Canada: Budget Proposal To Affect Gross-Up Clauses In Canadian Loan Agreements

Last Updated: November 2 2012
Article by Daniel Lang

Most Read Contributor in Canada, November 2017

The 2012 Canadian budget has proposed measures to treat interest that is not deductible by a Canadian borrower because of the thin capitalization restriction as being in the nature of a dividend that is deemed to be paid to the relevant nonresident lenders. As a result, a portion of the interest paid to a non- Canadian borrower may instead become subject to the imposition of Canadian withholding tax on the amount of this deemed dividend. The budget legislation was introduced in the Canadian Parliament on October 18, 2012, as Bill C-45 and, in particular, is reflected in proposed subsection 214(16) of the Canadian Income Tax Act.

The proposals are changing the scope of the tax ''gross-up'' clause typically included in loan documentation. Accordingly, non-Canadian lenders should carefully consider its impact before committing to new loan arrangements with Canadian resident borrowers.


It has become standard practice under Canadian loan agreements for a Canadian resident borrower to compensate the lender through a gross-up, or additional interest payment, for the withholding taxes that are imposed on interest payments made by that borrower.

In understanding the significance of the gross-up provision, note that the ITA has various statutory exemptions that limit the imposition of withholding tax on interest payments. Therefore, the interest payable under the Canadian commercial loan agreements might already be payable free of withholding tax and, before the application of the budget proposal, render moot the application of any gross-up clause. First, the ITA does not impose withholding tax on interest paid by a Canadian borrower to a Canadian resident lender. The tax gross-up provision in a lending agreement should be irrelevant to loans made by a Canadian resident lender to a Canadian borrower. Second, there is currently no withholding tax imposed on interest payments made by a Canadian borrower to an arm's-length nonresident lender, except for interest that would be characterized as ''participating interest.'' Participating interest is generally calculated by using the borrower's revenue, profit, cash flow, or a commodity price. Conventional lending agreements that use either a fixed rate or a floating rate tied to an industry benchmark, such as LIBOR, should not be characterized as being participating interest. As a result, interest paid to nonresidents of Canada under the loan agreement should not be subject to Canadian withholding tax, unless that recipient dealt at non-arm's-length to the borrower. Even if the ITA imposes withholding tax on interest payments between a Canadian borrower and a nonarm's- length U.S. resident lender, there might still be relief available from Canadian withholding tax if the lender qualified under Article XI(1) of the Canada-U.S. tax treaty.

Assuming that the lender is a nonresident of Canada and also does not qualify for relief under the Canada-U.S. tax treaty, the Canadian statutory exemption from withholding tax would require an assessment whether the nonresident lender deals at arm's length to the Canadian borrower.

It can be a somewhat complicated exercise to apply the ITA definition of arm's length. One branch of the definition focuses on whether the particular shareholder (and other related entities) holds a sufficient number of voting shares to elect a majority of the board of directors of the affected company. This is known as the de jure control test. If the particular shareholder (and other related entities) owned more than 50 percent of the voting shares of the company, then that shareholder would have de jure control over the company and the parties would not deal at arm's length. Since the 50 percent voting control threshold is a mechanical test, it is usually straightforward to apply. However, a second branch of the test is based on facts and circumstances. Even if that shareholder did not have sufficient votes to exercise de jure control of the borrower, it could still be considered to deal at nonarm's- length if circumstances caused that lender to exercise de facto control over the borrower.

Existing Canadian Gross-Up Provisions

The gross-up clause in Canadian loan agreements is not unlimited. Under current Canadian commercial practices, the gross-up clause would require that the lender and the nonresident borrowers be dealing at arm's length. Even with the difficulty that may arise in formulating a definition for arm's length, the arm's-length requirement should not present concerns regarding the typical Canadian loan agreement. The commercial loan agreements are premised on the notion that the lender would want sufficient security from the borrower to ensure repayment of the loan but that the lender would not otherwise wish to exercise any control over the management of the borrower. Nonresident lenders should recognize the consequences of acquiring control — either voting control or control in fact — over a Canadian corporate borrower. If such arm's-length threshold were to be violated by the nonresident lender, neither the Canadian statutory exemption from withholding tax (but subject to the possible subsequent relief under the Canada-U.S. tax treaty) nor the gross-up protection against withholding tax that is provided under the typical Canadian loan agreement should be available to that particular lender.

From a risk perspective, the intent of the gross-up clause is to provide protection to the arm's-length non- Canadian lenders should there ever be an unforeseen change in Canadian tax law that results in the imposition of a withholding tax. Moreover, from a regular operational perspective of the borrower, the gross-up clause should not present a financial cost to the borrower as it is unlikely to require a compensation payment be made under that gross-up clause.

