Canada: Back-To-Back Loans And The 5/25 Withholding Tax Exemption

The Canada Revenue Agency (CRA) has recently issued an administrative income tax ruling which expands the possible application of the 5/25 Canadian withholding tax exemption for interest paid by Canadian corporate borrowers, by blessing a back-to-back loan arrangement.

The ruling confirms that the general anti-avoidance rule (GAAR) would not be applied to deny the exemption in the circumstances presented.

The 5/25 withholding tax exemption generally applies when a Canadian resident corporation becomes indebted to a non-resident with which it deals at arm’s length, provided that the debtor cannot under any circumstances be obligated to repay more than 25% of the principal amount in the first five years after the date the debt is issued. An exception to the 25% limitation is made if there is an event of failure or default or illegality, in which case there can be an accelerated obligation to repay the debt in full.

The exemption has also been extended to debtors that are non-resident corporations with Canadian businesses or assets, provided that under Canadian tax law they are deemed to be resident for Canadian withholding tax purposes when they pay interest. Also, the exemption has been extended to partnerships, provided that each and every partner is a Canadian resident corporation or a non-resident corporation deemed to be Canadian resident for withholding tax purposes.

The exemption is not available if the Canadian debtor is a Canadian resident individual or trust or a partnership with one or more non-corporate partners. As a result, the exemption has not been available in a number of common situations in which Canadian entities may have wished to borrow from a non-resident of Canada. (Because individuals do not qualify, the exemption is not available for personal mortgage loans.)

The exemption is not available for a loan to a trust, such as a Canadian real estate investment trust (REIT), even if the trust has a corporate trustee.This is because a trust is deemed to be an individual for Canadian tax purposes. Many partnerships used for Canadian real estate investment and other activities have individuals as partners, so the withholding tax exemption is not available for partnership debt held by a non-resident.

In the past, CRA has frowned upon suggestions that the withholding tax exemption might be available where a Canadian corporation borrows from a non-resident on terms that would technically qualify for the exemption, and then on-lends to an entity that would not qualify to access the withholding tax exemption. If the Canadian corporation were properly characterised as an agent or nominee for the ultimate borrower, this would result in a failure to qualify for the exemption. Even if the Canadian corporation acted as principal to borrow and on-lend, the CRA’s position had been that GAAR may apply to deny the exemption. This depended on the facts and, in particular, whether the primary purpose for the loan to the Canadian corporation was to obtain the withholding tax exemption. If this were the primary purpose, there would be an "avoidance transaction". In addition, the position was that the loan to the Canadian corporation may be considered a misuse or abuse of the withholding tax exemption and, in that case, GAAR would apply to deny the exemption.

The recently released tax ruling appears to be the first publicly disclosed ruling granted by the CRA which confirms that GAAR would not be applied to deny the withholding tax exemption in the case of back-to-back loans.

In the ruling, the Canadian corporation that was the borrower from the non-resident investors was the general partner of a limited partnership operating a business in Canada. The limited partnership guaranteed the general partner’s obligations. The Canadian corporate general partner immediately on-lent the borrowed funds to the limited partnership on substantially the same terms, and earned a reasonable mark-up.

The ruling recited that the limited partnership was widely-held and publicly-traded, and had partners that were not corporations. Accordingly, the limited partnership could not have accessed the withholding tax exemption if it had borrowed directly from the non-resident lenders. In granting the ruling, the CRA must have concluded that the corporate general partner acted as principal when it borrowed from the non-residents, and not as agent or on behalf of the limited partnership.

A favourable withholding tax ruling was granted on the basis that there was no "avoidance transaction" when the corporate general partner borrowed and on-lent the funds to the limited partnership. For this purpose, an avoidance transaction is defined as a transaction that would result in a tax benefit, unless the transaction "may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit." Key to the finding that there was no avoidance transaction were several factual representations made by the taxpayer in the ruling request, regarding the commercial reasons why structuring the loan in this manner was favourable to the parties, and the commercial reasons why the limited partnership was unable to obtain equivalent financing or financing at as favourable a cost from Canadian resident lenders or investors.

One of the key representations made was that the general partner corporation was able to borrow money in the U.S. at a lower rate of interest than the limited partnership would have been able to borrow directly.This was stated to be based on "management’s experience and recent market enquiries". It was further represented that, in any event, the general partner would be liable for all debts incurred by the limited partnership and that the limited partnership could not make commitments on its own, but rather the general partner had to make commitments for it.These further representations seem to be simple truths regarding the operation of all limited partnerships.

There may be other situations in which there is an existing structure whereby a Canadian corporation can borrow and access the 5/25 withholding tax exemption, and then on-lend to another entity that cannot directly access the same exemption. One example might be a REIT and a Canadian corporation that manages and administers the REIT. If the facts and circumstances would allow for factual representations to be made along the lines made in the recent tax ruling, it may be possible for the Canadian corporation to borrow from non-residents without withholding tax and on-lend to the REIT, and obtain an advance tax ruling confirming that GAAR will not be applied. Explanations would have to be made in support of the ruling request regarding why this structure is primarily for commercial purposes rather than tax purposes. Presumably the explanations would include details as to why the REIT needs to access non-Canadian markets for the type of financing being sought, and why those non-Canadian markets would look more favourably on a loan to the Canadian corporation (guaranteed by the REIT) rather than a direct loan to the REIT itself.

If a back-to-back loan is sought to be put in place where there is no existing Canadian corporation already part of the structure, so that a new Canadian corporation would have to be inserted as part of the series of transactions including the back-to-back loans, it would presumably be more difficult to identify commercial reasons for forming the corporation and structuring the loans in this manner. It could be argued that the formation of the Canadian corporation and its participation in the structure would be primarily for the commercial purpose of allowing the ultimate borrower to obtain funding at the lowest cost of funds, on the basis that, if the loan were subject to withholding tax, the borrower would have to provide a gross-up which could increase the effective cost of borrowing. This argument would require the Canadian tax authority to go beyond the rationale for the ruling recently granted.

The Canadian case law regarding the interpretation of GAAR, including the interpretation of the definition of "avoidance transaction" and what constitutes a "misuse" or "abuse" of the Canadian Income Tax Act is still developing. We are still awaiting the first case on GAAR to be heard by the Supreme Court of Canada. The approach of the courts in the future will presumably affect both the rulings practices of the CRA and the comfort level of Canadian borrowers in carrying out withholding tax planning of the type discussed above.

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.