In an article published in Tax Notes
International, Steve Suarez of BLG's Tax Group provides an
in-depth analysis of the October 20th version of the back-to-back
loan proposals originally announced in the 2014 federal budget. To
read Steve's article, please click
here.
Relevant to: Canadian corporations and trusts with
outstanding debt (and their lenders), if a non-resident of Canada
not dealing at arm's length with the Canadian debtor
("Non-Resident") either (1) has a receivable owing by the
creditor (or a creditor affiliate), or (2) has granted an interest
in property to the creditor (or a creditor affiliate), and some
connection exists between the Canadian's debt and
Non-Resident's receivable or grant of an interest in
property.
Issue: Starting in 2015, such debt may be treated
as owing by the Canadian debtor directly to Non-Resident (not the
actual creditor), resulting in interest on such debt potentially
being subject to (1) Canadian interest withholding tax, and/or (2)
restrictions on interest deductibility under Canada's
"thin capitalization" rules.
Discussion: Canada levies 25% non-resident
withholding tax on interest paid by a Canadian resident to a
creditor who is a non-resident not dealing at arm's length with
the Canadian debtor. The rate of withholding tax is reduced
(usually to 10%) where the creditor is resident in a country that
has a tax treaty with Canada. The only Canadian tax treaty that
reduces the rate of tax to zero is the Canada-U.S. tax
treaty.
Canadian corporations and trusts are limited in the extent to which
they can reduce their taxable income through tax-deductible
interest expense under Canada's "thin capitalization"
rules, which limit the amount of debt that a Canadian entity can
incur owing to "specified non-residents" and be allowed
to deduct the interest expense on. "Specified
non-residents" are essentially non-residents who either are,
or do not deal at arm's length with, 25%+ equity holders of the
Canadian debtor. Interest on debt owing to specified
non-residents in excess of the permissible limit is
non-deductible for Canadian tax purposes, and subjected to dividend
withholding tax.
The Department of Finance is concerned with schemes that avoid
Canadian interest withholding tax and/or thin capitalization
restrictions by inserting an intermediary in between the Canadian
debtor and a creditor who is a non-arm's length non-resident
(i.e., a foreign parent or sister company): for example, a loan by
Non-Resident to a bank, which agrees to make a corresponding loan
to the Canadian debtor. Proposals included in the 2014 federal
budget to address this concern went far beyond such
"back-to-back loans" as discussed in our previous
bulletin (
see here).
A revised (and apparently final) version of these rules was issued
on October 20, 2014. This revised version is significantly
improved, as it generally requires a substantial causal connection
between (1) the Canadian entity's debt to the creditor, and (2)
the transaction between the creditor and Non-Resident, in order for
the new rules to apply. As such, the scope of the revised rules
come much closer to "back-to-back loans" and comparable
arrangements. Also, the rules have been amended so as to cause a
typical pledge of property by Non-Resident to the creditor in
support of the Canadian debtor's debt (i.e., a secured
guarantee) to generally not trigger the new rules, if the
creditor's rights are limited to selling the secured property
and applying the proceeds to pay down the debt upon default. In
general the revised rules appear to produce appropriate results for
the most part, although each case should be reviewed carefully (in
particular where a Canadian member of a multi-national group is
participating in an external group borrowing).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
