entered into force as of January
1, 1995, include a General Agreement on Trade in Services
(``GATS''). This agreement obligates members (such as the
United States and Canada) and their political subdivisions to
afford persons resident in member countries (and related
persons) ``national treatment'' and ``most-favored-nation
treatment'' in certain cases relating to services. If members
disagree as to whether a measure falls within the scope of a
tax treaty, or if a member considers that another member
violates its GATS obligations, then the GATS provides that
members will resolve their issues under procedures set up under
GATS, with one exception. Disagreements whether a measure falls
within the scope of a tax treaty existing on the date of entry
into force of the proposed Agreement Establishing the World
Trade Organization (January 1, 1995) may be subject to GATS
procedures only with the consent of both parties to the tax
treaty.
Article 17 of the proposed revised protocol specifies that
for this purpose, a measure falls within the scope of the
existing treaty (as modified by the proposed revised protocol)
if it relates to any tax imposed by Canada or the United
States, or to any other tax to which any part of the treaty
applies (e.g., a state, provincial, or local tax), but only to
the extent that the measure relates to a matter dealt with in
the treaty. Moreover, any doubt about the interpretation of
this scope is to be resolved between the competent authorities
as in any other case of difficulty or doubt arising as to the
interpretation or application of the treaty, or under any other
procedures agreed to by the two countries, rather than under
the procedures of the GATS.
The proposed revised protocol contains a provision that
requires the appropriate authorities to consult on appropriate
future changes to the treaty whenever the internal law of one
of the treaty countries is changed in a way that unilaterally
removes or significantly limits any material benefit otherwise
provided under the treaty. This provision corresponds to
provisions in U.S. treaties with the Netherlands, Mexico, and
Israel that contemplate further negotiations in the event of
relevant changes to internal law.
(18) Article 18 of the proposed revised protocol contains a
limitation on benefits, or ``anti-treaty-shopping'' article
that permits the United States to deny treaty benefits to a
resident of Canada unless requirements, similar in many
respects to those contained in recent U.S. treaties and in the
branch tax provisions of the Code, are met. This provision
replaces very limited anti-abuse provisions denying benefits
under the existing treaty. The proposed revised protocol
includes a derivative benefits provision. It is similar in some
respects to, and different in other respects from, the
derivative benefits provisions in the anti-treaty-shopping
articles of the Netherlands and Mexico treaties. Unlike most
other corresponding U.S. treaty provisions, the proposed anti-
treaty-shopping article does not entitle Canada to deny any
treaty benefits. The proposed revised protocol indicates, and
the Technical Explanation clarifies, that both countries may
deny benefits under otherwise applicable anti-abuse principles.
(19) Canada does not impose an estate tax. For Canadian
income tax purposes, however, capital assets of a decedent are
deemed to have been disposed of immediately before death. Thus,
gains inherent in capital assets held at death generally are
subject to Canadian income tax. Article 19 of the proposed
revised protocol is intended to coordinate the U.S. estate tax
with the Canadian income tax upon gains deemed realized at
death.
The estate tax coordination rules apply to residents of the
United States and of Canada as defined in the existing treaty
(as modified by the protocol, as noted above). The treaty's
residence rules are somewhat different from the residence rules
that apply for estate tax purposes under the Code or under most
U.S. estate tax treaties.
The proposed revised protocol obligates Canada and the
United States to treat a decedent's bequest to a religious,
scientific, literary, educational, or charitable organization
resident in the other country in the same manner as if the
organization were a resident of the first country. Thus, for
U.S. estate tax purposes, a deduction generally is allowed for
a bequest by a Canadian resident to a qualifying exempt
organization resident in Canada, provided the property
constituting the bequest is subject to U.S. estate tax.
In general, U.S. citizens and residents are allowed a
unified credit of $192,800 against their cumulative lifetime
U.S. estate and gift tax liability. Nonresident aliens
generally are allowed a credit of $13,000 against the U.S.
estate tax. For U.S. estate tax purposes, the proposed revised
protocol generally provides Canadian residents who are not
United States citizens with a pro rata portion of the unified
credit allowed to U.S. citizens and residents. 3 The pro
rata portion is based upon the ratio that the Canadian
resident's gross estate situated in the United States bears to
his worldwide gross estate. This credit must be reduced for any
gift tax unified credit previously allowed for any gift made by
the decedent. Also, the credit may not exceed the U.S. estate
tax imposed on the decedent's estate. Allowance of the pro rata
unified credit is conditioned upon the taxpayer providing
sufficient documentation to verify the amount of the credit.
\3\ The credit allowed to a Canadian resident would be not less
than $13,000.
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Since enactment of the Technical and Miscellaneous Revenue
Act of 1988 (``TAMRA''), the general 100-percent marital
deduction from the U.S. estate and gift tax has been
substantially limited in the case of property passing to a
noncitizen spouse. The proposed revised protocol allows an
estate to elect a limited estate tax marital credit for
property that would qualify for the marital deduction if the
surviving spouse had been a U.S. citizen, provided the
following conditions are met: (1) the surviving spouse is a
resident of one of the treaty countries, (2) the decedent
spouse was a U.S. citizen or a resident of one of the treaty
countries, (3) where both spouses are U.S. residents, at least
one spouse is a citizen of Canada, and (4) the executor of the
decedent's estate irrevocably waives any estate tax marital
deduction that may be allowed under the Code. In general, the
credit is the lesser of the decedent's unified credit (allowed
under the proposed revised protocol or under U.S. domestic
law), or the estate tax that would otherwise be imposed on the
marital transfer.
The United States by statute allows a foreign tax credit
against U.S. estate tax for foreign estate, inheritance, legacy
or succession taxes (sec. 2014). Imposition of the Canadian
income tax on deemed dispositions at death is not at present
creditable under Code section 2014 (Rev. Rul. 82-82, 82-1 C.B.
127). \4\ Under the proposed revised protocol, the estate of a
U.S. citizen or resident (or the estate of a surviving spouse
with respect to a qualified domestic trust) would receive a
U.S. estate tax credit for the Canadian Federal and provincial
income taxes imposed at the decedent's death with respect to
property situated outside of the United States. The credit is
limited to the amount of U.S. estate tax that is imposed on the
decedent's estate situated outside the United States. Also, no
credit against U.S. estate tax generally may be claimed to the
extent that a credit or deduction for the Canadian tax is
claimed against U.S. income tax.
\4\ The United States by statute also allows a foreign tax credit
against U.S. income tax for foreign income taxes (sec. 901). The
Canadian income tax on deemed dispositions at death generally is
creditable under Code section 901.
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Under the U.S. model estate and gift tax treaty, the United
States exempts the estate of a decedent domiciled in the other
country from U.S. estate tax, except to the extent that the
decedent's estate consists of real property situated in the
United States or assets that are part of the business property
of a permanent establishment or fixed base in the United
States. The proposed revised protocol extends this treatment to
the estate of a Canadian resident (who is not a citizen of the
United States), but only if the value of the decedent's
worldwide gross estate does not exceed $1.2 million.
The Canadian income tax on gain from the deemed disposition
of property of a decedent may be deferred if the property
passes to the surviving spouse or a ``spousal trust,'' provided
that both the decedent and the surviving spouse (or the spousal
trust, as applicable) were residents of Canada immediately
before the decedent's death. The proposed revised protocol
exempts from the gains at death tax deathtime transfers to a
surviving spouse where the decedent was a resident of the
United States immediately before death. Also, under the
proposed revised protocol, the Canadian competent authority may
agree to treat a qualified domestic trust for U.S. estate tax
purposes as a ``spousal trust'' for Canadian tax purposes.
Thus, the proposed revised protocol enables a transfer to a
trust on behalf of a non-U.S. citizen spouse to qualify
simultaneously for the U.S. estate tax marital deduction and
for deferral of the Canadian income tax on gains deemed
realized at death.
Canada, like the United States, generally gives a foreign
tax credit against the income tax only for foreign income tax.
The proposed revised protocol requires Canada to give a
Canadian resident decedent (and a Canadian resident spousal
trust) a limited income tax credit for certain U.S. estate and
inheritance taxes. The credit generally is limited to the
amount of Canadian income tax (after reduction by credit for
U.S. income tax) that is imposed on income that the United
States is entitled (without regard to the saving clause) to
subject to estate tax under the treaty. If the decedent is
subject to U.S. estate tax on property other than that situated
in the United States, the amount of U.S. estate tax that Canada
must credit against income tax is limited to that portion of
the U.S. tax imposed on U.S.-situs property.
(20) Article 20 of the proposed revised protocol requires
the appropriate authorities of Canada and the United States to
consult within 3 years with respect to further reductions in
withholding taxes, and with respect to the limitation on
benefit rules. They are to consult after 3 years also to
determine whether to make the arbitration provision effective
through an exchange of diplomatic notes.
IV. Entry Into Force
The proposed revised protocol will enter into force upon
the exchange of instruments of ratification.
With respect to taxes withheld at source on dividends,
interest, royalties and pensions and annuities (other than
social security benefits), the proposed treaty will be
effective with respect to amounts paid or credited on or after
the first day of the second month after the protocol enters
into force. A phase-down of the withholding rate applies with
respect to certain dividends (if the beneficial owner is a
company, other than a partnership, that holds directly at least
10 percent of the paying company's capital). Under the phase-
down, the rate after the above general effective date and
before 1996 will be 7 percent, and the rate after 1995 and
before 1997 will be 6 percent. Thereafter the rate will be 5
percent.
With respect to other taxes, the proposed revised protocol
generally is to be effective for taxable years beginning on or
after the first day of January after the protocol enters into
force. A different phase-down of the rate will apply to amounts
taxed under Article X, paragraph 6 of the existing treaty
(relating to the branch tax, as amended by the protocol); under
this phase-down, the applicable rate will be 6 percent for
taxable years beginning after the general effective date
(above) and ending before 1997, and 5 percent thereafter.
The provision relating to assistance in collection (Article
15 of the proposed revised protocol) will be effective for
revenue claims finally determined after the date that is 10
years before the date on which the proposed revised protocol
enters into force.
Provisions relating to taxes imposed by reason of death
(Article 19 of the proposed revised protocol, other than
paragraph 1 of Article 19 (relating to property passing to an
exempt organization by reason of an individual's death), and
certain related provisions) generally will be effective with
respect to deaths occurring after the date on which the
proposed revised protocol enters into force. If a claim for
refund is filed within one year after the date on which the
proposed revised protocol enters into force, or within the
otherwise applicable period for filing such claims under
domestic law, then these provisions will be effective with
respect to deaths occurring after November 10, 1988,
notwithstanding any limitation under internal Canadian or U.S.
law on the assessment, reassessment or refund with respect to a
person's return.
V. Committee Action
The Committee on Foreign Relations held a public hearing on
the proposed revised protocol to the income tax treaty between
the United States and Canada, and on other proposed tax
treaties and protocols, on June 13, 1995. The hearing was
chaired by Senator Thompson. The Committee considered the
proposed revised protocol to the income tax treaty between the
United States and Canada on July 11, 1995, and ordered the
proposed revised protocol favorably reported by a voice vote,
with the recommendation that the Senate give its advice and
consent to the ratification of the proposed revised protocol
with the declaration described below.
VI. Committee Comments
The Committee on Foreign Relations approved the proposed
revised protocol with a declaration regarding the exchange of
notes on the treatment of broadcasting royalties under the
proposed revised protocol. The Committee believes that the
proposed revised protocol is in the interest of the United
States and urges that the Senate act promptly to give its
advice and consent to ratification. The Committee has taken
note of certain other issues raised by the proposed revised
protocol, and believes that the following comments may be
useful to U.S. Treasury officials in providing guidance on
these matters should they arise in the course of future treaty
negotiations.
A. Taxes Imposed by Reason of Death
In general
Until 1972, Canada had a succession duty. At that time,
Canada instituted a system under which, instead of imposing an
estate tax, capital property of a decedent is deemed, for
income tax purposes, to have been disposed of immediately
before death. Thus, any gains inherent in capital assets held
at death generally are subject to Canadian income tax (the
``gains at death tax'').\5\
\5\ With respect to certain transfers to spouses or ``spousal
trusts,'' no tax is imposed because the amount deemed realized is the
decedent's basis in the property; the spouse or spousal trust obtains a
carryover basis.
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The United States and Canada previously have been parties
to bilateral estate tax treaties, the last of which was
terminated effective in 1985. Article 19 of the proposed
revised protocol adds a new Article XXIX B to the existing
treaty. The new Article XXIX B once again provides in certain
cases for the reduction of U.S. estate tax on the estate of a
decedent who is a resident of Canada; it would also in certain
cases provide for the reduction of the Canadian income tax on
gains deemed realized at death with respect to the estate of a
person that is liable for U.S. estate tax.