Changes to Canadian Thin Cap Restrictions

Until the budget measures were released, the Canadian thin capitalization provisions generally denied an interest expense deduction to the Canadian borrower if two conditions were satisfied. These conditions were that first, interest must be paid to a ''specified shareholder,'' and second, the debt owing to all specified shareholders could not exceed a determined ratio. If the non-Canadian lender were to qualify as a specified shareholder of the Canadian borrower and the thin capitalization ratios were then exceeded, a portion of the interest as calculated under a mathematical formula would not have been eligible for a Canadian tax deduction by the Canadian resident borrower.

The debt-to-share capital ratio was formerly 2 to 1, and it was calculated monthly. The budget measure will reduce this threshold to 1.5 to 1, by virtue of proposed subsection 18(4) of the ITA.

The thin capitalization restriction also required that some portion of the interest expense be payable to a lender who was not a resident of Canada and who met the conditions to be a specified shareholder of the Canadian borrower. A specified shareholder includes a nonresident person who holds shares in the Canadian corporate borrower, when those shares represent at least a 25 percent voting interest in that Canadian corporation or at least 25 percent of the fair market value of all issued shares of that Canadian corporation. Although a 25 percent shareholding may not represent a controlling share interest in the Canadian borrower, it would arguably represent a significant shareholding with a possible ability to influence the operations of the company. It is also important to recognize that even though the lender may be classified as a specified shareholder of the borrower, the lender and the borrower could still be dealing with each other at arm's length.

The budget measure, as provided under proposed subsection 214(16), will cause denied interest expense to be recognized by the nonresident lender as a dividend. This deemed dividend would then cause that lender to be subject to the imposition of Canadian withholding tax at the rate applicable to dividends. The statutory rate of withholding tax under the ITA for the payment of a dividend to a nonresident of Canada is 25 percent, but it could be reduced to a lower rate under a relevant tax treaty. However, none of Canada's tax treaties provide for a withholding tax rate of less than 5 percent.

Implication to Loan Agreements

The budget and proposed subsection 241(16) of the ITA will alter the withholding tax dynamics that have existed between the Canadian corporate borrowers and its nonresident lenders.

Subsequent to the budget measure, the evolving practice in the loan documentation applicable to a Canadian resident borrower is to exclude a lender who is a specified shareholder of the Canadian resident borrower from claiming the benefit of a gross-up clause. As a consequence, a tax gross-up clause inserted into Canadian loan agreements would now reflect the additional provisions of clause (2) as follows:

the foregoing obligations to pay additional interest amounts do not apply (1) to any Taxes imposed on a payment to a holder or beneficial owner of the loan with which the applicable Payor does not deal at arm's length (within the meaning of the Income Tax Act (Canada)) at the time of the payment; and (2) by virtue of all or any portion of such payment being deemed to be a dividend paid to such holder or beneficial owner pursuant to proposed subsection 214(16) of the Income Tax Act (Canada). [Emphasis added.]

From a non-Canadian lender's perspective, the concern is that a portion of the disallowed thin capitalization interest expense paid to that lender would now be recharacterized as a dividend receipt and, thereby, would subject the nonresident lender to Canadian withholding tax on a portion of the interest payment. Any such interest amount that would be reclassified as a deemed dividend would not be eligible for the interest withholding exemption provided under the ITA, since by definition it is to be treated for Canadian withholding tax purposes as a dividend.

The carveout from the gross-up clause for specified shareholders is a significant departure of the previous Canadian position that all nonresident lenders who dealt at arm's length with the Canadian borrower were protected from Canadian withholding tax that could be imposed on the interest payments. The implication is clear: A non-Canadian lender runs the risk of incurring uncompensated withholding tax once it crosses the threshold of being a specified shareholder of the Canadian borrower.

The potential exposure for Canadian withholding tax will not be problematic for those non-Canadian lenders who wish to maintain only a commercial lending relationship with the Canadian resident borrower.

Nonetheless, it is possible to conceive of unintended and adverse tax results, particularly in situations involving private equity and hedge funds. For example, assume that particular fund accumulates debt issued by a distressed Canadian company and then wishes to accumulate equity of that borrower in order to influence the restructuring process. If the fund acquires sufficient equity to then become a specified shareholder to the Canadian borrower, some portion of the interest received by a non-Canadian lender may now become subject to Canadian withholding tax. Under the evolving Canadian lending standards, such withholding tax would no longer be eligible for the benefit of the gross-up clause. Admittedly, based on the relevant mathematical formula under the ITA, the affected interest amount may only be a small portion of the total interest payable to the nonresident lender. Nonetheless, the key principle is that there is no longer any certainty that a non-Canadian lender dealing at arm's length with a Canadian borrower will always be compensated for any Canadian withholding tax that may be levied.

The exclusion from the tax gross-up clause would suggest that a non-Canadian lender, even if that lender deals at arm's length with the Canadian borrower, should carefully review whether it also wishes to become a shareholder in that borrower.

Originally published in Practitioners' Corner October 29, 2012

About BLG

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions