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Canada Eliminates Withholding Tax on Interest on Arm’s-Length Debt - International Law Office

International Law Office

Corporate Tax - Canada

Canada Eliminates Withholding Tax on Interest on Arm’s-Length Debt

January 18 2008

Domestic Rules
Changes to the Canada-US Treaty

In an effort to provide increased access to foreign capital for Canadian businesses, the Canadian government has eliminated Canadian non-resident withholding tax interest on arm’s-length debt obligations to non-residents of Canada after 2007. In addition, future amendments to the Canada-US Income Tax Convention will eliminate withholding tax on arm’s-length and, over time, non-arm’s-length interest payments made to residents of the United States.

Domestic Rules

Effective from January 1 2008, all Canadian non-resident withholding tax on all payments of interest to non-residents of Canada will be eliminated, other than on interest that is either (i) not fully exempt interest and paid to a person with whom the payer does not deal at arm's-length, or (ii) participating debt interest.

This exemption will apply even where interest paid or credited in 2008 is accrued in respect of a period before 2008 or where the debt was contracted before 2008. Further, the exemption will not be dependent upon the residency of the recipient of the interest.

Currently, most foreign lenders rely on the so-called ‘5/25’ exemption applicable to debt issued by Canadian corporate borrowers. Under this exemption, arm’s-length interest is exempt from withholding tax if less than 25% of the principal amount of the debt is payable within five years of issuance, except in the case of default or illegality. The Canada Revenue Agency has developed a number of arcane administrative positions that such 5/25 debt must meet. Under the amended rules, not only will the repayment schedule be unrestricted, but covenants and other provisions commonly found in such 5/25 credit agreements will no longer be necessary. An example of such a covenant is the restriction of a material adverse change provision to a determination that is independent of the control of the lender. Further, elimination of reliance on the 5/25 rule means that operating and revolving credit facilities need no longer be provided by a limited group of permitted lenders, allowing foreign lenders to provide such facilities directly subject to regulatory requirements. Finally, the group of Canadian borrowers that will be able to access foreign sources of capital will no longer be limited to Canadian corporations.

‘Fully exempt interest’ is defined to include interest arising in respect of:

  • debt obligations issued by government or quasi-government entities including the federal government, a provincial or municipal government and certain tax-exempt organizations;
  • mortgages in respect of real property located outside of Canada, except where the interest on the mortgage is deductible in computing income in Canada;
  • debt obligations issued by certain international organizations; and
  • certain securities lending arrangements.

Generally, fully exempt interest is interest that is exempt from Canadian non-resident withholding tax under the current domestic tax rules.

‘Participating debt interest’ is defined to mean interest that is paid or payable on an obligation. All or any portion of this interest is contingent or dependent on the use of or production from property in Canada or computed by reference to (i) revenue, profit, cash flow, commodity price or any other similar criterion, or (ii) dividends paid or payable to shareholders of any class of shares of the capital stock of any corporation.

Participating debt interest does not currently qualify for many of the specific exemptions from withholding tax currently available under Canadian tax legislation. The Canada Revenue Agency takes the position that interest that varies inversely with free cash flow, earnings before interest, tax, depreciation and amortization and similar criteria would not be considered participating interest, on the basis that participating interest is intended to encompass equity-like returns. Interest that increases as the financial condition of the borrower declines and decreases as that condition improves is not characteristic of an equity investment.

Interest payable on the final three items in the list above will, by definition, not be participating debt interest and will therefore be exempt from Canadian non-resident withholding tax when paid to both arm’s-length and non-arm’s-length lenders. Interest payable on government and quasi-government debt obligations described in the first item in the list above will be exempt from Canadian withholding tax regardless of any relationship between the borrower and the lenders, provided that such interest is not participating debt interest.

Under the current domestic rules, certain payments including standby, commitment and guarantee fees are treated for purposes of the Canadian non-resident withholding tax provisions as interest on the related debt that would be, or is, issued. Consequently, under the new rules these assimilated payments will also be exempt from Canadian non-resident withholding tax, provided that the recipient deals at arm’s length with the borrower and, where applicable, the amounts are not participating debt interest.

Borrowers and lenders that may be considering whether existing credit facilities that comply with the 5/25 exemption should be amended should, where those borrowings are denominated in a non-Canadian currency, determine whether the changes to be made to the original borrowing are so significant as to trigger the realization of foreign exchange gains or losses on the basis that the existing debt is considered to be repaid and new debt is considered to be issued.

