Canada-US Tax Treaty Benefits Both

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http://www.canada.com/nationalpost/....html?id=e517f1af-838c-4d0e-8c5f-4e13ebd50dec

Fresh tax treaty boon for investment


Finn Poschmann, Financial Post

Published: Saturday, September 22, 2007
Amid the din over parity in the Canada-US dollar exchange rate came some quieter good news. Yesterday's signing of a fresh protocol to the Canada-US tax treaty promises a different sort of parity for lenders and borrowers either side of the border.
The agreement touches several important issues. The primary one affecting investment is the coming elimination of withholding taxes on cross-border interest payments. If the protocol is ratified in Canada and the U.S. before the end of 2007, interest paid to unrelated parties across the border, beginning in 2008, will be spared the present 10% withholding tax. For interest paid to a related party, such as on debt owed by a Canadian subsidiary to a U.S. parent, the withholding rate will drop in stages to zero in the third year that the protocol is in effect.
The change is one small, but important, component of making the North American marketplace as open to trade in capital investment as it is intended to be in merchandise trade.
The result will be a better functioning capital market, where investment comes more cheaply and easily, as businesses think less about taxes when deciding whether to lend capital to a subsidiary in Michigan versus Ontario, or one in British Columbia versus Washington. What is more, removing the impediment to cross-border borrowing should improve competition in lending in the domestic market, to the benefit of all borrowers.
That is not all. Until now, Canadian tax rules have treated U.S. limited liability companies as corporations, even when they are really partnerships that pass their earnings through to partners, to be taxed in partners' hands. The new agreement will recognize LLCs as partnerships, or flow-through vehicles, rather than as corporations, so that they will not face double taxation. This is important to the Canadian venture-capital business, which has lately been pinched for funding, and from which U.S. LLCs had effectively been shut out. And that is good news for innovation, and for the financing of small technology businesses looking to grow.
For people working on one side of the border and living on the other, or thinking of retiring on the other, better tax treatment of savings and pensions is the best news in the protocol.
The agreement offers mutual recognition of pension contributions -- until now, there was no guarantee that the deduction offered for pension savings in one country would be recognized when calculating tax liability in the other. And there is now explicit language covering Roth accounts in the U.S. -- saving plans for which no tax deduction is offered upfront, but from which withdrawals are not intended to be taxed.
The mutual recognition language also applies to future savings plans that the parties agree are similar -- this will matter if Canada is wise enough to introduce Tax-Prepaid Savings Plans to expand the range of savings options available to Canadian workers.
The Canada-US tax treaty, therefore, looks to be much improved, and Finance Minister Jim Flaherty is right to be optimistic about swift approval by legislatures on either side of the border.
Now, Canada's stated plan is to extend withholding tax relief to interest payments to residents of all countries, not just the U.S.
This will bring down the effective tax rate on capital investment by as much as one percentage point, a useful nudge, given that the current tax rate puts Canada at 11th highest in the world. That said, the present agreement leaves out many more things, which the Minister should address soon.
For instance, withholding taxes on cross-border flows of interest payments are but a fraction of those on cross-border dividend payments.
We need a serious look at full liberalizing capital markets, including eliminating tax withholding on dividend payments, so that businesses can think economics, not taxation, when deciding whether to bulk up operations in British Columbia or Washington.
Other inhibitions on free trade in capital need attention, such as the cumbrous procedures required of U.S. private-equity firms that invest in Canadian ventures. The clearance process needed to establish their treaty exemption impedes and discourages them needlessly -- Canadian firms investing in U.S. markets are automatically recognized by the U.S.
Canada's statutory corporate tax rate, happily, is lower than that in the U.S., but it could be lower yet. Otherwise businesses will be tempted to load Canadian subsidiaries with debt, rather than booking taxable income in Canada. A low tax rate helps, and Canada may need to have a fresh look at the "thin-cap" rules that govern how much debt relative to equity a Canadian subsidiary is permitted, before beginning to lose deductibility of interest payments.
Moves on personal taxes are needed too. High on the list: lack of Tax-Prepaid Savings Plans in Canada means Canadians have fewer options and less tax-recognized room to save for retirements. That is easy to fix.
Finn Poschmann is Director of Research at the C.D. Howe Institute.