The long-awaited fifth protocol to the Canada-United States Income Tax Treaty (the “Treaty”) was signed on September 21, 2007, and contains several significant changes that will affect both U.S. and Canadian individuals and businesses. The protocol will generally be effective on the later of its ratification by each country and January 1, 2008, though several important provisions have other effective dates.

Among the most significant changes is the elimination of withholding tax on interest payments. Currently, if interest is paid by a resident of one country to a resident of the other country, the Treaty withholding tax rate is 10%. The protocol eliminates this withholding tax as applied to payments between unrelated parties effective on or after the first day of the second month that begins after the date on which the protocol enters into force, which will be no sooner than March 1, 2008.

For interest payments between related parties, the withholding tax will be phased out over a three year period, starting in the first calendar year after the protocol enters into force, when it will be reduced to 7%. The withholding tax rate on interest will be reduced to 4% in the second calendar year, and finally to 0 in the third calendar year and thereafter. The elimination of withholding on interest between related and unrelated parties is expected to stimulate lending between Canadian and U.S. parent-subsidiary companies, as well as Canadian persons borrowing from U.S. lenders.

Another significant change is the extension of treaty benefits to U.S. LLCs and other hybrid entities, which were previously denied such benefits due to their different treatment under the laws of Canada and the U.S. Under the protocol, income from one country earned by a resident of the other country through a hybrid entity (such as an LLC) will be entitled to treaty benefits where the U.S. treatment of the income is the same as though the income had been earned directly. This rule will apply for withholding tax purposes as of the second month after the protocol enters into force.

The protocol also contains provisions that may adversely affect certain cross-border structures involving hybrid entities, by denying treaty benefits in some circumstances. Careful review of new and existing hybrid structures should be made in light on the new protocol provisions. However, these rules will not be effective until two years after the protocol enters into force.

The protocol also provides relief to persons that cease to be a resident of one country and become a resident of the other country and are subject to taxation on emigration (such as the Canadian “departure tax”). Previously, such an individual faced potential double taxation on the same gains, without use of offsetting foreign tax credits. The protocol provides a stepped-up basis to a Canadian individual, so that in most cases no tax will be payable in the U.S. on pre-residency gains. This provisions applies to emigrations after September 17, 2000.

The protocol also contains provisions modifying the rules applicable to, inter alia, employee stock options, pension contributions, mandatory arbitration, permanent establishments, and limitations on benefits (i.e., “treaty shopping”).