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

Article by Kathleen Penny

© 2004 Blake, Cassels & Graydon LLP

This article was originally published in Blakes Bulletin on Cross Border Taxation - November 2004

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 for the second time 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, a Canadian resident 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 REIT or securitization vehicle, 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.

The CRA had in the past 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 was 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 second 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. However, it is the first ruling granted where the corporation that borrowed from a foreign lender, and loaned funds to an ultimate borrower that did not itself qualify for the exemption, was a special purpose vehicle newly formed to participate in the back-to-back loan transactions.

A favourable GAAR ruling was granted. Key to the finding that GAAR did not apply were several factual statements made by the taxpayer in the ruling request, regarding the reasons for structuring the transaction in this manner.

One of the key representations made was that debt could not be raised for the securitization trust from Canadian financial institutions on terms and conditions at least as favourable as those under the proposed loan from the foreign lender. It was also not an alternative for the Canadian corporation sponsoring the securitization trust to borrow from the foreign lender, because the lender would consider the credit risk of the entire business of the corporation, unlike the securitization trust where credit risk was isolated. (Query whether the CRA was viewing the transactions as a form of indirect financing for this Canadian corporation, rather than financing for the securitization trust.) Lastly, the taxpayer stated that there would be significant costs and delays associated with unwinding the securitization transactions currently being carried out with the trust, and implementing a new securitization platform.

It will be interesting to see whether the CRA will extend the same treatment to other types of trusts (including REITs), partnerships and the like. Presumably it will always be the case that the terms and conditions of the loan from the foreign lender would be more favourable than would be obtained from Canadian financial institutions (otherwise there would be no commercial reason to favour the foreign lender). It will presumably also always be the case that there are valid existing reasons for the non-corporate structure of the borrower, and likely also adverse consequences of restructuring into a corporate structure. Nevertheless, a GAAR ruling is always dependent on all of the facts and circumstances.

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.