Interest Across the Border: Why the Treaty Rate Is Zero, and the Cases Where It Isn't

Since the Fifth Protocol took effect, interest paid between Canada and the United States is generally exempt from withholding in the source country. A Canadian holding US bonds or a US savings account pays no US tax on the interest; an American holding a Canadian GIC pays no Canadian tax on it. The residence country taxes the interest at ordinary rates with nothing to credit. The exceptions are narrow but real: contingent and participating interest, interest paid by certain entities, and the domestic rules that apply when the treaty does not.

Key takeaways

• Treaty rate: zero withholding on interest paid to a resident of the other country, for both arm's-length and related-party interest, under Article XI as amended by the Fifth Protocol (fully effective 2010).
• Exceptions: contingent interest (interest determined by reference to the payer's receipts, sales, income, or profits) is taxed at 15%; interest from a US real estate mortgage investment conduit residual interest is taxed under domestic rules.
• Domestic rules without the treaty: Canada withholds 25% Part XIII tax on interest paid to non-arm's-length non-residents and on participating debt interest; the US withholds 30% on interest to non-residents except portfolio interest and bank deposit interest, which are exempt domestically.
• Residence country: taxes the gross interest at ordinary rates. Canada gives no preferential rate for interest; the US taxes it as ordinary income.
• Reporting: Canadian payers issue NR4 slips for interest paid to non-residents even at a zero rate; US payers issue Form 1042-S. Canadian residents report US interest on the T1 with T1135 if foreign property exceeds $100,000 CAD; US residents report Canadian interest on the 1040 with FBAR and Form 8938.

Canadian residents earning US interest

US bank deposit interest and portfolio interest on US bonds are exempt from US withholding under domestic law regardless of the treaty, and the treaty exempts the rest. The broker or bank needs a Form W-8BEN on file; without it, backup withholding at 24% can apply and is recoverable only by filing a 1040-NR. The interest is reported on the T1 in Canadian dollars as foreign interest income, taxed at marginal rates with no foreign tax credit because none was withheld. US accounts count toward the T1135 threshold.

US residents earning Canadian interest

Canadian interest paid to arm's-length non-residents is exempt from Part XIII tax under domestic law since 2008; interest paid to non-arm's-length non-residents (a shareholder loan, a loan from a related company) is subject to 25% Part XIII tax, reduced to zero under the treaty on a Form NR301. Participating debt interest (interest tied to revenue or profits) is subject to 25% regardless of the relationship, reduced to 15% under the treaty's contingent interest rule. The Canadian payer issues an NR4. The US resident reports the interest on the 1040 as ordinary income; Canadian accounts count toward the FBAR and Form 8938 thresholds.

Related-party loans

A Canadian corporation borrowing from its US parent, or a Canadian shareholder lending to a US company, pays or receives interest that is non-arm's-length. The treaty zero rate applies, but the domestic rules require the withholding form to be on file and the interest rate to be at arm's length under transfer pricing rules. Canada's thin capitalization rules limit interest deductions on debt from specified non-residents above a 1.5-to-1 debt-to-equity ratio; the US's section 163(j) limits business interest deductions to 30% of adjusted taxable income.

Shareholder loans across the border

A US-resident shareholder of a Canadian corporation who borrows from it faces Canada's shareholder loan rules: the loan is included in income unless repaid within one year after the corporation's year-end, and deemed interest applies. A Canadian-resident shareholder of a US corporation who borrows from it faces US constructive dividend risk on below-market loans.

Worked example

A Miami resident holds $300,000 in Canadian GICs at a Canadian bank and has lent $200,000 to a Canadian corporation she owns 30% of, at 6%.

• GICs. Arm's-length interest; exempt from Part XIII under domestic law; NR4 issued at zero; $12,000 of interest reported on the 1040 as ordinary income; the account is on the FBAR and Form 8938.
• Shareholder loan. Non-arm's-length; Part XIII 25% applies domestically; reduced to zero on an NR301 filed with the corporation. $12,000 of interest reported on the 1040; the corporation issues an NR4; the interest rate must be defensible as arm's length.
• Total US tax. $24,000 at ordinary rates plus NIIT; no Canadian tax; no foreign tax credit.

Official sources

"Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State." — Canada-United States Tax Convention, Article XI(1), https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties/country/united-states-america-convention-consolidated-1980-1983-1984-1995-1997.html

"Portfolio interest exempt from chapter 3 withholding." — Internal Revenue Service, Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, https://www.irs.gov/publications/p515

"The most common types of Canadian income subject to Part XIII tax are: dividends, rental and royalty payments, pension payments [...] The usual Part XIII tax rate is 25% unless a tax treaty between Canada and your home country reduces this rate." — Canada Revenue Agency, Non-residents of Canada, https://www.canada.ca/en/revenue-agency/services/tax/international-non-residents/individuals-leaving-entering-canada-non-residents/non-residents-canada.html

Practitioner note

Zero withholding does not mean zero paperwork. The NR301 or W-8BEN has to be on file before the first payment, the NR4 or 1042-S still gets issued, and the accounts still appear on the T1135 or FBAR. The clients who get audited on interest are not the ones who owed tax; they are the ones who assumed a zero rate meant nothing to report.

See also: Planning a full move? Start with the Canada-to-US tax checklist and browse every corridor by city, province, and state.

Next step

Fairlight prepares the withholding form filings, the interest reporting on both returns, and the related-party loan documentation. See cross-border pricing or book a call.