A principal purpose of the proposed revised protocol is to
coordinate the U.S. estate tax with the Canadian gains at death
tax. In this respect, the proposed revised protocol is unique;
it is the first time the United States has entered into a tax
treaty covering estate taxes with a country that does not
impose an estate or inheritance tax. The Committee believes
that the unique coordination of the two death tax regimes is
warranted, given the special relationship between the United
States and Canada. The Committee wishes to stress, however,
that the coordination of the two death tax regimes under the
proposed revised protocol should not be viewed as a precedent
in future treaty negotiations with other countries that do not
impose estate or inheritance taxes. In this connection, at the
hearing the Committee queried the Treasury Department and
received the following response by letter to Senator Thompson
dated July 5, 1995:\6\
\6\ Letter from Assistant Secretary of the Treasury (Tax Policy),
Leslie B. Samuels to Senator Fred Thompson, Committee on Foreign
Relations, July 5, 1995 (``July 5, 1995 Treasury letter'').
2. Is the coordination of [the U.S. estate tax and
the Canadian gains at death tax] necessary? If so, are
the concessions granted by the U.S. appropriate to
achieve coordination?
We believe that coordination of the U.S. and Canadian
death tax regimes is necessary and that the Protocol
accomplishes this coordination in an appropriate
manner. Like the United States, Canada imposes a
substantial tax at death. In many cases, both the U.S.
and the Canadian death taxes apply to a particular
transfer of property at death. This can result in
double taxation at a combined tax rate of more than 75
percent, even where the property is transferred to a
surviving spouse. The laws of the two countries do not
relieve such double taxation because the Canadian death
tax is structured as an income tax at death, while the
United States imposes an estate tax. Treaty relief is,
therefore, necessary.
The death tax provisions of the Protocol are narrowly
targeted and are drafted reciprocally where necessary.
Each country agrees to allow an appropriate credit for
the death taxes imposed in the other country. The pro
rata unified credit and marital credit allowed by the
United States are limited in amount and linked to the
estate tax exposure of the particular case. In return,
Canada agreed to allow unlimited deferral for transfers
to surviving spouses and, in appropriate cases, for
transfers to spousal trusts. The limited waiver of U.S.
estate tax on certain types of property provides some
reciprocity to Canada and is consistent with provisions
in U.S. estate tax treaties; Canada already waives its
death tax, without limitation, on the same types of
property under the current treaty.
A comprehensive tax treaty cannot be evaluated based
on only one of its provisions. However, the substantial
benefits that this provision will provide to residents
of both countries represent an important factor
weighing in favor of approval of this Protocol.
Charitable bequests
Under paragraph 1 of new Article XXIX B, a charitable
bequest by a resident of either the United States or Canada to
a qualifying exempt organization of the other country is
treated as if the exempt organization were a resident of the
first country. A similar provision already exists for income
tax purposes under Article XXI of the existing treaty between
the United States and Canada. Thus, although this provision
appears on its face to grant reciprocal benefits, it is in
effect only a concession by the United States to allow a U.S.
estate tax deduction for charitable bequests by a Canadian
resident to a qualifying Canadian resident organization.7
Charitable bequests by Canadian residents to qualifying U.S.
resident organizations already are deductible from the Canadian
gains at death tax under the terms of the existing treaty.
\7\ Under Code section 2055, charitable bequests by a U.S. citizen
or resident to a qualifying Canadian resident organization are
deductible for U.S. estate tax purposes in determining the decedent's
taxable estate.
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It is anticipated that the determination of an
organization's exempt status for purposes of this charitable
bequest provision is made in the same manner as under the
provisions of Article XXI of the existing treaty for income tax
purposes.
Pro rata unified credit
In TAMRA, Congress passed Code section 2102(c)(3) which
permits a ``pro rata'' unified credit for nonresidents to the
extent provided by treaty. The pro rata unified credit equals
the unified credit allowed to U.S. citizens and residents,
multiplied by the fraction of the total worldwide gross estate
situated in the United States. Paragraph 2 of new Article XXIX
B provides such a pro rata unified credit to Canadian residents
who are not U.S. citizens.8
\8\ The saving clause of the proposed revised protocol preserves
the ability of the United States to reduce the unified credit allowable
to $13,000 under Code section 2107 with respect to citizens who have
expatriated to Canada within the past ten years.
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This is the first time that a pro rata unified credit has
been granted under a treaty with a treaty partner that does not
itself impose an estate or inheritance tax. The Committee
believes that the special relationship between Canada and the
United States warrants the grant of the pro rata unified credit
to Canadian residents who are not U.S. citizens. The Committee
wishes to stress that this treatment should not be viewed as a
precedent in future treaty negotiations with other countries
that do not impose an estate or inheritance tax.
Under the proposed revised protocol, assets exempted from
the estate tax under the Canadian treaty (e.g., under paragraph
8 of new Article XXIX B) arguably are treated as ``situated in
the United States'' and thus are still taken into account in
the numerator for purposes of computing the pro rata unified
credit. A proposed technical correction to Code section
2102(c)(3) that is currently under consideration by the
Congress would clarify that, in determining the pro rata
unified credit under a treaty, property exempted by the treaty
from U.S. estate tax would not be treated as situated in the
United States.9 The Committee wishes to clarify its
understanding that the question of whether property is situated
in the United States for purposes of this provision of the
proposed revised protocol is determined under U.S. domestic
law. Thus, the Committee intends and believes that, if the
proposed technical correction is adopted, property exempted by
the Canadian treaty would not be treated as situated in the
United States and therefore would be excluded from the
numerator for purposes of computing the pro rata unified credit
under the proposed revised protocol.
\9\ H.R. 1215, as passed by the House, 104th Cong., 1st Sess.
(1995), section 604(f)(1) (1995).
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Estate tax marital credit for Canadian residents
To determine the taxable estate of a decedent for U.S.
estate tax purposes, a deduction generally is allowed for the
value of any property that passes to his or her surviving
spouse. TAMRA, however, eliminated this marital deduction where
the surviving spouse is not a U.S. citizen (except for
transfers to a ``qualified domestic trust'' (``QDOT'') 10
or where the surviving spouse becomes a U.S. citizen). Several
countries have sought U.S. treaty relief from this TAMRA
provision, including some countries with pre-TAMRA U.S. estate
tax treaties that have provisions relating to the marital
deduction. The proposed revised protocol contains the first
agreement by the United States to provide such relief. The
Committee believes that the granting of the marital deduction
in the proposed revised protocol is appropriate in part because
of the special relationship between the United States and
Canada, and should not necessarily be viewed as a precedent by
other countries seeking similar relief.
\10\ A trust may qualify as a QDOT if it has at least one trustee
that is a U.S. citizen or a domestic corporation and if no
distributions of corpus can be made unless the U.S. trustee may
withhold the tax from those distributions. Code section 2056A.
Under the proposed revised protocol, Paragraphs 3 and 4 of
new Article XXIX B provide a marital credit against the U.S.
estate tax on property passing to a noncitizen spouse if the
decedent and the surviving spouse meet certain requirements
regarding residency and citizenship. In addition, the credit is
available only if the executor of the decedent's estate
irrevocably waives the benefits of any estate tax marital
deduction that may otherwise be allowed.
The credit allowed under the treaty equals the lesser of
(1) the same amount as the pro rata unified credit allowable
under the proposed revised protocol or under U.S. domestic law,
and (2) the amount of the U.S. estate tax that would otherwise
be imposed on the qualifying property transferred to the
spouse. The marital credit is in addition to any amount
exempted by the unified credit. Thus, the marital credit
effectively grants couples covered by the treaty a
proportionate share (based on the portion of their gross estate
situated in the U.S.) of the same aggregate $1.2 million estate
tax exemption allowed to U.S. citizen couples.11 This
provision is similar to the approach taken in recent proposed
legislation to grant a limited marital transfer credit to
employees of ``qualified international organizations.'' (See,
for example, H.R. 1401, 104th Cong., 1st Sess. (1995).) The
credit amount also generally is sufficient to resolve a
principal area of concern--the reduction of the estate tax
burden on transfers of personal residences and retirement
annuities.
\11\ Because of the graduated estate tax rate structure, full
availability and use of both credits will never completely shelter the
U.S. estate tax on a $1.2 million gross estate. See example 2 of the
Technical Explanation.
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Treatment of certain transfers to spouses
For purposes of the Canadian gains at death tax, Canada
grants an exemption for transfers to surviving spouses and
``spousal trusts,'' provided that both the decedent and the
spouse (or the spousal trust, as applicable) were residents of
Canada immediately before the decedent's death. Thus, under
present Canadian law, a transfer from a Canadian resident
decedent to a U.S. resident spouse or from a U.S. resident
decedent to a Canadian resident spouse does not qualify for the
marital exemption.12 Under the proposed revised protocol,
Paragraph 5 of new Article XXIX B exempts from the gains at
death tax deathtime transfers to a spouse where the decedent
was a resident of the United States immediately before death.
Thus, transfers from a U.S. resident decedent to a Canadian
resident spouse (or for that matter a spouse with any
residence) qualifies for exemption. The converse, however, is
not true--a transfer from a Canadian resident decedent to a
U.S. resident spouse does not qualify for exemption.
\12\ Nonresidents generally are subject to the gains at death tax
on certain Canadian situs property.
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Under Canadian domestic law, a spousal trust is treated as
resident in Canada if the trustee is a Canadian resident or a
Canadian corporation. Upon request by a U.S. resident trust,
the Canadian competent authority may agree, under the proposed
revised protocol, to treat the trust as a Canadian resident
trust (i.e., by treating its trustee as a Canadian resident)
for purposes of the exemption from the gains at death tax. The
Canadian competent authority also can refuse to grant treatment
as a Canadian resident trust if the trust does not meet ``terms
and conditions satisfactory to such competent authority.'' The
Technical Explanation states that this provision is ``intended
to enable a trust that is a qualified domestic trust for U.S.
estate tax purposes to be treated at the same time as a spousal
trust'' for purposes of the Canadian gains at death tax.
Canadian gains at death tax credit for estate tax credit
Paragraph 6 of new Article XXIX B is a reciprocal
concession by Canada for the U.S. estate tax credit granted
under paragraph 7 of new Article XXIX B for payments of the
Canadian gains at death tax. Under this paragraph 6, Canadian
residents and Canadian resident spousal trusts receive a credit
for U.S. estate taxes and state inheritance taxes imposed with
respect to U.S. situs property. The credit is only available
where the U.S. tax is imposed upon the decedent's death or, in
the case of a spousal trust, upon the death of the surviving
spouse. Thus, for reasons similar to those discussed below with
respect to paragraph 7, availability of the credit for U.S.
estate and inheritance taxes is dependent upon when the
relevant taxes are imposed. In situations where the taxes are
imposed between the deaths of the two spouses, the credit
apparently is not available (absent competent authority
relief).
Estate tax credit for Canadian gains at death tax
Under the proposed revised protocol, Paragraph 7 of new
Article XXIX B provides in certain cases a U.S. estate tax
credit for the Canadian Federal and provincial gains at death
taxes. The credit is available only with respect to (1) a U.S.
estate tax that is imposed either by reason of the death of an
individual who was a U.S. citizen or resident at the time of
the decedent's death, or (2) the U.S. estate tax imposed with
respect to property remaining in the QDOT at the time of the
death of the surviving spouse.
To qualify for the credit, the Canadian taxes must be
imposed at the death of the decedent, or the death of the
surviving spouse in the case of taxes imposed with respect to
property remaining in the QDOT. In addition, the Canadian gains
at death taxes must be imposed on property situated outside the
United States which is subject to the U.S. estate tax. The
Canadian gains at death taxes are creditable against the U.S.
estate tax regardless of whether the taxable event and the
identity of the taxpayer are the same under Canadian law as
under U.S. law. The amount of the allowable credit is computed
in accordance with the provisions and subject to the
limitations of U.S. internal law, except that the Canadian
gains at death tax will be treated as ``a creditable tax''
under U.S. internal law as if it were a death tax rather than
an income tax.
The proposed revised protocol generally prevents a taxpayer
from taking either a deduction or a credit for the same
Canadian death tax against both his U.S. income tax and his
estate tax liability. An exception will be available for the
estate tax imposed on the QDOT at the death of the surviving
spouse. No interest will be paid on any refunds of U.S. tax
resulting from the credit for Canadian gains at death taxes.
Marital transfers
Under the proposed revised protocol, the availability of
the Canadian gains at death tax credit will be dependent upon
when the U.S. estate tax is imposed and when the Canadian gains
at death tax is imposed. There are nine different combinations
of when these two taxes can be imposed with respect to marital
transfers.13 The following discussion illustrates each of
these possible combinations and the tax consequences of each
under the proposed revised protocol. For purposes of each
example, assume the following facts: an individual resident of
the United States owns Canadian real property; the individual's
spouse is not a U.S. citizen; the credit, if available, would
be claimed within the 4-year limitation period under Code
section 2014(e); 14 and U.S. tax is not eliminated by the
application of any available credits under the proposed revised
protocol and U.S. internal law.15
\13\ The nine different combinations arise because the U.S. estate
tax can be imposed on a marital transfer at three different times (date
of death of first spouse, corpus distributions from QDOT between the
deaths of spouses, and the date of death of second spouse) and the
Canadian gains at death taxes also can be imposed at three different
times (date of death of first spouse, sale of assets by spousal trust
between deaths of spouses, and the date of death of second spouse).
