Article by Chris Van Loan, Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Cross-Border Taxation - November 2004
The ability to borrow and lend securities without significant tax consequences is essential to various capital markets activities including repo financings and hedging the obligations created by certain derivative products. U.S.-based securities lenders have traditionally faced difficulties in lending to Canadian-based securities borrowers because of potential withholding tax on payments made as compensation for dividend or interest payments on the borrowed securities. U.S.-based borrowers must be concerned with the application of withholding tax on interest paid on cash collateral and the reluctance of certain Canadian securities lenders to lend Canadian equities because of concerns with respect to the Canadian tax characterization of compensation payments.
A technical amendments bill released earlier this year included a number of proposals designed to address shortcomings in the existing income tax rules governing securities lending. Most significantly, these rules will now apply to units of most income trusts. Although these proposed changes are largely helpful, significant withholding tax and characterization pitfalls continue to exist in the context of cross-border securities lending transactions and will, in fact, likely be even more significant where the borrowed securities are units of income trusts.
Extending the Rules to Arrangements Involving Income Trust Units
Generally, the securities lending rules in the Income Tax Act (Canada) (the Act) deem a person who lends a "qualifying security" under a "securities lending arrangement" not to have disposed of such security for tax purposes. These rules also govern the tax characterization of payments made by a securities borrower to a securities lender as compensation for distributions on the borrowed security.
One of the proposals introduced earlier this year will extend the securities lending rules to qualifying arrangements involving units of mutual fund trusts that are listed on prescribed stock exchanges. This category should encompass the vast majority of income trusts which have become an important component of Canadian capital markets. The extension of the securities lending rules to arrangements involving such trust units applies retroactively to loans of listed mutual fund trusts made after 2001.
Compensation Payments and Withholding Tax
The treatment of compensation payments for purposes of withholding tax is also dealt with in the proposed amendments. This is relevant to the compensation payments made by a Canadian resident securities borrower to a U.S. securities lender. Generally, the proposals will allow a compensation payment in respect of a security distribution on a qualified trust unit to retain the character and composition of the underlying payment and to be deemed to have been paid directly by the trust to the securities lender. This characterization would also be relevant for the new taxes applicable to certain payments made by qualifying mutual fund trusts to non-resident beneficiaries discussed below. Unlike the existing provisions governing compensation payments relating to borrowed equity or debt securities, there is no requirement that the securities lending arrangement be 95% collateralized with cash or government debt obligations in order to obtain such deeming treatment.
Characterization of Compensation Payments
A key issue that had to be addressed in the context of securities lending transactions involving trust units concerned the characterization of compensation payments received by a securities lender. Under existing rules, qualifying compensation payments relating to dividends paid on a share of a Canadian corporation are deemed to be dividends for tax purposes, ensuring that a Canadian-resident securities lender continues to be entitled to preferential tax treatment for qualifying dividend compensation payments. In order to qualify for this deeming treatment, the securities borrower generally must be resident in Canada or a non-resident who paid the amount in the course of carrying on business through a permanent establishment in Canada. Because compensation payments made by a U.S. securities lender would generally not qualify for such deeming treatment, Canadian entities are reluctant to lend dividend-paying Canadian equities to U.S. borrowers unless the Canadian entity is a tax exempt entity, such as a pension fund, that is indifferent to the tax character of the compensation payment.
The proposed amendments include an extension of such deeming treatment to compensation payments made or received in respect of qualified trust unit distributions. Income trusts make distributions to beneficiaries of amounts representing capital gains realized by the trust or returns of capital in addition to dividends received by the trust from Canadian corporations. This array of trust distributions required broader deeming treatment for compensation payments where the borrowed security was a trust unit as opposed to a share of a Canadian corporation. Under the proposed amendments, qualifying compensation payments relating to trust distributions will take on the character of the "underlying payment". Unfortunately, consistent with the existing rules governing the character of payments made to compensate for Canadian dividends, such deeming treatment will generally not be available where the securities borrower making the payment is not resident in Canada or making the payment in the course of carrying on business through a permanent establishment in Canada.
The Budget Proposals
In an unrelated development, the March 23, 2004 federal budget (the Budget) included two proposals that would be relevant to transactions where income trust units have been borrowed from a non-resident. The first of these proposals imposes a 25% withholding tax on capital gains distributions made by a mutual fund trust to non-resident holders to the extent that such capital gains arise from the disposition of taxable Canadian property after March 22, 2004.
In addition, the Budget also introduced a new 15% tax applicable to otherwise tax-free distributions made to non-residents by certain listed mutual fund trusts where, at any time after 2004, the value of the units of the trust is primarily attributable to real property in Canada, Canadian resource property or timber resource property. A Canadian resident who has borrowed income trust units from a non-resident will have to keep these new taxes in mind as the rules may require withholding from compensation payments to be made by the securities borrower.
Although the proposed amendments to the securities lending rules contained in the Act make it possible to borrow and lend income trust units without facing significant tax disadvantages, one should not expect that there will be a great increase in the amount of cross-border securities lending arrangements. There are still significant drawbacks to Canadian securities lenders who require compensation payments to retain the tax character of the underlying payments. Furthermore, a Canadian-resident borrower of qualifying trust units will have to keep the new taxes proposed in the Budget in mind when making compensation payments to a non-resident securities lender.
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.