Canadian 'anti-hybrid' rules: review agreements by January 2010.

While the Canadian-United States Tax Treaty Protocol introduced significant changes that may improve cross-border cashflow between the U.S. and its top trading partner, Canada (such as 0 percent withholding tax on cross-border interest payments), the new "anti-hybrid" provisions of the protocol introduced an impediment that may require certain U.S. investors in Canada to restructure their operations.

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The anti-hybrid provisions of the protocol are scheduled to take effect in January 2010.

In essence, the protocol will apply a 25-percent withholding tax on interest and dividend payments to U.S. shareholders from Canadian hybrid entities. A hybrid is an entity--normally a Canadian unlimited liability company (ULC)--that is treated as a corporation for Canadian tax purposes, but as a flow-through for U.S. purposes.

It's particularly attractive to U.S. individuals and S Corporations because a hybrid can flow through the taxes paid in Canada to U.S. individual shareholders as a foreign tax credit, while a corporate entity cannot.

These significant new withholding taxes on hybrid entities may compel some U.S. shareholders to change their structure.

In considering a different structure, some common options include:

* Capitalize the ULC. Continue operating as a hybrid but fund it through capital rather than loans. When it's time to remit cash, capital can be repatriated free of withholding tax.

* Incorporate the ULC. Terminate hybrid status by electing corporate rather than flow-through treatment for U.S. purposes. The corporate election will mean more tax--full corporate tax when earned plus an additional 15 percent U.S. tax when distributed--but the increase will be less than the tax under the new anti-hybrid rules.

* Convert to a Branch. Liquidate the hybrid entity and re-establish as a Canadian branch. Branch income is subject to full Canadian tax when earned but benefits from reduced withholding when distributed.

Why pay attention now? In essence the new treaty protocol increases significantly the tax burden on hybrid earnings: income distributed from a hybrid is taxed at full Canadian corporate tax rates and additionally at a 25-percent withholding tax rate.

If analysis shows that the U.S. shareholder cannot claim a full foreign tax credit on these new taxes, the time to consider planning options is now.

These remaining months leading up to 2010 are the window to review and if necessary to implement a new structure. Often the solution may not be dramatic--such as a decision to defer distributions or to re-route a loan. The key is for companies to understand the issues, to review their structure and to identify the best solution.

--Jonathan Lysenko, director, International Tax, Amper, Politziner & Mattia [e-mail]