\14\ Under Code section 2014(e), the credit for foreign death taxes
generally is only allowed with respect to foreign death taxes that are
paid and for which credit is claimed within 4 years after the filing of
the estate tax return.
\15\ The hypothetical situations described below as possibly
resulting in the timing results at issue are included only as examples,
and are not meant to suggest that other facts would not also be
accompanied by the same timing results. Furthermore, the analysis
provided in each case only pertains to the specific fact patterns
described.
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(1) U.S. estate tax and Canadian gains at death tax both
imposed at death of first spouse
This result could occur where there is a marital bequest to
a trust, the QDOT election is not made, and the trust does not
qualify for carryover basis under Canadian law (e.g., the
Canadian competent authorities do not agree to treat the trust
as a spousal trust).16 In such a case, both U.S. estate
tax and Canadian death tax are imposed at the death of the
first spouse.
\16\ This is also the typical non-marital case in which a decedent
passes away and his assets are inherited by someone other than his
spouse; no deferral of either the U.S. estate tax or the Canadian death
tax is available.
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A foreign death tax credit would be allowed under the
proposed revised protocol for the Canadian death tax imposed on
the estate of the first spouse. All the conditions stipulated
by the proposed revised protocol are satisfied.
(2) U.S. estate tax imposed at death of first spouse;
Canadian gains at death tax imposed on sale of
assets between death of spouses
This case might arise where the property is transferred to
a trust that meets the spousal trust requirements for Canadian
tax purposes, but no QDOT election is made for U.S. tax
purposes. The trust subsequently sells the property before the
second spouse dies.
The amount of Canadian death tax would not automatically be
allowed as a credit under the proposed revised protocol,
because the Canadian gains at death tax is not imposed at the
death of either the first or second spouse. However, the
competent authorities of the two countries may decide to grant
relief under the proposed revised protocol.17 This
analysis holds for all of the scenarios where the Canadian
gains at death tax is imposed on the sale of an asset between
the date of the two spouses' deaths (scenarios (5) and (8)
below).
\17\ Article 14 of the proposed revised protocol states that
competent authority relief may be sought in cases where double taxation
results from differences in the tax laws of the United States and
Canada due to ``dispositions or distributions'' of property by a QDOT
or a spousal trust.
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(3) U.S. estate tax imposed at death of first spouse;
Canadian gains at death tax imposed on death of
second spouse
This case might arise where the property is transferred to
a trust that meets the spousal trust requirements for Canadian
tax purposes, but no QDOT election is made for U.S. tax
purposes and the trust holds the property until the second
spouse dies.
The Committee understands that a foreign death tax credit
would be allowed in this case under the proposed revised
protocol for the Canadian death tax imposed on the spousal
trust.
(4) U.S. estate tax imposed on corpus distributions from
QDOT; Canadian gains at death tax imposed at death
of first spouse
This case might arise where the property is transferred to
a trust that meets the requirements of a QDOT, but not those of
a Canadian spousal trust (e.g., the Canadian competent
authorities do not agree to treat the trust as a spousal
trust), and there is a corpus distribution between the spouses'
deaths.
The credit for Canadian gains at death taxes apparently
would not be allowed automatically under the proposed revised
protocol because the U.S. estate tax (against which the
Canadian tax would be credited) is not imposed by reason of the
death of the first spouse or imposed on the QDOT upon the death
of the surviving spouse. Rather, the U.S. estate tax sought to
be reduced is being imposed on the QDOT under Code section
2056A(b)(1)(A) on the distribution of property from the QDOT.
Thus, a credit would be allowable only if the QDOT tax imposed
under Code section 2056A(b)(1)(A) is determined to be the same
as imposition of the estate tax upon the death of the first
spouse. It does not appear that this is the result under either
the internal U.S. law or the proposed revised protocol.
As discussed previously, competent authority relief may be
available under the proposed revised protocol.
(5) U.S. estate tax imposed on corpus distributions from
QDOT; Canadian gains at death tax imposed upon sale
of assets between spouses' deaths
This case is likely to occur where property is transferred
to a trust which qualifies as both a QDOT for U.S. estate tax
purposes and a spousal trust for Canadian death tax purposes,
and the trust sells the property and distributes the proceeds
to the second spouse before his or her death.
The credit for Canadian gains at death taxes would not be
available automatically under the proposed revised protocol for
two reasons. First, as in scenario (4), the U.S. estate tax is
not imposed by reason of the death of either spouse. In
addition, as in scenario (2), the Canadian tax also is not
imposed by reason of the death of either spouse. However, as
discussed previously, competent authority relief may be
available under the proposed revised protocol.
(6) U.S. estate tax imposed on corpus distributions from
QDOT; Canadian gains at death tax imposed at death
of second spouse
This case might arise where the trustee of the QDOT/spousal
trust distributed property in-kind to the second spouse. There
would be U.S. estate tax on the corpus distribution, but there
may not be a Canadian capital gains tax until there is a
disposition of the property by the second spouse or the second
spouse dies.
As in scenario (4), the credit apparently would not be
available automatically because the U.S. estate tax is not
imposed upon the death of either spouse. Competent authority
relief may be available.
(7) U.S. estate tax imposed at death of second spouse;
Canadian gains at death tax imposed at death of
first spouse
This case may occur where the property is transferred to a
trust that meets the requirements of a QDOT, but not those of a
Canadian spousal trust (e.g., the Canadian competent
authorities do not agree to treat the trust as a spousal
trust), and the trust holds the property without distributions
until the death of the second spouse.
A credit would be allowed under the proposed revised
protocol for the Canadian gains at death tax imposed on the
estate of the first spouse. All the conditions of the proposed
revised protocol are satisfied.
(8) U.S. estate tax imposed at death of second spouse;
Canadian gains at death tax imposed on sale of
assets between death of spouses
This case is likely to arise where property in the QDOT/
spousal trust is sold and the proceeds retained in the trust
until the death of the second spouse.
The credit would not be available automatically because the
Canadian tax is not imposed upon the death of either spouse. As
under scenario (2), competent authority relief may be sought.
(9) Both U.S. estate tax and Canadian gains at death tax
imposed at death of second spouse
This is the typical case of the QDOT/spousal trust that
holds the property throughout the remaining lifetime of the
second spouse. There will be a U.S. QDOT estate tax and a
Canadian death tax imposed at the death of the second spouse.
A credit would be allowed under the proposed revised
protocol for the Canadian gains at death taxes imposed on the
spousal trust on the death of the second spouse. All the
conditions required by the proposed revised protocol are
satisfied.
Estate tax exemption for small estates
Paragraph 8 of new Article XXIX B limits the U.S. estate
tax that could be imposed on Canadian residents with small
gross estates. Under this provision, if the worldwide estate of
a Canadian resident is equal to or less than $1.2 million, the
U.S. estate tax will apply only to any U.S. real estate or U.S.
business property of a permanent establishment or fixed base in
the United States. Gains on those two types of property are the
only gains on which the situs country is permitted to impose
income tax, including the gains at death tax, under Article
XIII of the existing treaty.
Paragraph 8 is similar to a provision contained in the U.S.
model estate tax treaty and other U.S. estate tax treaties,
except that those treaties generally do not impose a limitation
on the size of the estate. The provision in the model treaty
(and other similar treaties) are reciprocal concessions granted
with respect to each country's estate tax. Because Canada
imposes no estate tax, the concession in Paragraph 8 relates
only to U.S. estate tax; however, as noted above, Canada
already grants a similar concession with respect to the gains
at death tax under the existing treaty. The Committee believes
that this concession is appropriate given the special
relationship between the United States and Canada. This
concession should not necessarily be viewed as a precedent in
future treaty negotiations with countries that do not impose an
estate or inheritance tax.
This provision benefits individuals with small estates who
are treated as residents in the United States at death under
U.S. internal estate tax law, but are treated as Canadian
residents under the treaty.\19\ This provision, however,
provides no benefit to a decedent who is a U.S. resident under
the treaty definition but not under the U.S. estate tax
definition. Such a person does not qualify for the small estate
exemption; only Canadian residents (as defined by the treaty)
may qualify.
\18\ This can occur, because as noted above, the existing treaty
and proposed revised protocol use an income tax definition of
residency, rather than an estate tax definition.
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Effective date
The provisions of the proposed revised protocol relating to
taxes imposed at death generally are effective on a prospective
basis. At the election of the taxpayer, however, all of these
provisions (other than paragraph 1 applicable to charitable
bequests) can be applied retroactively to the date of the
enactment of TAMRA.\19\ Thus, the retroactive effective date
applies reciprocally to the concessions made by the United
States and the concessions made by Canada. Moreover, the
retroactive relief applies even to provisions that are not
aimed at providing TAMRA relief. For example, under the
proposed revised protocol, the estate of a Canadian resident
who had a small estate may be retroactively eligible for a
refund of estate taxes previously paid with respect to assets
exempted from U.S. estate tax under paragraph 8.
\19\ To qualify, a taxpayer must file a claim for refund by the
later of one year from the date that the proposed revised protocol
enters into force or the date that such a claim must be filed under
Canadian or U.S. law, as applicable.
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According to the Technical Explanation, the negotiators of
the treaty believed that, while ``it is unusual for the United
States to agree to retrospective effective dates,''
retroactivity was justified in this case ``given the fact that
the TAMRA provisions were the impetus for negotiation of the
Protocol and that the negotiations commenced soon after the
enactment of TAMRA.'' The Committee wishes to clarify that
retroactive relief is desirable, in part, because of the
special relationship between the United States and Canada and
should not necessarily be viewed as a precedent by other
countries.
b. Royalties
In general
The proposed revised protocol restricts source country
taxation of royalties to a greater extent than the existing
treaty, although not to the extent provided for in the U.S.
model. Compared to the existing treaty, the proposed revised
protocol expands the categories of royalties that are exempt
from source-country taxation, and modifies the rule for
determining the source of royalty payments.
As discussed in Part III., above, the existing treaty
contains a two-tier (10-percent or exempt) limitation on
source-country taxation of royalties. The proposed revised
protocol expands the type of royalties that are eligible for
exemption from source country taxation. The expanded category
of exempt royalties expressly includes payments for the use of,
or the right to use, computer software, patents, and
information (unless provided in connection with a rental or
franchise agreement) concerning industrial, commercial or
scientific experience.
``Shrink wrap'' software
Internal Revenue Service (``IRS'') has issued a private
letter ruling holding that no U.S. withholding tax is due on
outbound software royalties paid by a U.S. person under a
treaty like the existing treaty.\20\ Furthermore, prior to the
conclusion of the negotiation of the proposed revised protocol,
the Canadian government issued a ruling that exempted from
withholding royalty payments made by a taxpayer with respect to
``shrink wrap'' software sold under a general license. This
result was adopted as policy later in 1994. Thus, the inclusion
of software royalties under the exempt category in the proposed
revised protocol may have little practical effect with respect
to ``shrink wrap'' royalties, because they appear to be exempt
from Canadian withholding tax under current Canadian law or
practice. This result is not the case with respect to other
types of software royalties, however.
\20\ Private letter rulings relate to particular taxpayers and are
not intended to be used or cited as precedent. In PLR 9128025 (April
12, 1991), the IRS held that payments by a U.S. distributor of computer
software to a foreign developer of the software, under a license to
reproduce the developer's software in the United States, are exempt
from U.S. withholding tax under the applicable treaty. Although the
identity of the applicable tax treaty was not revealed in the ruling,
the language of the article that the IRS relied on for the applicable
treaty is identical to the text of the existing treaty with Canada.
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Bifurcation
The proposed revised protocol extends the exemption rate on
royalties to cover amounts paid for the use of patents and
certain know how. Contrary to the U.S. model and the provisions
of many U.S. tax treaties with other industrial nations, no
similar relief is available for royalties on trademarks, which
will continue to be taxed at a 10-percent rate.
The Technical Explanation indicates that in a case where
royalties are paid for a bundle of rights in a mixed contract
or similar arrangements, some of which, by themselves, would be
exempt from source-country taxation, and others would be
taxable, exemption would apply to those royalties to the extent
that they are paid for the former. This is the first time that
the United States has explicitly confirmed in the Technical
Explanation a requirement of bifurcating a single payment of
royalties into a tax-exempt and a taxable portion in a
bilateral treaty.\21\ Hence, there is no precedent to determine
whether the policy may work effectively. It can be argued that
the concept of un-bundling royalties attributable to a bundle
of rights including both trademark and know-how rights applies
an arms-length principle in the very type of case where an
arms-length principle is least effective; that is, where the
intangible may be unique.
\21\ Other U.S. tax treaties provide that different classes of
royalties are subject to differing rates. For example, the treaty with
Spain provides for a 10 percent rate on trademark royalties and an 8
percent rate for royalties with respect to know-how. This 2-percent
spread in rates for two different types of taxable royalties may not,
however, have the same impact as treating one type as exempt from tax
and the other as taxable at a 10-percent rate, as under the proposed
revised protocol.
