Limitation on Benefits (LOB): When the US-Canada Treaty Denies Treaty Benefits

Tax treaties exist to prevent double taxation and to reduce withholding rates on cross-border income. But treaties can also be exploited by third-country residents who route income through a treaty country to claim benefits they are not entitled to. This is “treaty shopping.” The Limitation on Benefits (LOB) article in the US-Canada treaty (Article XXIX-A, added by the Third Protocol in 1995) is designed to prevent treaty shopping by requiring that a person claiming treaty benefits have a genuine connection to the treaty country.

What is treaty shopping?

Treaty shopping occurs when a resident of a third country (one that does not have a favorable treaty with the US or Canada) routes income through an entity in a treaty country to claim reduced withholding rates. For example, a resident of a country with no US tax treaty creates a Canadian corporation to hold US investments. The Canadian corporation claims the 15% dividend withholding rate under the US-Canada treaty, instead of the 30% statutory rate that would apply if the dividends were paid directly to the third-country resident.

The LOB article prevents this by requiring the Canadian corporation to demonstrate a genuine connection to Canada before it can claim treaty benefits.

Who automatically qualifies for treaty benefits?

Individuals: A natural person who is a resident of Canada (or the US) for treaty purposes always qualifies for treaty benefits. The LOB article does not restrict individuals. If you are a Canadian resident and you are a real person, you qualify.

The Canadian or US government and subdivisions: Government entities, their political subdivisions, and local authorities always qualify.

Publicly traded companies: A company whose principal class of shares is “primarily traded” on a recognized stock exchange in the residence country (the Toronto Stock Exchange, the NASDAQ, the NYSE, and other designated exchanges) qualifies automatically. “Primarily traded” generally means a majority of the shares are traded on a qualifying exchange.

Tax-exempt organizations: Certain tax-exempt entities (religious, charitable, scientific, literary, or educational organizations, and pension funds) qualify if they are established and maintained in the residence country and more than half of the beneficiaries, members, or participants are residents of the US or Canada.

What is the ownership and base erosion test?

For entities that are not publicly traded, the most commonly used LOB test is the combined ownership and base erosion test. This has two parts:

Ownership: More than 50% (by vote and value) of the entity’s shares (or beneficial interests) must be owned, directly or indirectly, by qualifying persons (individuals, publicly traded companies, government entities, or tax-exempt organizations that are residents of the US or Canada).

Base erosion: The entity’s deductible payments (interest, royalties, management fees, and other amounts) to persons who are not qualifying residents of the US or Canada must not exceed 50% of the entity’s gross income. If a Canadian corporation pays 60% of its gross income in management fees to a Bermuda parent, it fails the base erosion test, even if Canadian residents own it.

Both parts must be satisfied. An entity that passes the ownership test but fails the base erosion test (or vice versa) does not qualify under this provision.

What is the active trade or business test?

An entity that fails the ownership/base erosion test can still qualify if the income for which treaty benefits are claimed is “derived in connection with” or is “incidental to” an active trade or business carried on in the residence country. The business must be substantial relative to the activity in the source country generating the income.

This test is fact-intensive. A Canadian manufacturing company that earns interest from a US customer on extended payment terms can likely claim the interest income is derived in connection with its Canadian manufacturing business. A Canadian shell company with no employees or operations that holds US bonds cannot.

The “substantiality” requirement prevents abuse: the Canadian business must be substantial enough that the entity is not merely a conduit for collecting US-source income. The IRS and CRA look at revenue, employees, assets, and the nature of the business activity.

What is the derivative benefits test?

Under the derivative benefits test (added by the Fifth Protocol in 2007), an entity can qualify for treaty benefits if the owners of the entity would have been entitled to the same or better treaty benefits on the income if they had received it directly.

For example, a Canadian corporation owned 100% by a UK resident may claim US treaty benefits on US dividends if the UK-US treaty would have provided the UK resident with the same or lower withholding rate on those dividends. Since the UK-US treaty rate on dividends is also 15% (or 5% for qualifying corporate shareholders), the derivative benefits test is satisfied, and the Canadian corporation qualifies.

This test is particularly useful for entities owned by residents of countries with favorable US tax treaties.

What is the competent authority discretion?

If an entity fails all of the objective LOB tests, it can request a determination from the competent authorities of both countries (the IRS for the US, the CRA for Canada) that it should be granted treaty benefits despite not satisfying any test. This is a case-by-case determination, and approval is not guaranteed. The entity must demonstrate that its establishment, acquisition, or maintenance was not motivated by a desire to obtain treaty benefits.

This is a last resort. The process is slow (months to years), and the outcome is uncertain. Planning should aim to satisfy one of the objective tests rather than relying on competent authority discretion.

When does LOB matter in practice?

For most cross-border situations involving individuals and operating businesses, the LOB is not a barrier:

• Canadian individuals earning US income: Always qualify (individual test).
• Canadian operating companies with US clients: Usually qualify under the ownership/base erosion test (if Canadian-owned) or the active trade or business test (if the income relates to Canadian operations).
• Canadian public companies: Qualify under the publicly traded test.

The LOB becomes relevant for:

• Canadian holding companies owned by third-country residents (e.g., a Canadian corporation owned by a non-treaty-country trust or corporation).
• Canadian investment vehicles (private equity funds, family offices) with diverse international ownership.
• Conduit structures where a Canadian entity is interposed between a US payer and a non-treaty-country recipient primarily to access treaty benefits.
• Hybrid entities where the US and Canada disagree on the entity’s classification (a Canadian entity that is transparent for Canadian purposes but opaque for US purposes, or vice versa), which can create confusion about who is entitled to claim treaty benefits.

How do you claim LOB compliance?

When filing Form 8833 (Treaty-Based Return Position Disclosure) with a US return, the taxpayer identifies the treaty article being claimed and the LOB test being relied upon. The IRS can request documentation supporting the LOB determination.

On the Canadian side, the LOB is less frequently tested because Canada is usually the residence country claiming benefits in the US (the LOB primarily restricts benefits claimed FROM the source country). But Canadian entities claiming US treaty benefits should maintain documentation showing which LOB test they satisfy.

Related guides:

• US-Canada Tax Treaty Explained covers the treaty’s core provisions for residency, withholding, and double-tax relief
• When Do I Need Form 8833? covers when a treaty-based return position requires disclosure on Form 8833
• Cross-Border Dividend Tax: Canada and the US covers treaty withholding rates on dividends paid between the two countries
• Foreign Tax Credit Limitation and Carryover covers how the FTC limitation interacts with treaty-reduced withholding rates
• Cross-Border Gift Tax: Canada and the US covers treaty provisions that affect cross-border transfers between related parties

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.