11.2.2 Canadian Interpretation of the Treaty
11.2.2[a] Article XI(1) – Residence-based Jurisdiction to Tax
Article XI(1) confirms the jurisdiction right of Canada to impose tax on the interest arising from the U.S. sources and paid to a Canadian resident.
Secondly, Article XI(1) defines the scope of payments that may be eligible for the Treaty relief under Article XI (2).
11.2.2[b] Article XI(2) – Source-based jurisdiction to Tax at the Reduced Rate
Article XI(2) provides that the interest arising in Canada and paid to a beneficial owner resident in the U.S. should be subject to the 10 percent rate of tax in Canada.
Article XI(2) serves three main functions in the framework of Article XI.
First, it provides that interest arising in Canada may be subject to tax in Canada in accordance with Canadian law.
Secondly, it reduces the rate of withholding tax that Canada may impose on such interest payments.
Finally, it serves as a limited anti-avoidance rule by stipulating that the U.S. resident may avail herself to a reduced rate in Article XI(2) if and only if she is a beneficial owner of such interest payment.
11.2.2[c] Article XI(3) – Exemptions to Source-based jurisdiction
Article XI(3) provides a list of important exemptions from the withholding tax imposed under Part XIII in respect of interest payments arising in Canada. The treaty based exemptions are generally consistent with the exemptions provided in paragraph 212(1)(b). The withholding tax exemptions provided by the Treaty can be divided into the following three distinctive categories:
1 – Interest received or paid by various governmental entities in Canada or the U.S.;
2 – Interest arising from credit sales to unrelated parties; and
3 – Interest exempt from Canadian tax under the 1942 Treaty.
11.2.2[d] Article XI(4) – Definition of Interest
Article XI(4) establishes what constitutes interest for the purposes of Article XI. The definition of “interest” applies only for the purposes of Article XI and, unless specifically referenced to, cannot be extended to other provisions of the Treaty or be used for the purposes of the Act.
For the purposes of Article XI(4), the term “interest” generally means income form debt-claims of every kind (whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits). The term “interest” in particular includes (i) income from government securities and from bonds or debentures, including premiums and prizes attaching to these instruments; and (ii) income assimilated to income from money lent under Canadian law, provided that such income arises in Canada.
The term “interest” expressly excludes the income characterized as dividends under Article X. in the case of conflict between Article X (Dividends) and XI (Interest), the former should prevail and the payments qualifying as both dividends and interest should be treated, for the purposes of the Treaty, as dividends and, as such, fall within the purview of Article X.
11.2.2[e] Article XI(5) – Interest Income Associated with a Permanent Establishment
Article XI(5) generally provides that interest arising in Canada and paid to a beneficial owner resident in the U.S. should be subject to tax in Canada pursuant to Article VII(Business Profits) or Article XIV (Independent Personal Services), when (i) the beneficial owner either carries on business in Canada through a permanent establishment or performs independent personal services through a fixed place of business; and (ii) the debt obligations in respect of which the interest is paid are effectively connected with such permanent establishment or fixed base.
In such a case, the interest will be taxed on a net basis using the rates and rules of taxation generally applicable to residents of Canada.
11.2.2[f] Article XI(6) – Source Rules for Interest
The function of Article XI(6) is to determine whether a particular payment of interest to a U.S. resident arises in Canada for the purposes of Article XI. The source rules in Article XI(6) also determine the source of income for the purposes of Article XXIV (Elimination of Double Taxation).
1 – Generally, subject to no. 2 below, Article XI(6) provides that the interest is deemed to have arisen in Canada when the payer is (1) Canada itself, (2) its political subdivision or a local authority, or (3) a resident of Canada, as determined pursuant to Article IV (Residence).
2 – If a particular debt was incurred by any person (resident in Canada, U.S. or any third State) in connection with a permanent establishment or a fixed base that that person has in a State and the interest incurred in respect of that debt is borne by that permanent establishment or fixed base, then the interest is deemed to have arisen in that particular State where the permanent establishment is situated and not in the State of which the payer is a resident.
11.2.2[g] Article XI(7) – Excess Interest
Article XI(7) generally limits the amount of interest eligible for Treaty relief to the commercially reasonable arm’s length amount. In particular, this provision stipulates that where, by reason of a special relationship between the payer and the beneficial owner, the amount of interest exceeds the amount that would be agreed by arm’s length parties, the amount of such excess should be taxable under the laws of each Contracting State, with due regards to other provisions of the Treaty.
11.2.2[h] Article XI(8) – Triangular Interest Payments
Article X(8) is a jurisdictional provision that limits the ability of Canada to impose tax on the inbound interest payments unless certain conditions have been met.
Article XI(8) provides that where a resident in the U.S. pays interest to a resident of a third State, Canada cannot impose tax in respect of these payments, except and to that extent that such interest either (1) arises in Canada under the rules in Article XI(6), or (2) the indebtedness in respect of which the interest is paid is effectively connected with a permanent establishment or a fixed base situated in Canada. Interest is deemed to have arisen in Canada if it is paid by a person resident in Canada or the indebtedness at issue was deductible in computing income from a business carried on by a permanent establishment in Canada.
References:
Advisor’s Guide to Canada – U.S. Tax Treaty
By: Vitaly Timokhov, Raymond Montero, David Kerzner
Published by: Thomson Carswell
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