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As part of its consideration of the proposed revised
protocol, the Committee asked the Treasury Department to
address the Committee's concern that the bifurcation notion is
likely to cause uncertainty and to be difficult for taxpayers
to apply in practice. The Committee also made clear that it
supports the efforts of the Treasury Department to reduce to
zero the withholding rates on all royalties, and asked the
Treasury Department to address the Committee's concern that the
bifurcation approach of the proposed revised protocol has the
potential to erode a zero-withholding-rate policy in future
treaty negotiations.
In its July 5, 1995 letter to Chairman Helms explaining the
royalty provisions of the proposed revised protocol in greater
detail, the Treasury Department wrote:
July 5, 1995.
Hon. Jesse A. Helms,
U.S. Senate,
Washington, DC.
Senator Helms: At the June 13th hearing before the
Committee on Foreign Relations regarding the pending tax
conventions and protocols, you asked us to provide you with a
letter explaining the royalty provisions of the Protocol with
Canada in greater detail. I am writing in response to that
request.
Although the provisions of the Protocol do not fully
reflect the U.S. policy of exemption for all royalties, they
represent a substantial improvement over our current Income Tax
Convention with Canada. Under the current Convention, most
types of cross-border royalty payments are subject to tax in
the country of source at a rate of 10 percent. The United
States made this a major issue in the Protocol negotiations and
did persuade Canada to exempt most types of royalties from
source country taxation.
Royalties paid for the use of trademarks remain subject to
a withholding tax of 10 percent because Canada was unwilling to
grant a complete exemption at this time. Canada did agree,
however, to discuss further reductions in withholding within
three years of the date on which the Protocol enters into
force. The Treasury Department intends to continue to pursue a
zero rate of withholding for all royalties in future
negotiations with Canada, as well as with other countries.
In the meantime, we are confident that the provisions of
the Protocol can be administered satisfactorily to determine
the proper taxation of ``bundled'' royalty payments. A number
of our existing treaties provide different rates of tax for
various classes of royalties. Our recent treaty with Spain, for
example, actually provides three different rates. We are not
aware of any problem under these treaties in dividing a
payment, where necessary, into separate classes.
The Treasury Department Technical Explanation to the
Protocol with Canada explicitly confirms that ``bundled''
royalty payments may be bifurcated to obtain a zero rate of
withholding on the exempt portion, and that the United States
and Canada will work together in good faith to resolve any
administrative issues that may arise. As indicated by the
attached press release, the Canadian Government has confirmed
in advance that it fully agrees with the understandings
reflected in our Technical Explanation.
Please let me know if you have any further questions
regarding these provisions.
Sincerely yours,
Leslie B. Samuels,
Assistant Secretary (Tax Policy).
Similarly, in the July 5, 1995 Treasury letter (to Senator
Thompson) responding to various questions that were raised as
part of the Committee's consideration of the proposed revised
protocol, the Treasury Department stated:
1. How will the current procedures adequately
determine proper taxation where royalties are paid for
in a bundle of rights in a contract that mixes
trademarks taxable at the 10 percent rate and the
exempt royalties?
We do not anticipate problems in determining the
proper taxation of ``bundled'' royalty payments. A
number of our existing treaties provide different rates
of tax for various classes of royalties. Our recent
treaty with Spain actually provides three different
rates. We are not aware of any problem that has arisen
under these treaties in dividing a payment, where
necessary, into separate classes.
The Treasury Department Technical Explanation to the
Protocol with Canada (to which Canada has agreed)
explicitly assures taxpayers that ``bundled'' royalty
payments may be bifurcated and that the United States
and Canada will work together to resolve any
administrative issues that may arise in applying the
royalty provisions of the Protocol.
Thus, while the Treasury Department has assured the
Committee that the provisions of the proposed revised protocol
that call for a differentiated rate of taxation on royalties
will be administered satisfactorily to determine the proper
taxation of ``bundled'' royalty payments, the Committee
emphasizes its concern that in addition to its potential to
erode a zero withholding-rate policy with respect to royalties,
such differentiation creates administrative burdens that have
not been identified clearly prior to Senate ratification. The
Committee would like to be further assured of the
administrability of this unique provision in actual operation.
Exchange of notes regarding broadcasting royalties
The proposed revised protocol permits the treaty countries
to agree, through an exchange of diplomatic notes (that is,
without any additional treaty ratification procedures), to
expand further the exempt category to cover payments with
respect to broadcasting. The Committee is extremely concerned
about the self-executing nature of this provision,\22\
notwithstanding the fact that the treaty modification
authorized to be effective without further ratification
procedures would conform the treatment of certain royalties to
the preferred U.S. position.
\22\ The approach taken in the proposed revised protocol differs,
for example, from the approach taken in the proposed treaty and
protocol with Kazakhstan. There, the proposed revised protocol
explicitly refers to a future change to a significant term of the
treaty (i.e., a lower rate of withholding tax would be applicable
between the United States and Kazakhstan if any lower rate is agreed to
in a treaty between Kazakhstan and another OECD country), but the
Memorandum of Understanding indicates that such change would be subject
to ratification by the United States and by Kazakhstan.
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Therefore, the Committee recommends that the Senate give
its advice and consent to the proposed revised protocol with
the declaration that the Treasury Department shall inform the
Committee as to the progress of all negotiations with and
actions taken by Canada that may affect the application of the
provision of the proposed revised protocol relating to payments
with respect to broadcasting as may be agreed in an exchange of
notes between the United States and Canada.
The Committee does not favor an approach under which
changes to the terms of a treaty or protocol are made without
the subsequent advice and consent of the Senate. The Committee
recognizes, however, that the unique relationship that the
United States has with Canada, our major trading partner and a
nation with which the United States has a long, cordial
relationship, justifies acceptance of this particular provision
in this particular case, with the declaration described above.
The Committee strongly disapproves of taking this type of
approach in future treaty negotiations.
Source rules
Existing treaty
The existing treaty includes a source rule for royalties
which sources royalties by place of use, if the place of use is
Canada or the United States. Similarly, U.S. internal law
sources royalties based on the place of its use (even if the
place of use is outside the United States or Canada). For
example, if a U.S. resident pays a royalty to a Canadian
resident for the right to use intangible property exclusively
in Mexico, then under internal U.S. law the Canadian resident
has received no U.S. source income, and no U.S. tax under Code
sections 871, 881, 1441, or 1442 applies to the royalty. On the
other hand, if the same Canadian resident receives a royalty
from a Mexican resident for the right to use intangible
property exclusively in the United States, then under both U.S.
internal law and the existing U.S.-Canada treaty, the Canadian
resident has received U.S. source income despite the absence of
a payment from a U.S. person.23 As a result, the Code will
impose a U.S. gross-basis tax at the 10-percent rate provided
in the existing treaty.24
\23\ Under the U.S.-Mexico treaty, such a royalty would be treated
as arising from sources in Mexico.
\24\ There may be no U.S. withholding agent to collect and pay over
the tax, however.
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If a Canadian resident pays a royalty to a U.S. resident
for the right to use intangible property exclusively in the
United States, then under internal U.S. law that royalty
generates U.S. source income and does not increase the U.S.
resident's foreign tax credit limitation. Under the existing
treaty that income generally would not be taxable by Canada.
Under the elimination of double taxation article, that income
generally would be treated as arising in the United States.
Only where the payment is made by a resident of the United
States or Canada, for the right to use the property outside the
United States or Canada, does the existing treaty source
royalties outside the country of use. In that case the existing
treaty sources the royalty by reference to the country where
the payor resides (or where the payor has a permanent
establishment or fixed base, if the royalty was incurred and
borne by the permanent establishment or fixed base). And if the
rule sourcing the royalty outside the country of use is
applicable, then under the elimination of double taxation
article, the royalty will only be deemed to arise in a treaty
country if the treaty otherwise authorizes taxation of the
royalty by that country. For example, if a resident of Canada
pays a copyright royalty to a U.S. resident for the right to
use a literary work exclusively in the United Kingdom, and
neither person has a permanent establishment or fixed base in
the country in which the other person resides, then
notwithstanding that the royalty may be sourced in Canada under
the existing royalty provision, it is not deemed to arise in
Canada under the elimination of double taxation article,
because Canada generally is precluded by treaty from taxing a
literary royalty paid to a U.S. resident.
Proposed revised protocol
The proposed revised protocol reverses the source rules in
the existing treaty. It replaces the source rule in the
existing treaty with a provision similar to the corresponding
provision in several U.S. treaties, including the U.S. treaties
with Australia, New Zealand, and Mexico. In general, the
proposed revised protocol sources a royalty by reference to the
country where the payor resides (or where the payor has a
permanent establishment or fixed base, if the royalty was
incurred and borne by the permanent establishment or fixed
base). Only when the payor is not a resident of the United
States or Canada are royalties sourced on the basis of the
place of use of the property. As a result, then, the general
royalty source rule under the proposed revised protocol
(sourced at residence of the payor) differs from the internal
U.S.-law rule (sourced at place of use).
For example, if a Canadian resident (who has no permanent
establishment in the United States) pays a royalty to a U.S.
resident for the right to use intangible property exclusively
in the United States, then under internal U.S. law, that
royalty generates U.S. source income and does not increase the
U.S. resident's foreign tax credit limitation. However, under
the proposed revised protocol, that income could be subject to
Canadian tax. If so, then under the elimination of double
taxation article, that income would also be treated as arising
outside the United States. The Committee believes that under
current business practices, this situation would arise in
relatively few cases (compared to the more common presence of a
permanent establishment in the country where the property is
used).
The effect of this provision is that certain royalty
payments that are treated as U.S. source income under both the
existing treaty and U.S. internal law would be treated, under
the proposed revised protocol, as foreign source income. This
change prevents the United States from imposing withholding tax
on some royalties on which U.S. tax may currently be imposed
(as in the above example, where a resident of Canada with no
permanent establishment in the United States pays royalties to
a resident of the United States, for the use of property in the
United States). In addition, treating such royalty income as
foreign source income can enhance a U.S. taxpayer's foreign tax
credit limitation. A U.S. taxpayer that has excess foreign tax
credits may offset the U.S. tax imposed on such income, causing
further erosion of the U.S. tax base.25
\25\ While the proposed revised protocol will permit the United
States to impose tax in the reverse situation (where a resident of the
United States pays royalties to a resident of Canada for the use of
property in Canada), no U.S. withholding tax will actually be imposed
under internal U.S. law.
Under Article XXIX of the existing treaty (Miscellaneous
Rules), a Canadian resident may elect to be taxed under the
U.S. internal rules to determine the source of the income, to
the extent it is favorable.26 Such an election may be made
by a Canadian resident who receives a royalty for the use of
property outside the United States that is paid by a U.S.
person. The Committee has been assured, however, that under
current business practices, this situation will arise in
relatively few cases (compared to the currently more common
situation in which a U.S. resident receives a royalty for the
use of property outside the United States that is paid by a
Canadian person).
\26\ As stated in the Technical Explanation, however, ``under a
basic principle of tax treaty interpretation recognized by both
Contracting States, the prohibition against so-called `cherry-picking,'
the Canadian resident would be precluded from claiming selected
benefits under the Convention (e.g., the tax rates only) and other
benefits under U.S. domestic law (e.g., the source rules only) with
respect to its royalties.'' (Technical Explanation at 12.)
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Finally, the fact that the proposed revised protocol
changes the source of the royalty payments might induce a
third-country resident to try to use the unusual royalty source
rules of the proposed revised protocol to avoid U.S. tax. This
might be attempted, for example, by structuring a license
through a Canadian company that qualifies for derivative
benefits under the proposed revised protocol, as discussed
below. Because the source rules in the proposed revised
protocol differ from most other U.S. treaties, taxpayers may
seek to take advantage of the inconsistencies among U.S.
treaties in structuring licensing arrangements.27 The
Committee does not favor such inconsistencies in the source
rules, but believes that the opportunity to achieve this result
is limited as a practical matter.
\27\ See also the discussion of the derivative benefits rule in
Part VI. C., below, of this report, (relating to ``Limitation on
Benefits'').
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c. limitation on benefits
In general
The proposed revised protocol is intended to limit double
taxation caused by the interaction of the tax systems of the
United States and Canada as they apply to residents of the two
countries. At times, a person who is not a resident of either
country seeks certain benefits under the income tax treaty
between the two countries (referred to as ``treaty shopping'').
Under certain circumstances, and without appropriate
safeguards, the nonresident is able indirectly to secure these
benefits by establishing a corporation (or other entity) in one
of the countries. Such an entity, as a resident of that
country, is entitled to the benefits of the treaty without such
safeguards. Additionally, it may be possible for the third-
country resident to reduce the income tax base of the treaty-
country resident by having the latter pay out interest,
royalties, or other amounts under favorable conditions (i.e.,
it may be possible to reduce or eliminate taxes of the resident
company by distributing its earnings through deductible
payments or by avoiding withholding taxes on the distributions)
either through relaxed tax provisions in the distributing
country or by passing the funds through other treaty countries
(essentially, continuing to treaty shop), until the funds can
be repatriated under favorable terms.
