The Protocol will enter into force once Canada and the U.S. exchange ratification documents, which is not expected to occur before later on in 2008, and not earlier than January 1, 2008. Generally, the Protocol is effective for taxable years that begin after the calendar year in which ratification documents are exchanged (i.e. as early as 2008), but several provisions have other effective dates, as described below.

The principal elements of the Protocol were widely anticipated as their content was announced as part of Canada's controversial March 19, 2007 Budget; however, other changes to the Treaty come as a surprise. The key implications of the Protocol may be briefly summarized as follows.

- The most significant change to the Treaty is the elimination of the current 10% withholding tax on payments of interest between residents of Canada and the U.S.

This provision is effective for interest paid on or after the first day of the second month that begins after the date of the Protocol's entry into force (i.e. as early as March 1, 2008). However, with respect to cross-border group financings and - other related party loans, the exemption from withholding tax on interest will be phased in: the current 10% rate will drop to 7% for the first calendar year ending after the date of entry into force of the Protocol (i.e. as early as 2008), then to 4% in the calendar year that follows and, finally, to 0% thereafter. The March 19, 2007 Budget announced that once the exemption from withholding tax on both arm's length and non-arm's length interest is implemented under the Canada-U.S. Tax Treaty, Canada will unilaterally eliminate its domestic withholding tax on all arm's length interest regardless of the country of residence of the lender.

The elimination of withholding tax on interest will eliminate the need for Canadian borrowers to comply with Canada's domestic "5/25 exemption" (exemption from withholding tax on interest where the borrower may not be obliged to repay more than 25% of the principal within 5 years). The Protocol will also eliminate withholding on interest paid by U.S. borrowers to Canadian banks or other lenders which are not eligible for the U.S. domestic "portfolio interest exemption".

The new withholding tax exemption on interest will not apply to contingent or participating interest; rather, the 15% withholding tax rate on dividends will apply. This limitation corresponds to the limitations that currently apply to Canada's 5/25 "exemption" and the U.S. "portfolio interest exemption".

- Unfortunately for multinational groups, the substantial representations made to the Canadian government have not resulted in the two countries adopting the current U.S. treaty policy of exempting cross-border subsidiary-to-parent dividends from withholding tax.

One notable change to the "Dividends" article of the Treaty clarifies that where a company derives dividends through a fiscally transparent entity, such as a partnership, for the purposes of the 5% rate on dividends, it is considered to own voting stock of the payer in proportion to the company’s ownership in the fiscally transparent entity.

Also, the Protocol extends the benefit of the 15% dividend withholding rate to certain distributions from U.S. REITs that previously were not eligible for such treatment. Specifically, the 15% rate will continue to be available to individuals holding 10% or less of a U.S. REIT; and will become available to any shareholder holding 5% or less of any class of a publicly traded U.S. REIT or any person holding l0% or less of a diversified U.S. REIT.

- Unfortunately, the 10% withholding tax on cross-border trade-name and trade-mark royalties has been maintained.

- Multinationals in both countries, with operating subsidiaries in the other, will be delighted with the adoption of a taxpayer right to binding arbitration to resolve ubiquitous and contentious inter-company transfer pricing issues.

- A major issue under the current Treaty for U.S. investors or multinationals with interests in Canada, which have been structured through, or use a form of U.S. hybrid entity – a limited liability company ("LLC") – which is treated as a corporation from a Canadian standpoint, but, by default, is considered a flow-through for U.S. tax purposes, is addressed by the Protocol. U.S. resident investors in or owners of LLCs should no longer be denied the treaty benefit of a reduction of or an exemption from Canadian tax otherwise available on Canadian source income derived by them through LLCs. While this appears to be the clear intent of the Treaty negotiators, the Protocol falls short of spelling out exactly how all the conditions for Treaty relief are met. Specifically, the Protocol does not contain a clear rule that members of an LLC are the beneficial owners of income derived through the LLC, which is regarded as a separate taxpayer for Canadian tax purposes. We understand that these concerns may be addressed by a technical explanation to the Protocol to be jointly released by Canada and the U.S.  Also, because of the limited scope of the changes, investors in or owners of U.S. LLCs who are resident in third countries will continue to be denied treaty benefits under the Treaty while not eligible for treaty benefits under a treaty between a third country and Canada.