Changes to the Canada-US Treaty

On September 21 2007 representatives from Canada and the United States signed the Fifth Protocol to the Canada-US Income Tax Convention. Once ratified, the protocol will amend the treaty to eliminate withholding tax on all arm’s-length interest payments made by a person resident in Canada or the United States to a person resident in the other contracting state who is otherwise entitled to the benefits of the treaty. Withholding on all non-arm’s-length interest payments crossing the border will also be eliminated over a period of time, provided that the rate of interest charged does not exceed the amount that would be agreed upon by arm’s-length parties. Interest payments in excess of this arm’s-length amount will not qualify for an exemption from withholding tax under the treaty.

As with the Canadian domestic law changes, there will be a carve-out in the treaty for ‘participating interest’ which is defined as interest arising in Canada that is determined with reference to:

  • receipts, sales, income, profits or other cash flow of the debtor or a related person;
  • any change in the value of any property of the debtor or a related person; or
  • any dividend, partnership distribution or similar payment made by the debtor to a related person.

While similar, the treaty definition of ‘participating interest’ and that for ‘participating debt interest’ under the Canadian domestic rules are not identical and can have different applications. Such interest will, in effect, be treated as dividends and will be subject to Canadian non-resident withholding tax at a rate of 15%.

For arm’s-length interest payments, the effective date for these changes will be the first day of the second month that begins after the date on which the protocol is ratified. As the protocol is yet to be ratified, the exemption for arm’s-length interest now provided for in the Canadian domestic tax rules will take effect before the exemption provided for in the protocol.

The elimination of withholding tax on non-arm’s-length interest payments under the treaty will be phased in over a two-year period. During the first calendar year that ends after the entry into force of the protocol, the rate will be 7%, and during the second calendar year after ratification the rate will be 4%. Thereafter, the rate of withholding will be nil. The 7% rate will apply retroactively to interest paid in the year of ratification but paid prior to the actual date of ratification of the treaty.

These transitional rules have encouraged planning to defer the payment or crediting of interest on currently issued debt between US-related party lenders and their Canadian affiliates to a subsequent year in order to benefit from the application of expected lower Canadian non-resident withholding rates. However, in such planning, several points should be kept in mind, including the following:

  • Interest that is payable by a Canadian borrower to a non-arm’s-length foreign lender that remains unpaid for more than two years will be included in the income of the Canadian borrower in the third year;
  • Care must be taken to avoid a constructive receipt of the interest thereby giving rise to deemed payment of the interest under US or Canadian tax principles;
  • The possible application of the general anti-avoidance rule must be considered; and
  • The protocol will amend the treaty to exempt guarantee fees from taxation by the payer state except where the fee is attributable to a business carried on through a permanent establishment in that state, in which case the fee will be taxed as business profits.

In considering the effect of these rules, two other significant changes contained in the protocol must also be considered. First, the protocol will add reciprocal limitation of benefits (LOB) provisions to the treaty. Currently, Canada does not rely upon any specific LOB provisions in the treaty to counter abuse of the treaty, but instead relies upon the general anti-avoidance rule and other domestic anti-avoidance rules. Under the treaty, once the protocol is ratified, in addition to its domestic rules, Canada will grant benefits under the treaty only to US residents who are 'qualified persons' and to other persons in limited circumstances. These provisions will in many ways mirror the existing LOB provisions of the treaty relied upon by the United States (for further details please see “US and Canada Sign New Tax Treaty Protocol”). Care must be taken to ensure that a US resident non-arm’s-length recipient of interest is eligible for treaty benefits.

In addition, the protocol will restrict the application of the treaty where fiscally transparent entities in Canada and the United States are considered to be “hybrids”, in certain circumstances. In such cases, and despite the widely publicized extension of treaty benefits in the protocol to US-based limited liability companies, US resident members receiving amounts from or through affected fiscally transparent hybrid entities may, regardless of the treaty reductions on withholding rates on related-party interest, be denied treaty benefits and subjected to full domestic Canadian non-resident withholding rates of 25%.

For further information on this topic please contact Elinore J Richardson at Borden Ladner Gervais LLP's Toronto office by telephone (+1 416 367 6000) or by fax (+1 416 367 6749) or by email (erichardson@blgcanada.com). Alternatively, please contact Randy S Morphy at Borden Ladner Gervais LLP's Vancouver office by telephone (+1 604 687 5744) or by fax (+1 604 687 1415) or by email (rmorphy@blgcanada.com).

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