The proposed revised protocol contains a limitation on
benefits or ``anti-treaty shopping'' article that permits the
United States to deny treaty benefits to a resident of Canada
unless requirements, similar in many respects to those
contained in recent U.S. treaties and in the branch tax
provisions of the Code, are met. This provision replaces very
limited anti-abuse provisions restricting benefits under the
existing treaty. Nevertheless, there are significant
differences between the provisions of the proposed revised
protocol and the corresponding provisions of other U.S.
treaties and internal U.S. law. Such differences include:
The lack of a base-erosion rule in the test relating to
subsidiaries of publicly-traded companies, to limit potentially
abusive structures.
The testing of aggregate vote and value in the ownership
and base-erosion test without any appropriate anti-abuse
provisions (e.g., a rule to prohibit the issuance of shares
that achieve disproportionate allocation of rights).
The ability to satisfy the active-business test if a person
related to the entity claiming treaty benefits is conducting
the active business. As in some other U.S. treaties, it is
unclear to what extent such a rule may open the active-business
test to potential abuse.
The derivative benefits rule, which extends benefits of the
proposed revised protocol to a Canadian company that is wholly
owned by third-country residents, even though the ultimate
owners may not obtain the identical benefits under the treaty
between their country of residence and the United States.
Unlike most other corresponding U.S. treaty provisions, the
proposed anti-treaty-shopping article does not affirmatively
provide Canada any basis on which to deny any treaty benefits.
It does, however, include an explicit understanding, not found
in any other U.S. treaty, as to the noninterference of the
treaty with application by each country of its internal anti-
abuse rules. Such a rule permits Canada to unilaterally change
its standards in implementing the anti-avoidance provisions.
Thus, a U.S. person could face uncertainty in determining its
ability to claim benefits under the proposed revised
protocol.28 This explicit understanding might also be
construed by some as creating a negative inference about the
applicability of internal-law anti-avoidance rules in other
treaties and protocols of the United States. In addition, the
fact that the anti-treaty-shopping provisions of the proposed
revised protocol are looser than, or differ from, comparable
provisions in other U.S. tax treaties could create an
unintended disincentive to third countries to enter into
bilateral tax treaties with the United States that include
tighter provisions relating to limitations on benefits.
\28\ The Technical Explanation suggests that this concept is
implicit in all tax treaties. It could therefore be argued that
uncertainty resulting from changes in internal law could arise under
any tax treaty.
In accepting this unusual set of provisions, the Committee
notes that treaty shopping through the United States is
unlikely given its generally relatively high tax rates. The
Committee believes that, with respect to whether any negative
inference is created by explicit reference to internal-law
anti-abuse rules, the better view is that no negative inference
is created; and moreover, certainly none is intended. The
Committee does not believe that the proposed revised protocol
suffers from any greater degree of uncertainty in application
of treaty partners' internal anti-abuse rules than does any
other treaty or protocol of the United States. Further, the
Committee has given consideration to the argument that U.S.
policy is not impaired if a treaty partner (Canada in this
case) does not wish to establish reciprocal limitation on
benefit rules, so long as the treaty partner does not object to
establishment of such rules protecting U.S. interests. In
considering these issues, the Committee requested a response
from the Treasury Department. In the July 5, 1995 Treasury
letter, the Treasury Department provided the following
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assurances:
3. Since the limitations on benefits are determined
by Canadian domestic law, doesn't this provision result
in uncertainty as to the determination of a U.S.
person's ability to claim benefits under the proposed
protocol? Will this provision contribute to an
unintended disincentive to third countries to enter
into bilateral tax treaties with the U.S. because this
provision might erroneously be perceived as
representing U.S. unwillingness to accept treaty
partners' attempts to protect themselves from erosion
of the tax bases?
The limitation on benefits article does not create
any uncertainty regarding the ability of U.S. persons
to claim treaty benefits. The article simply confirms
that it does not prevent either country from invoking
applicable anti-avoidance rules to recharacterize a
particular transaction if necessary to prevent abuse of
the treaty. Neither the United States nor Canada
believes that it is necessary to confirm this principle
explicitly, but Canada wanted to ensure that the
unilateral nature of the other limitation on benefits
provisions of the Protocol would not give rise to any
negative inference regarding the applicability of such
anti-avoidance rules in this case. The Technical
Explanation states that no negative inference should be
drawn regarding the applicability of such rules in
connection with other United States or Canadian tax
treaties.
Both the United States and Canada take the position,
which is supported by the Commentaries to the OECD
Model Convention, that domestic anti-avoidance rules
apply in connection with all of their treaties. Since
these rules are applicable under the current treaty
with Canada, the Protocol does not expand or otherwise
modify the applicability of such rules. The application
of such rules (such as anti-conduit, substance-over-
form, and step-transaction rules) is essential to the
prevention of tax evasion in the United States as well
as in Canada.
The unilateral nature of the remainder of the
limitation on benefits article will not create any
concern among potential treaty partners. The Technical
Explanation explains that these provisions are
unilateral at Canada's request. This decision was
properly left to Canada, because the issue of ``treaty-
shopping'' into Canada does not implicate any U.S. tax
policy or fiscal interest. The limitation on benefits
provisions of all other U.S. treaties, including those
now before the Committee, apply reciprocally. This
Protocol will not be taken as any indication of a
change in U.S. policy.
Qualifying person
Under the proposed new anti-treaty-shopping article, a
resident of Canada is not entitled to the benefits of the
treaty from the United States unless it is a so-called
``qualifying person,'' or satisfies an active business test, a
derivative benefits test, or the U.S. competent authority
otherwise grants treaty benefits based on criteria set forth
below.
A qualifying person must be a Canadian resident. Having
satisfied that criterion, an individual or an estate will be a
qualifying person. The term qualifying person also includes a
company or trust that satisfies an ownership and ``base
erosion'' test. The term includes a company or trust that
satisfies an exchange-traded test, and a company that is
closely held by exchange-traded companies or trusts. Also
qualifying are Canadian governmental entities and
instrumentalities, as well as certain not-for-profit or
employee benefits organizations.
Exchange-traded company or trust or its subsidiary
Under the exchange-traded test, a company or trust that is
a resident of Canada is a qualifying person if there is
substantial and regular trading in its principal class of
shares or units on a recognized stock exchange. The term
``recognized stock exchange'' includes the NASDAQ System owned
by the National Association of Securities Dealers, Inc. in the
United States; any stock exchange registered with the
Securities and Exchange Commission as a national securities
exchange for the purposes of the Securities Exchange Act of
1934; any Canadian stock exchange that is a ``prescribed stock
exchange'' under the Income Tax Act; and any other stock
exchange agreed upon by the two countries in an exchange of
notes, or by the competent authorities of the two countries. At
the time the proposed revised protocol was signed, ``prescribed
stock exchanges'' were the Alberta, Montreal, Toronto,
Vancouver, and Winnipeg Stock Exchanges.
In order for a company to satisfy the test for being
closely held by exchange-traded companies or trusts, more than
50 percent of the vote and value of the company's shares (other
than debt substitute shares) must be owned, directly or
indirectly, by five or fewer persons each of which is a company
or trust that is exchange traded as provided above, provided
that each company or trust in the chain of ownership is either
a qualifying person, or a U.S. resident or citizen. The term
``debt substitute share'' refers to certain shares issued in
exchange or substitution for debt in certain cases of financial
difficulty, as described in section 248(1)(e) of the Canadian
Income Tax Act (part of the definition of the term ``term
preferred share''). The term also refers to such other type of
share as may be agreed upon by the competent authorities of the
treaty countries.
This rule for subsidiaries of exchange-traded companies is
similar to a provision in the U.S.-Netherlands treaty, but
omits certain provisions that can be regarded as attempts to
prevent abuse. Like the U.S. branch tax rules, the Netherlands
treaty allows benefits to be afforded to the wholly owned
subsidiary of a publicly-traded company. Unlike any other
existing treaty, but like the proposed revised protocol, the
Netherlands treaty provides that benefits must be afforded to
certain joint ventures of publicly-traded companies. However,
the Netherlands treaty requires that if benefits are to be
afforded a company resident in a treaty country on the basis of
public trading in the stock of the company's shareholder or
shareholders, then the company seeking treaty benefits must
also meet one of two additional tests that measure base
erosion. That is, the company either must not be a ``conduit
company'' or, if it is a conduit company, the company must meet
a ``conduit company base-reduction test.'' 29 There are no
additional tests that measure base erosion that apply to a
Canadian company that seeks treaty benefits on the basis of
ownership by exchange-traded companies. A comparable provision
exists under the branch profits tax provision of the U.S.
internal law. Under that provision, only a wholly-owned
subsidiary of a publicly-traded corporation that is organized
under the laws of the same country may be treated as a
``qualified resident'' of its country of residence.
Consequently, this provision of the proposed revised protocol
is less stringent than U.S. tax policy in this area under both
our internal law and existing treaty practices.
\29\ Under the Netherlands treaty, a conduit company is one that
pays out currently at least 90 percent of its aggregate receipts that
are deductible payments (including royalties and interest, but
excluding those at arm's length for tangible property in the ordinary
course of business or services performed in the payor's residence
country). A conduit company meets the conduit base-reduction test if
less than a threshold fraction (generally 50 percent) of its gross
income is paid to associated enterprises subject to a particularly low
tax rate (relative to the tax rate normally applicable in the payor's
residence country).
Ownership and base-erosion test
A company satisfies the ownership requirement of the
ownership and base-erosion test if 50 percent or more of the
vote and value of the shares (other than debt substitute
shares) are not owned, directly or indirectly, by persons other
than qualifying persons, or U.S. residents or citizens. A trust
satisfies the ownership and base-erosion test if 50 percent or
more of the beneficial interest in the trust is not owned,
directly or indirectly, by persons other than qualifying
persons, or U.S. residents or citizens. This rule could, for
example, result in denial of benefits of the reduced U.S.
withholding tax rates on dividends or royalties paid to a
Canadian company that is controlled by individual residents of
a third country.
This ownership requirement is not as strict as that
contained in the anti-treaty-shopping provision proposed at the
time that the last U.S. model income tax treaty was proposed,
which required 75-percent ownership by residents of the
person's country of residence, in order to preserve benefits.
On the other hand, it is in some ways similar to provisions in
recently negotiated treaties. It differs from other treaties,
however, in at least two respects.
First, like the U.S.-Netherlands treaty (and unlike most
other U.S. treaties), a Canadian entity determines whether the
ownership requirement is met, in part, by reference to whether
the owners of that entity are themselves entities that have met
the ownership and base-erosion test. However, in contrast to
the corresponding provision in the Netherlands treaty (Article
26(1)(d)(i)), the relevant portion of the proposed Canadian
protocol is worded in the negative. An effect of the wording of
this provision in the negative is that intervening tiers of
companies are also treated as qualifying persons, or not, by
reference to the ultimate beneficial owners. This aspect of the
proposed revised protocol is similar to the proposed treaty
with France but differs from other U.S. tax treaties, including
the proposed treaty with Portugal and the existing treaty with
the Netherlands.
A second difference between the ownership requirement in
the proposed revised protocol and the ownership requirements in
other recent treaties concerns the application of the vote and
value tests to multiple classes of shares. In order for an
entity to meet the corresponding provisions in some treaties,
such as the U.S.-Germany treaty, appropriate persons must own
50 percent of each class of the entity's shares. Under other
treaties, such as the U.S.-Israel treaty (as modified by its
second protocol) and the U.S. Netherlands treaty, the
corresponding provision is applied by reference to the
aggregate votes and values represented by all classes of shares
(as is true in the proposed revised protocol), but anti-abuse
provisions are inserted to prevent avoidance of the
requirements by issuing classes of shares bearing rights that
achieve disproportionate allocations among taxpayers. The
proposed revised protocol omits any similar anti-abuse
provisions. Thus, in contrast to a case arising under another
treaty, in a case arising under the proposed revised protocol
such abuses must be addressed by the IRS, if at all, by
exercising its authority provided outside the treaty, and
recognized in paragraph 7 of the limitation on benefits
article.
A company or trust that meets the foregoing ownership
requirements must also meet a base-erosion requirement in order
to satisfy the ownership and base-erosion test. This
requirement is met only if the amount of the expenses
deductible from gross income that are paid or payable by the
company or trust for its preceding fiscal period (or, in the
case of its first fiscal period, that period) to persons that
are not qualifying persons, or U.S. residents or citizens, is
less than 50 percent of its gross income for that period. This
rule is of a type commonly referred to as a ``base erosion''
rule and is necessary to prevent a corporation, for example,
from distributing (including paying, in the form of deductible
items such as interest, royalties, service fees, or other
amounts) most of its income to persons not entitled to benefits
under the treaty. If payments are made, for example, from one
Canadian person to another Canadian person that is not a
qualifying person, the payor would have to know that the payee
is in fact a qualifying person in order to obtain the favorable
rate under the protocol. The Committee believes that this
circumstance may be relatively rare, and therefore should not
create a significant problem in the administration of the
provision.