The change designed to provide U.S. investors in or owners of LLCs with benefits under the Treaty is accompanied by two anti-avoidance provisions dealing with hybrid entities. Under the first provision, U.S.-based multinationals with Canadian operating subsidiaries will no longer be able to minimize overall (Canadian and U.S.) group taxes by financing those subsidiaries through Canadian-formed partnerships which elect to be treated for U.S. tax purposes as separate corporations, but that are seen as fiscally transparent in Canada. The Protocol will deny any reduction in Canada's 25% withholding tax on interest paid by such subsidiaries to such hybrid entities. This rule effectively reflects the thrust of IRC section 894(c). Surprisingly, under the second anti-avoidance rule, treaty benefits would seemingly be denied to U.S. residents deriving income from a Canadian unlimited liability company ("ULC"), organized under the laws of either Alberta, British Columbia or Nova Scotia, that is treated as fiscally transparent in the U.S. Therefore, it appears that dividends paid by a ULC will not qualify for the reduced withholding tax under the Treaty and will thus be subject to Canada's statutory withholding rate of 25%. This result is clearly unwarranted as under the Protocol the overall Canadian tax on amounts derived by a U.S. resident through a ULC would be significantly higher than the tax levied where the U.S. resident either derives the amounts directly or through an interposed regular corporation that is not fiscally transparent under the law of either Canada or the U.S. Accordingly, this outcome may not have been intended by the treaty negotiators.  These anti-avoidance provisions will likely affect a wide range of other investments as well and take effect as of the first day of the third calendar year that ends after the entry into force of the Protocol (i.e. no earlier than January 1, 2010).

- For individuals, a major issue under the current Treaty for Canadians is that, upon emigration, the Canadian departure tax which deems emigrants to have disposed of and re-acquired their assets at fair market value, may not be reflected in an increased cost basis for U.S. tax purposes, thus potentially resulting in double taxation. Effective September 17, 2000, the Protocol will amend the Treaty to provide that the emigrant can choose to be treated in the new home country as likewise having disposed of and reacquired the property at the time of changing residence, thus correspondingly increasing the individual's tax cost in the property in the new home country.

- Finally, the "Limitation on Benefits" provision of the Treaty, which currently applies only with respect to the application of the Treaty by the U.S., will apply bilaterally and has been updated to reflect the most recent U.S. Model Tax Convention. This is a significant departure from Canada's position that it could rely on its domestic general anti-avoidance rule (the "GAAR") to police abuses of Canada's tax treaties and, because of the complex and arbitrary nature of these rules, will inevitably increase the cost of cross-border transactions, rather than facilitate them.

Other notable changes to the Treaty introduced by the Protocol are as follows:

- The tax treatment of pension contributions is harmonized;

- Canada and the U.S. have agreed on common interpretation of the Treaty to prevent double taxation on stock option benefits.

- The tax effects of corporate continuance have been clarified, as previously announced by the Canadian Department of Finance on September 18, 2000. Specifically, absent agreement between the competent authorities, treaty benefits will be denied to corporations that continue from one state to the other but do not discontinue in the state of origin.

The Protocol, together with the related Backgrounder and Annexes, is available on the Department of Finance's web site at http://www.fin.gc.ca/news07/07-070e.html.

For additional information, please contact Ian Crosbie or Stephen Ruby in the Toronto office at (416) 863-0900, Brian Bloom, Nathan Boidman, Michael Kandev, or Alan Shragie  in the Montréal office at (514) 841-6400, or Peter Glicklich, Abraham Leitner or Candice Turner  in the New York office at (212) 588-5500.

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practises nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstance. For particular applications of the law to specific situations, the reader should seek professional advice