In an article recently published in Tax Notes International, Steve Suarez of BLG's tax group provides an in-depth analysis of the proposed back-to-back loan proposals in the 2014 federal budget. To read Steve's article, please click here.
Relevant to: Canadian entities with debt,
if the creditor (or a creditor affiliate) has received an interest
in property of a non-resident as security for that debt; and
lenders to a Canadian debtor seeking security from foreign entities
related to the debtor.
Issue: Starting in 2015, such debt may be treated
as owing by the Canadian debtor directly to the non-resident whose
property is securing the debt (not the creditor), resulting in
interest on such debt potentially being subject to (1) non-resident
interest withholding tax, and/or (2) restrictions on interest
deductibility under Canada's "thin capitalization"
rules.
Canada levies 25% non-resident withholding tax on interest paid by
a Canadian 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 entities are prevented from reducing 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 from "specified
non-residents" and be permitted 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%+ shareholders of the Canadian debtor. Interest on
debt incurred in excess of this limit is non-deductible for
Canadian tax purposes, and subjected to dividend withholding
tax.
The Department of Finance is concerned with schemes that seek to
avoid the application of these limitations by inserting an
intermediary in between the Canadian debtor and a non-resident
creditor: for example, a loan by the 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 go far beyond such "back-to-back loans" however,
to include situations in which a non-resident has merely provided
an interest in its property to the creditor (or an affiliate of the
creditor) as security for the Canadian entity's debt, (i.e., a
secured guarantee). In such instances, the non-resident
providing the security is effectively treated as having made a
direct loan to the Canadian debtor (ignoring the real creditor),
potentially (1) triggering interest withholding tax (where the
non-resident does not deal at arm's-length with the Canadian
debtor and is not a U.S. resident entitled to the withholding tax
exemption under the Canada-U.S. tax treaty) on debt that would
otherwise be withholding-tax exempt (e.g., bank debt); and/or (2)
causing otherwise "good" debt for thin capitalization
purposes to be subject to the thin capitalization limitations
(e.g., where the non-resident providing the security is, or does
not deal at arm's length with, a 25% shareholder of the
Canadian debtor). These over-broad proposals (which will be
effective starting in 2015) apply to a wide range of ordinary
commercial transactions with no tax avoidance motive, and are
particularly likely to apply where the non-resident providing
security for the Canadian entity's debt is a foreign parent,
sister or subsidiary of the Canadian debtor. It is understood
that the Department of Finance is considering revisions to these
proposals to address the inappropriate results they produce.
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.