Active-business test
Under the active-business test, treaty benefits with
respect to certain income are available to a Canadian resident
that is not a qualifying person, if that Canadian resident, or
a person related to that Canadian resident, is engaged in the
active conduct of certain types of trades or businesses in
Canada. A trade or business for this purpose means any trade or
business other than the business of making or managing
investments, unless carried on with customers in the ordinary
course of business by a bank, an insurance company, a
registered securities dealer or a deposit-taking financial
institution. In this case, benefits are provided with respect
only to income derived from the United States in connection
with or incidental to that trade or business, including any
such income derived directly or indirectly by that resident
person through one or more other persons that are residents of
the United States. Under the proposed revised protocol, income
is deemed to be derived from the United States in connection
with the active conduct of a trade or business in Canada only
if that trade or business is substantial in relation to the
activity carried on in the United States giving rise to the
income in respect of which U.S. treaty benefits are claimed.
This provision corresponds to provisions found in other
recent U.S. treaties, although it is not identical to any of
them. For example, where the proposed revised protocol provides
treaty benefits if the active trade or business in connection
with which the income is earned is carried on by a related
person, or received indirectly through a related person, the
Netherlands treaty provides a more elaborate set of attribution
rules, and the German treaty is interpreted in a memorandum of
understanding to operate under similar principles.30
\30\ For example, under the limitation on benefits provision of the
U.S. treaty with the Netherlands, the committee report states, ``the
active business test takes into account the extent to which the person
seeking treaty benefits either is itself engaged in business, or is
deemed to be so engaged through the activities of related persons. . .
. Attribution for this purpose, although generally not set forth in the
literal language of the active business test language in other recent
treaties, has been used under those treaties.'' ``Report of the Senate
Committee on Foreign Relations on the 1992 U.S.-Netherlands Income Tax
Treaty and 1993 Protocol,'' Sen. Exec. Rept. 103-19, 103d Cong., 1st
Sess. at 117 (1993). See also ``Understandings Regarding the Scope of
the Limitation on Benefits Article in the Convention between the
Federal Republic of Germany and the United States of America,'' Example
II.
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The Technical Explanation indicates that for purposes of
the active business test under the proposed revised protocol,
the term ``related person'' has the same meaning as under Code
section 482, which permits the IRS to reallocate items between
two or more organizations, trades, or business that are owned
or controlled directly or indirectly by the same interests.
This definition of related party generally depends on all the
facts and circumstances, and does not provide a bright-line
test ensuring certainty to taxpayers that a more mechanically
applied attribution rule provides.
Derivative benefits rule
The limitation on benefits article in the proposed revised
protocol includes a ``derivative benefits'' provision
corresponding to those found in only a limited number of other
limitation on benefit articles (contained in the U.S. treaties
with the Netherlands, Mexico, and Jamaica, and the proposed
treaty with France), under which a Canadian company is entitled
to reduced U.S. tax on dividends, interest, and royalties based
on the eligibility of its stockholders, who may be residents of
a third country, for treaty relief at least as favorable under
a treaty between the United States and the third country. It
should be noted that this provision reflects a significant
departure from the derivative benefits article contained in
almost all other U.S. tax treaties, in that it does not require
any same-country ownership of the Canadian corporation claiming
the relevant treaty benefits.\31\ In other words, a Canadian
entity that is 100-percent owned by third-country residents and
that does not otherwise have a nexus with Canada (e.g., by
engaging in an active trade or business there) may be entitled
to claim certain benefits under the proposed revised protocol.
\31\ Article 26(1)(c)(iii) of the U.S.-Netherlands tax treaty, for
example, requires 30-percent Dutch ownership of the entity claiming
derivative benefits. The other 70 percent of the company must be owned
by residents of the United States or of members of the European Union.
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Under this provision, a Canadian resident company is
entitled to the benefits of Articles X (Dividends), XI
(Interest) and XII (Royalties) if it satisfies an ownership
requirement and a base-erosion requirement. The base-erosion
requirement matches the corresponding requirement under the
ownership and base-erosion test for status as a ``qualifying
person.'' To satisfy the ownership requirement, however, a
different test is used. Under the derivative benefits rule,
shares that represent more than 90 percent of the aggregate
vote and value represented by all of its shares (other than
debt substitute shares) must be owned, directly or indirectly,
by persons each of whom is a qualifying person, a U.S. resident
or citizen or a person who meets each of three conditions.
First, the person must be a resident of a country with
which the United States has a comprehensive income tax treaty,
and must be entitled to all of the benefits provided by the
United States under that treaty. The effectiveness of this
requirement in limiting treaty-shopping opportunities could be
questioned in cases where U.S. treaty with the third country of
which the person is a resident does not itself contain a
limitation on benefits provision (which are contained in fewer
than half of U.S. bilateral income tax treaties), or provides
less restrictive rules. However, because of the special
relationship of the United States with Canada and the unique
reasons that make the limitation on benefits provisions under
the proposed revised protocol acceptable to the Committee, the
Committee does not anticipate that this rule has any
significant precedential value in future treaty negotiations.
If the United States permits residents of third countries to
claim benefits of one of its treaties, it should only permit
such derivative benefits in cases where the benefits that a
third-country resident could claim, under its own treaty with
the United States, are no less favorable than the ones that are
available under a derivative benefits article, in order to
avoid potential abuses.
Second, the person must be one either who would be a
``qualifying person'' under the proposed revised protocol if
the person were a resident of Canada, or who could satisfy an
active business test. To satisfy the active business test, the
person must be one who would qualify for benefits under the
proposed revised protocol's active business test, if that
person were a resident of Canada and the business it carried on
in the country of which it is a resident were carried on by it
in Canada. The active-business test qualifies a person for
benefits only with respect to certain income: that is, income
derived in connection with or incidental to that business. The
Technical Explanation clarifies that the income that is
relevant for purposes of qualification under this test is the
same income with respect to which treaty benefits would be
available by satisfying the requirements of the provision (that
is, income that is eligible for the reduced rate: interest,
dividends or royalties). In addition, it is understood that it
is permissible under the proposed revised protocol for the
United States to deny treaty benefits to any particular portion
of the income of the Canadian resident on the ground that
portion represents income not derived in connection with or
incidental to the appropriate business.
In defining ``qualifying person'' for this purpose, the
language of the proposed revised protocol differs from the
comparable provision of the Netherlands treaty.\32\ The
determination of whether a person is a resident of Canada for
this purpose should be made as if the third country were
Canada. The Technical Explanation clarifies that the provision
is intended to apply in this manner.
\32\ See Article 26(8)(i) of the U.S.-Netherlands tax treaty which
provides: ``The term `resident of a member state of the European
Communities' means a person that would be considered a resident of any
such member state under the principles of Article 4 (Resident) and
would be entitled to the benefits of this Convention under the
principles of paragraph 1, applied as if such member state were the
Netherlands . . .'' (emphasis supplied).
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Third, under the treaty between that person's country of
residence and the United States, the person must be entitled to
a limitation on the rate of U.S. tax on the particular class of
income for which benefits are being claimed under the Canadian
treaty, that is at least as low as the rate applicable under
the Canadian treaty.\33\
\33\ See the discussion in Part VI. B. above, relating to
royalties, for an issue raised by using solely the rate as the
benchmark for the third requirement.
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Grant of benefits by the competent authority
Further, like other treaties, the proposed revised protocol
provides a ``safety-valve,'' under which benefits may be
provided to a treaty-country resident that has not established
that it meets one of the other more objective tests. In other
treaties, particularly in newer treaties and the branch profits
tax provisions of the Code, such provisions typically provide
the competent authority with discretion to grant treaty
benefits. In addition, other treaties sometimes set forth
guidelines in greater or lesser detail for the competent
authority's exercise of that discretion.
The proposed revised protocol provides that where a
resident of Canada is not entitled under the preceding
provisions of the limitation on benefits article to U.S. treaty
benefits, the U.S. competent authority shall, upon that
person's request, determine whether one of two conditions
apply. The determination is to be made on the basis of all
factors including the history, structure, ownership and
operations of that person. If the competent authority
determines that either condition applies, then the person is to
be granted the benefits of the treaty.
The first condition is that the person's creation and
existence did not have as a principal purpose the obtaining of
benefits under the treaty that would not otherwise be
available. The second condition is that it would not be
appropriate, having regard to the purpose of the limitation on
benefits article, to deny the benefits of the treaty to that
person. The Technical Explanation does not clarify the
circumstances under which treaty benefits would be granted by
the competent authority under the second condition.
There appears to be no comparable provision with precisely
identical language in this respect. Some earlier treaties, such
as those with Australia and New Zealand, require treaty
benefits to be provided if the establishment, acquisition, and
maintenance of the person, and the conduct of its operations
did not have as one of its principal purposes the purpose of
obtaining benefits under the treaty.
The language of the proposed revised protocol differs from
that in the German treaty in that the proposed revised protocol
may require a factor that might otherwise merely be taken into
consideration to be dispositive. The Committee does not favor
any interpretation of this provision leading to the result that
the competent authorities may not have adequate authority to
deny benefits.\34\ The Committee believes that in future treaty
negotiations, any provision permitting the grant of treaty
benefits by the competent authority should be drafted so as
clearly to permit the competent authorities adequate discretion
to deny benefits in appropriate circumstances as well.
\34\ That is, if the competent authority does determine that the
person's creation and existence did not have as a principal purpose the
obtaining of benefits under the treaty that would not otherwise be
available, then the competent authority must grant treaty benefits.
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Anti-abuse rules
The proposed revised protocol includes a provision, not
found in any other treaty, that either of the countries may
deny treaty benefits ``where it can reasonably be concluded
that to do otherwise would result in an abuse of the provisions
of the Convention.'' Under this provision, either Canada or the
United States may apply internal law to deny treaty benefits.
This is the only limitation on the provision of treaty benefits
by Canada, whereas it supplements all of the foregoing rules
for limitation on treaty benefits by the United States. The
Technical Explanation states that Canada will remain free to
invoke its applicable anti-avoidance rules to counter abusive
arrangements involving treaty-shopping through the United
States, and the United States will remain free to apply its
substance-over-form and anti-conduit rules, for example, in
relation to Canadian residents.
Internal U.S. law
U.S. courts have stated that the incidence of taxation
depends upon the substance of a transaction as a whole.\35\ In
certain cases, courts have recharacterized transactions in
order to impose tax consistent with this principle. For
example, where three parties have engaged in a chain of
transactions, the courts have at times ignored the ``middle''
party as a mere ``conduit,'' and imposed tax as if a single
transaction had been carried out between the parties at the
ends of the chain.
\35\ See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331
(1945).
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In Aiken Industries, Inc. v. Commissioner,\36\ the Tax
Court recharacterized an interest payment by a U.S. person on
its note held by a related treaty-country resident, which in
turn had a precisely matching obligation to a related non-
treaty-country resident, as a payment directly by the U.S.
person to the non-treaty-country resident. The transaction in
its recharacterized form resulted in a loss of the treaty
protection that would otherwise have applied on the payment of
interest by the U.S. person to the treaty-country resident, and
thus caused the interest payment to give rise to the 30-percent
U.S. withholding tax.
\36\ 56 T.C. 925 (1971), acq. on another issue, 1972-2 C.B. 1.
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The IRS has taken the position that it will apply a similar
result in cases where the back-to-back related party debt
obligations are less closely matched than those in Aiken
Industries, so long as the intermediary entity does not obtain
complete dominion and control over the interest payments.\37\
The IRS has taken an analogous position where an unrelated
financial intermediary is interposed between the two related
parties as lender to one and borrower from the other, as long
as the intermediary would not have made or maintained the loan
on the same terms without the corresponding borrowing.\38\ In a
technical advice memorandum, the IRS has taken the position
that interest payments by a U.S. company to a related, treaty-
protected financial intermediary may be treated as payments by
the U.S. company directly to the foreign parent of the
financial intermediary even though the matching payments from
the intermediary to the parent are not interest payments, but
rather are dividends.\39\
\37\ Rev. Rul. 84-152, 1984-2 C.B. 381; Rev. Rul. 84-153, 1984-2
C.B. 383.
\38\ Rev. Rul. 87-89, 1987-2 C.B. 195.
\39\ Tech. Adv. Mem. 9133004 (May 3, 1991).
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A provision of the Code enacted in 1993 expressly
authorizes the Treasury Secretary to promulgate regulations
that set forth rules for recharacterizing any multiple-party
financing transaction as a transaction directly among any two
or more of such parties where the Secretary determines that
such recharacterization is appropriate to prevent avoidance of
any tax imposed by the Code.\40\ The Code authorizes
regulations that apply not solely to back-to-back loan
transactions, but also to other financing transactions. For
example, it is within the proper scope of the provision for the
Secretary to issue regulations dealing with multiple-party
transactions involving debt guarantees or equity investments.
