11.3 Explanation & Interpretation of Article XI under U.S. Law
11.3 Explanation & Interpretation of Article XI under U.S. Law
11.3.1 U.S Domestic Taxation of Interest Paid to Canadian Residents
11.3.1[a] Definition of Interest
Interest has been broadly defined by the courts as representing the cost of using borrowed money, the amount which one has contracted to pay for the use of borrowed money, compensation for the use or forbearance of money, and the equivalent of rent for the use of funds.
11.3.1[b] Classification of Corporate Instruments: Debt vs. Equity
The proper characterization of debt versus equity under U.S. tax principles can have important tax implications on a number of such matters as: interest deductibility; tax-free repayment of debt, various issues related to losses; and cancelation of indebtedness.
11.3.1[c] Sourcing Rules
Interest income is treated as from sources within the U.S. under a variety of circumstances, including; interest from the U.S., a State or any political subdivision thereof, and interest on bonds, notes, or other interest-bearing obligations of non-corporate residents or domestic corporations. Generally, interest from debt issued by a partnership is U.S. source if the partnership is a non-corporate resident. Interest paid by a foreign partnership is generally not U.S. source where the partnership is predominantly engaged in the active trade or business engaged in by the partnership in the U.S., and where it is not paid by a trade or business engaged in by the partnership in the U.S. and is not allocable to income that is effectively connected with the conduct of a U.S. trade or business.
11.3.1[d] Statutory Rate of Tax under Sections 871 & 881
U.S withholding tax is limited to U.S. source “fixed or determinable annual or periodical” items. FDAP income earned by a Canadian resident person is subject to 30 percent flat tax on gross amounts unless an exception under the Code or Treaty applies.
11.3.1[e] Withholding Obligations under Sections 1441 & 1442
The 30 per cent tax on FDAP income is to be withheld by the withholding agent under the complex rules under sections 1441 and 1442 and their regulations. Special withholding rules also apply under section 1445 for withholding in connection with section 897 (FIRPTA) and on certain payments to foreign partners under section 1446.
11.3.1[f] Earnings Stripping Limitations under Section 163(j)
Present law provides rules to limit the ability of U.S. corporations to reduce the U.S. tax on their U.S. source income through certain earnings stripping transactions. Section 163(j) specifically addresses earnings stripping involving interest payments, by limiting the deductibility of interest paid to certain related parties.
11.3.1[g] Branch Level Interest Tax
A Canadian corporation operating with a branch in the U.S. may be subject to a branch level interest tax.
11.3.1[h] Conduit Financing Regulations
Under the regulations, if there is a financing arrangement between related parties and the arrangement includes a financing company, intermediary company, and a financed company, and the use of the intermediary reduces the rate of U.S. withholding tax on interest, rents or royalties, and is pursuant to a plan having tax avoidance as one of its principal purposes, then the IRS has the discretion to ignore the intermediate entity and treat any payments as if made from the U.S. to the foreign financing company directly.
11.3.1[i] Related Party Interest
A consideration for bona fide indebtedness between related persons is that the interest be earned on the basis of an arm’s length interest rate consistent with the principles of section 482. These rules also contain certain safe harbours.
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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