\40\ Code section 7701(l).
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Proposed Treasury regulations under this provision
establish a standard for treating an intermediate entity as a
conduit. If the intermediate entity is related to the financing
entity or the financed entity, the financing arrangement
generally will be subject to recharacterization if (1) the
participation of the intermediate entity in the financing
arrangement reduces U.S. withholding tax, and (2) the
participation of the intermediate entity in the financing
arrangement is pursuant to a tax avoidance plan. If the
intermediate entity is unrelated to both the financing entity
and the financed entity, the financing arrangement generally
will be subject to recharacterization if the two conditions
described above are satisfied and, in addition, the
intermediate entity would not have participated in the
financing arrangement on substantially the same terms but for
the fact that the financing entity engaged in the financing
transaction with the intermediate entity. The proposed
regulations are intended to provide anti-abuse rules that
supplement, but do not conflict with, the limitation on
benefits articles in U.S. income tax treaties. The Committee
understands that final regulations under this provision are
likely to be promulgated soon.
Internal Canadian law
A general anti-avoidance rule enacted in 1988 provides that
where a transaction is an avoidance transaction, the tax
consequences shall be determined as is reasonable under the
circumstances in order to deny a tax benefit that would
otherwise result, directly or indirectly, from that transaction
or from a series of transactions that includes that
transaction.\41\ The term ``avoidance transaction'' refers to a
transaction other than one that may reasonably be considered to
have been undertaken or arranged primarily for bona fide
purposes other than to obtain the tax benefit.\42\ Tax benefits
are not to be denied where it may reasonably be considered that
the transaction would not result directly or indirectly in a
misuse of the provisions of the Income Tax Act or an abuse
having regard to the provisions of that Act (other than the
general anti-avoidance rule), read as a whole.\43\ The terms
``tax benefit'' and ``tax consequences'' also refer only to
taxes and related concepts as they are relevant under the
Income Tax Act. Thus, for example, they may not include treaty
relief from taxes imposed under the Income Tax Act.
\41\ Income Tax Act sec. 245(2).
\42\ Income Tax Act sec. 245(3).
\43\ Income Tax Act sec. 245(4).
Additional considerations
The provision might be considered as not providing
taxpayers with adequate guidance or certainty, in that it
relies only on internal Canadian law to determine whether a
person, otherwise treated as a resident of the United States
under Article IV of the treaty, is not entitled to treaty
benefits in Canada due to ``abuse'' of the treaty provisions.
Legislative or judicial developments could change the substance
of Canadian tax law as to what constitutes such an abuse. For
example, a new general income tax anti-avoidance rule was
enacted in Canada in 1988 which considerably changed the notion
of abuse and which may be the subject of further interpretation
or change.44
\44\ See Arnold, Brian J. and James R. Wilson, ``The General Anti-
Avoidance Rule'' (a 3-part article), 36 Can. Tax J. 829 (Jul.-Aug.
1988) (part I); 36 Can. Tax J. 1123 (Sep.-Oct. 1988) (part 2); and 36
Can. Tax J. 1369 (Nov.-Dec. 1988) (part 3).
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The Committee notes, nevertheless, that internal rules
apply in determining treaty-country residents' tax liability,
and the fact that such rules may change do not necessarily make
for a weakness in the treaty provisions. This issue is
addressed in the commentary to the OECD model treaty published
by the Committee on Fiscal Affairs of the OECD. The commentary
to Article 1 of the OECD model treaty states that the purpose
of tax treaties is to promote, by eliminating international
double taxation, exchanges of goods and services, and the
movement of capital and persons; and that tax treaties should
not help tax avoidance or evasion. The OECD model treaty
contains no anti-abuse provisions, but the commentary discusses
the types of provisions that treaty negotiators might wish to
consider. In addition, the commentary mentions internal law
measures that provide possible ways to deal with abuse of tax
treaties, such as ``substance-over-form'' rules. The commentary
indicates a difference of views among representatives of the
member countries on the Committee of Fiscal Affairs whether or
not general principles such as ``substance-over-form'' are
inherent in treaty provisions, i.e., whether they can be
applied in any case, or only to the extent they are expressly
mentioned in treaties. The commentary states that it is the
view of the wide majority of OECD member countries that such
rules, and the underlying principles, do not have to be
confirmed in the text of the treaty to be applicable. Where
these rules are not addressed in tax treaties, the commentary
indicates a majority view that these rules are not affected by
the treaties. The commentary also indicates that internal law
measures designed to counteract abuses should not be applied to
countries in which taxation is comparable to that of the
country of residence of the taxpayer.
Consistent with the majority view expressed in the OECD
commentary, the Technical Explanation of the proposed revised
protocol states that the two countries have agreed that the
principle that each treaty country's applicable anti-abuse
rules apply in interpreting the proposed revised protocol is
inherent in the existing treaty. Further, the Technical
Explanation states that the absence of similar language in
other treaties is not intended to suggest that the principle it
expresses is not also inherent in other tax treaties.
The anti-abuse rule (unlike the rest of the limitation on
benefits provision of the proposed revised protocol) is
reciprocal. As a practical matter, however, because of the
detailed limitation on benefit rules that apply only in the
case of Canadian residents and the fact that U.S. internal-law
anti-abuse rules may reach more broadly than Canada's,45
the provision could be considered lacking in reciprocity. While
the provisions limiting treaty-shopping through Canada protect
the U.S. interest in preventing base erosion, the Technical
Explanation indicates that Canada itself prefers not to utilize
such rules to prevent treaty shopping through its treaty
partners.
\45\ See, e.g., Arnold and Wilson, supra, at 872, 880-882.
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The Committee accepts the provision because, given the
unique preferences of Canada, the Committee understands that
the provision as proposed does not serve as a precedent, in
future treaty negotiations, that might interfere in the efforts
of the United States to maintain a network of anti-treaty-
shopping provisions that adequately protects the U.S. tax base
as well as the interests of residents of the United States.
D. Deductibility of Gambling Losses
A nonresident alien individual or foreign corporation
generally is subject to U.S. tax on gross U.S. source gambling
winnings, collected by withholding. In general, no offsets or
refunds are allowed for gambling losses (Barba v. United
States, 2 Cl. Ct. 674 (1983)). On the other hand, a U.S.
citizen, resident, or corporation may be entitled to deduct
gambling losses to the extent of gambling winnings (Code sec.
165(d)). It is understood that Canada does not have a provision
comparable to Code section 165(d). Instead, an individual is
subject to tax on income derived from gambling only if the
gambling activities constitute carrying on a trade or business
(e.g., the activities of a bookmaker). Whether gambling
activities rise to the level of a trade or business is
determined on the facts and circumstances of each case.
The proposed revised protocol adds a provision not found in
any other U.S. treaty or the model treaties, permitting a
resident of either country the benefit of certain gambling
losses against taxes paid to the other country. As applied to a
Canadian resident with U.S. tax liability, the Technical
Explanation indicates that the protocol requires the United
States to allow a Canadian resident to file a refund claim for
U.S. tax withheld, to the extent that the tax would be reduced
by deductions for U.S. gambling losses the Canadian resident
incurred under the deduction rules that apply to U.S.
residents. This provision has the practical effect of
permitting a refund only of U.S. taxes imposed on U.S. gambling
winnings, while not changing the Canadian tax treatment of
Canadian gambling winnings (which are generally exempt from
Canadian tax for a person not engaged in the trade or business
of gambling).46
\46\ The ``other income'' provision of most U.S. tax treaties
permits taxation of income not addressed elsewhere in the treaty (such
as gambling winnings) only in the country in which the recipient
resides.
For example, assume that in 1996, a Canadian resident
individual has, before reduction for any U.S. taxes withheld,
$5,000 of U.S. source gambling winnings, $5,000 of non-U.S.
source gambling winnings, $10,000 of U.S. source portfolio
dividends, and $7,500 of losses from gambling. All of his
losses were at wagers that, had he won, would have generated
U.S. source income. At the end of the year he has borne $3,000
U.S. tax by withholding, $1,500 of which was imposed on his
U.S. source gambling winnings. It is understood that the
proposed revised protocol would authorize a refund of no more
than $1,500 of U.S. tax.
It is understood that the provision would not permit a
Canadian resident who is not engaged in the trade or business
of gambling, and who has Canadian gambling losses and U.S.
gambling winnings, to offset the losses and winnings against
each other for U.S. tax purposes. For example, assume that in
1996, a Canadian resident individual has, before reduction for
any U.S. taxes withheld, $15,000 of U.S. source gambling
winnings and $8,000 of gambling losses from wagers that, had he
won, would have generated Canadian source winnings. At the end
of the year he has borne $3,000 U.S. tax by withholding, none
of which may be refunded under this provision of the proposed
revised protocol.
The Committee believes that, on balance, this special
provision is justified in the context of the proposed revised
protocol. The Committee's acceptance of this provision in this
case should not be construed, however, as a general acceptance
of treaty provisions that accord treaty-partner residents
favorable U.S. treatment of certain gambling losses without
significantly changing the treatment of U.S. residents under
the treaty partner's internal law.
E. Relationship to Uruguay Round Trade Agreements
The multilateral trade agreements encompassed in the
Uruguay Round Final Act, which entered into force as of January
1, 1995, include a General Agreement on Trade in Services
(``GATS''). This agreement generally obligates members (such as
the United States and Canada) and their political subdivisions
to afford persons resident in member countries (and related
persons) ``national treatment'' and ``most-favored-nation
treatment'' in certain cases relating to services. The GATS
applies to ``measures'' affecting trade in services. A
``measure'' includes any law, regulation, rule, procedure,
decision, administrative action, or any other form. Therefore,
the obligations of the GATS extend to any type of measure,
including taxation measures.
However, the application of the GATS to tax measures is
limited by certain exceptions under Article XIV and Article
XXII(3). Article XIV requires that a tax measure not be applied
in a manner that would constitute a means of arbitrary or
unjustifiable discrimination between countries where like
conditions prevail, or a disguised restriction on trade in
services. Article XIV(d) allows exceptions to the national
treatment otherwise required by the GATS, provided that the
difference in treatment is aimed at ensuring the equitable or
effective imposition or collection of direct taxes in respect
of services or service suppliers of other members. ``Direct
taxes'' under the GATS comprise all taxes on income or capital,
including taxes on gains from the alienation of property, taxes
on estates, inheritances and gifts, and taxes on the total
amounts of wages or salaries paid by enterprises as well as
taxes on capital appreciation.
Article XXII(3) provides that a member may not invoke the
GATS national treatment provisions with respect to a measure of
another member that falls within the scope of an international
agreement between them relating to the avoidance of double
taxation. In case of disagreement between members as to whether
a measure falls within the scope of such an agreement between
them, either member may bring this matter before the Council
for Trade in Services. The Council is to refer the matter to
arbitration; the decision of the arbitrator is final and
binding on the members. However, with respect to agreements on
the avoidance of double taxation that are in force on January
1, 1995, such a matter may be brought before the Council for
Trade in Services only with the consent of both parties to the
tax agreement.
Article XIV(e) allows exceptions to the most-favored-nation
treatment otherwise required by the GATS, provided that the
difference in treatment is the result of an agreement on the
avoidance of double taxation or provisions on the avoidance of
double taxation in any other international agreement or
arrangement by which the member is bound.
It is understood that both Canada and the United States
agree that, in the case of a treaty that is treated as in force
on January 1, 1995, as discussed above, a protocol to that
treaty also is treated as in force on January 1, 1995 for
purposes of the GATS. Nevertheless, inasmuch as the proposed
revised protocol extends the application of the existing
treaty, and particularly the nondiscrimination article, to
additional taxes (e.g., some non-income taxes imposed by
Canada), the negotiators sought to remove any ambiguity and
agreed to a provision that clarifies the scope of the treaty
and the relationship between the treaty and GATS.
Thus, the proposed revised protocol specifies that for this
purpose, a measure will fall within the scope of the existing
treaty (as modified by the proposed revised protocol) if it
relates to any tax imposed by Canada or the United States, or
to any other tax to which any part of the treaty applies (e.g.,
a state, provincial, or local tax), but only to the extent that
the measure relates to a matter dealt with in the treaty.
Moreover, any doubt about the interpretation of this scope is
to be resolved between the competent authorities as in any
other case of difficulty or doubt arising as to the
interpretation or application of the treaty, or under any other
procedures agreed to by the two countries.
This provision of the proposed revised protocol is drafted
more narrowly than the corresponding provisions of the proposed
treaties with France, Portugal, and Sweden. It is understood
that the difference results solely from an effort not to
interfere with the operation of the North American Free Trade
Agreement (``NAFTA''), and that the corresponding provisions of
the proposed treaties with France, Portugal, and Sweden reflect
the preferred position of the U.S. Treasury Department.
The Committee believes that it is important that (1) the
competent authorities are granted the sole authority to resolve
any potential dispute concerning whether a measure is within
the scope of the proposed treaty, and that (2) the
nondiscrimination provisions of the proposed treaty are the
only appropriate nondiscrimination provisions that may be
applied to a tax measure unless the competent authorities
determine that the proposed treaty does not apply to it (except
nondiscrimination obligations under GATT with respect to trade
in goods). The Committee believes that the provision of the
proposed treaty is adequate to preclude the preemption of the
mutual agreement provisions of the proposed treaty by the
dispute settlement procedures under the GATS.
F. Assistance in Collection
The proposed revised protocol adds a new article to the
treaty requiring each country to undertake to lend
administrative assistance to the other in collecting taxes
covered by the treaty. The assistance provision is
substantially broader than the most nearly comparable provision
in the U.S. model treaty or the existing treaty.47
\47\ Under the existing treaty, similar to the U.S. model treaty
and other U.S. treaties, each country will endeavor to collect on
behalf of the other country such amounts as may be necessary to ensure
that relief granted by the treaty from taxation imposed by that other
country does not enure to the benefit of persons not entitled thereto
(Article XXVI(4) (Mutual Agreement Procedure). The proposed revised
protocol does not alter this provision.
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The proposed revised protocol provides that the countries
are to undertake to lend assistance to each other in collecting
all categories of taxes collected by or on behalf of the
government of each country, together with interest, costs,
additions to such taxes and civil penalties. No assistance,
however, is to be provided under this article for a revenue
claim with respect to an individual taxpayer to the extent that
the taxpayer can demonstrate that the claim relates to a
taxable period in which the taxpayer was a citizen of country
from which assistance is requested (the ``requested country'').
Similarly where the taxpayer is a company, estate, or trust, no
assistance is to be provided under this article for a revenue
claim to the extent that the taxpayer can demonstrate that the
claim relates to a taxable period in which the taxpayer derived
its status as such an entity from the laws in force in the
requested country. The only collection assistance in such a
case would be assistance authorized under the existing treaty's
mutual agreement procedure article.
When one country applies to the other for assistance in
enforcing a revenue claim, its application must include a
certification that the taxes have been finally determined under
its own laws. For purposes of this article, a revenue claim is
finally determined when the applicant country has the right
under its internal law to collect the revenue claim and all
administrative and judicial rights of the taxpayer to restrain
collection in the applicant country have lapsed or been
exhausted.
The proposed revised protocol specifies that each country
may accept for collection a revenue claim of the other country
which has been finally determined. Consistent with this
language, the Technical Explanation states that each country
has the discretion whether to accept any particular application
for collection assistance. If the request is accepted,
generally the accepting country is to collect the revenue claim
as though it were its own revenue claim, finally determined in
accordance with the laws applicable to the collection of its
own taxes. However, a revenue claim of an applicant country
accepted for collection will not have, in the requested
country, any priority accorded to the revenue claims of the
requested country.
If the accepting country is the United States, it will
treat the claim as an assessment under U.S. law against the
taxpayer as of the time the application is received; if the
accepting country is Canada, it will treat the claim as an
amount payable under the Income Tax Act, the collection of
which is not subject to any restriction.
Nothing in the assistance in collection article shall be
construed as creating or providing any rights of administrative
or judicial review of the applicant country's finally
determined revenue claim by the requested country, based on any
such rights that may be available under the laws of either
country. On the other hand, if, at any time pending execution
of a request for assistance under this provision, the applicant
country loses the right under its internal law to collect the
revenue claim, its competent authority will promptly withdraw
the request for assistance in collection.
In general, amounts collected under the assistance in
collection article are to be forwarded to the competent
authority of the applicant country. Unless the competent
authorities otherwise agree, the ordinary costs incurred in
providing assistance are to be borne by the requested country,
and any extraordinary costs by the applicant country.
Nothing in the proposed new article is to be construed as
requiring either country to carry out administrative measures
of a different nature from those used in the collection of its
own taxes, or that would be contrary to its public policy. The
competent authorities shall agree upon the mode of application
of the article, including agreement to ensure comparable levels
of assistance to each country.
The proposed new article is similar to the provision on
assistance in recovery of tax claims that is in the Convention
on Mutual Administrative Assistance in Tax Matters, among the
member States of the Council of Europe and the OECD.48 The
Convention entered into force on April 1, 1995. The Convention
differs from the proposed revised protocol in that it involves
multiple parties, not two parties; the negotiating
considerations may have differed from those that were relevant
in negotiating the proposed revised protocol. The United States
ratified the Convention subject to a reservation that the
United States will not provide assistance in the recovery of
any tax claim, or in the recovery of an administrative fine,
for any tax.
\48\ Section II, Articles 11 through 16, Senate Treaty Doc. 101-6,
November 8, 1989.
At that time,49 it was pointed out that by entering
into such a reservation, the United States might forego
significant benefits. The reservation, could, for example,
prevent the United States from collecting the maximum amount of
taxes due it by causing it not to be able to avail itself of
the collection procedures of another government. On the other
hand, it was noted that a reservation with respect to this
issue could be appropriate, in that the United States should
not be obligated to help another government collect its
uncontested tax claims against U.S. residents or to collect its
claims against its own residents.50
\49\ See Joint Committee on Taxation, ``Explanation of Proposed
Convention on Mutual Administrative Assistance in Tax Matters'' (JCS-
14-90), June 13, 1990.
\50\ For example, in 1951, the Senate considered income tax
treaties for Greece, Norway, and South Africa which, as originally
submitted to the Senate, would have obligated the treaty countries to
provide broad tax collection assistance to each other. The Senate gave
its advice and consent to those treaties subject to an understanding
that the countries would only provide such collection assistance as
would be necessary to ensure that the exemption or reduced rate of tax
granted by the treaties would not be enjoyed by persons not entitled to
those benefits.
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The Committee believes that, because of the special and
unusually compatible relationship between the United States and
Canada, inclusion of this provision in the proposed revised
protocol is justified. Inclusion of the assistance in
collection provision in the proposed Canadian protocol may lead
to increased interest in the inclusion of similar provisions in
protocols or treaties with other governments. In each instance,
consideration may need to be given as to whether it is
appropriate for the United States to assist in the collection
of another government's taxes. This analysis may involve an
evaluation of both the substantive and procedural elements of
the other government's taxes, as well as an analysis of broader
policy issues, such as the relative compatibility of the other
government's legal systems and individual protection with those
of the United States.
G. Arbitration of Competent Authority Issues
In a step that has been taken only recently in U.S. income
tax treaties (i.e., beginning with the 1989 income tax treaty
between the United States and Germany and the 1992 income tax
treaties between the United States and the Netherlands), the
proposed treaty delegates to the executive branch the power to
enter into an agreement under which a binding arbitration
procedure may be invoked, if both competent authorities and the
taxpayers involved agree, for the resolution of those disputes
in the interpretation or application of the treaty that it is
within the jurisdiction of the competent authorities to
resolve. This provision is effective only after diplomatic
notes are exchanged between Canada and the United States.
Consultation between the two countries regarding whether such
an exchange of notes should occur will take place after a
period of three years after the proposed treaty has entered
into force.
Generally, the jurisdiction of the competent authorities
under the proposed treaty is as broad as it is under any U.S.
income tax treaties. Specifically, the competent authorities
are required to resolve by mutual agreement any difficulties or
doubts arising as to the interpretation or application of the
treaty. They may also consult together regarding cases not
provided for in the treaty.
As an initial matter, it is necessary to recognize that
there are appropriate limits to the competent authorities' own
scope of review.51 The competent authorities would not
properly agree to be bound by an arbitration decision that
purported to decide issues that the competent authorities would
not agree to decide themselves. Even within the bounds of the
competent authorities' decision-making power, there likely will
be issues that one or the other competent authority will not
agree to put in the hands of arbitrators. Consistent with these
principles, the Technical Explanation expects that the
arbitration procedures will ensure that the competent
authorities would not accede to arbitration with respect to
matters concerning the tax policy or domestic tax law of either
treaty country.
\51\ In discussing a clause permitting the competent authorities to
eliminate double taxation in cases not provided for in the treaty,
Representative Dan Rostenkowski, then Chairman of the House Committee
on Ways and Means, submitted the following testimony in 1981 hearings
before the Senate Committee on Foreign Relations:
Under a literal reading, this delegation could be
interpreted to include double taxation arising from any
source, even state unitary tax systems. Accordingly, the
scope of this delegation of authority must be clarified and
limited to include only noncontroversial technical matters,
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not items of substance.
``Tax Treaties: Hearings on Various Tax Treaties Before the Senate
Committee on Foreign Relations,'' 97th Cong., 1st Sess. 58 (1981).
As stated in recommending ratification of the U.S.-Germany
treaty and the U.S.-Netherlands treaty, the Committee still
believes that the tax system potentially may have much to gain
from use of a procedure, such as arbitration, in which
independent experts can resolve disputes that otherwise may
impede efficient administration of the tax laws. However, the
Committee believes that the appropriateness of such a clause in
a treaty depends strongly on the other party to the treaty, and
the experience that the competent authorities have under the
corresponding provision in the German and Netherlands treaties.
The Committee understands that to date there have been no
arbitrations of competent authority cases under the German
treaty or the Netherlands treaty, and few tax arbitrations
outside the context of those treaties. The Committee believes
that the negotiators acted appropriately in conditioning the
effectiveness of this provision on the outcome of future
developments in this evolving area of international tax
administration.
H. Effect of Subsequent Legislation on Implementation of the Protocol
The proposed revised protocol contains a provision that
requires the appropriate authorities to consult on appropriate
future changes to the treaty whenever the internal law of one
of the treaty countries is changed in a way that unilaterally
removes or significantly limits any material benefit otherwise
provided under the treaty. When a treaty partner's internal tax
laws and policies change, it may be desirable that treaty
provisions designed and bargained to coordinate the predecessor
laws and policies be reviewed to determine how those provisions
apply under the changed circumstances. There are cases where
giving continued effect to a particular treaty provision does
not conflict with the policy of a particular statutory change.
In certain other cases, however, a mismatch between an existing
treaty provision and a newly-enacted law may exist, in which
case the continued effect of the treaty provision may frustrate
the policy of the new internal law. In some cases the continued
effect of the existing treaty provision would be to give an
unbargained-for benefit to taxpayers or one of the treaty
partners, especially if changes in taxpayer behavior result in
a treaty being used in a way that was not anticipated when the
original bargain was struck. At that point, the treaty
provision in question may no longer eliminate double taxation
or prevent fiscal evasion; if not, its intended purpose would
no longer be served.52 Strict adherence to all existing
treaty provisions pending bilateral agreement on changes may
impose significant limitations on the implementation of desired
tax policy. Termination of the entire treaty may not be a
desirable alternative.
\52\ See the discussion of the Senate Committee on Finance's view
on this subject in Sen. Rept. No. 100-445, 100th Cong., 2d Sess. at 323
(1988) (relating to a provision that would have modified the 1954
transition rule in Code sec. 7852(d) governing the relationship between
treaties and the Code, to clarify that it does not prevent application
of the general rule providing that the later in time of a statute or a
treaty controls).
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While the Committee agrees that attempts to resolve tax
treaty abuse problems should be carried out on a bilateral
basis, where resolution by that route is timely and otherwise
practical, the Committee believes that obligations under a
treaty or protocol should not be permitted to impinge on
Congress' power to lay and collect taxes, nor should they be
interpreted to preclude changes in U.S. domestic tax policy.
The Committee wishes to clarify that, in recommending that the
Senate give advice and consent to ratification of the proposed
revised protocol, the Committee understands that this consent
in no way alters the constitutional prerogatives of the
Congress.
VII. Budget Impact
The Committee has been informed by the staff of the Joint
Committee on Taxation that the proposed revised protocol is
estimated to increase Federal budget receipts by less than $50
million annually during the fiscal year 1995-2000 period.
VIII. Explanation of Revised Protocol Provisions
For a detailed, article-by-article explanation of the
proposed revised protocol, see the ``Treasury Department
Technical Explanation of the Protocol Amending the Convention
Between the United States of America and Canada With Respect to
Taxes on Income and on Capital Signed at Washington on
September 26, 1980, as Amended by the Protocols Signed on June
14, 1983 and March 28, 1984.''
IX. Text of the Resolution of Ratification
Resolved (two-thirds of the Senators present concurring
therein), That the Senate advise and consent to the
ratification of a Revised Protocol Amending the Convention
between the United States and Canada with Respect to Taxes on
Income and on Capital signed at Washington on September 26,
1980, as Amended by the Protocols signed on June 14, 1983 and
March 28, 1984. The Revised Protocol was signed at Washington
on March 17, 1995 (Treaty Doc. 104-4). The Senate's advice and
consent is subject to the following declaration, which shall
not be included in the instrument of ratification to be signed
by the President:
That the United States Department of the Treasury
shall inform the Senate Committee on Foreign Relations
as to the progress of all negotiations with and actions
taken by Canada that may affect the application of
paragraph 3(d) of article XII of the Convention, as
amended by article 7 of the proposed Protocol.
