Article by Kenneth Snider and Kathleen Penny, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Taxation - April 2005.
Canadian enterprises have raised billions of dollars on foreign capital markets. Such markets have provided sources of capital at interest rates and on other terms that are not otherwise available in the domestic Canadian capital market. Generally, the Income Tax Act (Canada) (the Act) imposes Canadian withholding tax at the rate of 25% (unless reduced by applicable treaty) on any amount that a Canadian resident pays or credits, or is deemed to pay or credit to a non-resident as, on account or in lieu of payment of, or in satisfaction of interest. This withholding tax is subject to certain exceptions, the most broadly available of which is discussed below.
Withholding Tax Cost
Canadian withholding tax is a very important commercial issue in connection with indebtedness between a Canadian resident borrower and a non-resident lender. It may represent a very significant cost that will make a transaction uneconomic for either the Canadian borrower (Canco) or the non-resident lender (the NR). As a condition of making a loan, the NR typically requires that it will receive interest without a deduction of withholding taxes. Any Canadian withholding tax may add a non-recoverable expense because the NR may not, for a variety of reasons, fully claim the Canadian withholding tax as a foreign tax credit. Accordingly, if withholding taxes are or may be applicable, the NR will likely require that Canco make an additional payment representing the withholding tax liability. This is typically structured as a gross-up requirement and an indemnity to protect the NR. If an exemption from withholding tax will be relied on, often a high level of comfort (such as a "will" opinion or an advance tax ruling) is required by the NR and Canco.
Exemptions From Non-Resident Withholding Tax On Interest Under The Act
There are a limited number of exemptions in the Act for non-resident withholding tax on interest. Several OECD member countries provide exemptions from withholding tax in respect of certain corporate debt. In order to improve access to international capital markets and to reduce financing costs, the Canadian federal government introduced a withholding tax exemption for long and medium term corporate debt effective after June 23, 1975. Subparagraph 212(1)(b)(vii) of the Act (or the "5/25 exemption" as it has become known) was enacted and has been amended on numerous occasions.
This exemption contains numerous requirements which must be satisfied in order to qualify for the exemption. Because of the importance of the exemption, tax advisors have frequently sought the advice of the Canada Revenue Agency (the CRA) or advance income tax rulings from the CRA. Consequently, there has developed a large body of CRA administrative policy with respect to the interpretation of the exemption.
Status of Canco
The provision states that for the 5/25 exemption to apply, the interest must be payable by a corporation resident in Canada. The CRA has confirmed that the exemption is available to a non-Canadian corporation that is deemed to be resident in Canada with respect to payments of interest, for example where the interest is deductible in computing the taxable income of a Canadian permanent establishment of the borrower corporation. Also, the CRA has stated that interest paid to the NR under an obligation that otherwise satisfied the requirements is not disqualified from the exemption simply because the Canadian borrower is a partnership, all the members of which are corporations resident or deemed by the Act to be resident in Canada.
Status of Lender
There is no requirement as to the legal personality or status of the lender or the lender’s residency.
Arm’s Length Relationship
The interest must be payable to a person dealing at arm’s length with Canco. If Canco is a partnership, the NR must deal at arm’s length with each member of the partnership. Persons who are related for purposes of the Act are deemed not to be dealing at arm’s length, and otherwise it is a question of fact whether persons are dealing at arm’s length.
The Act has detailed rules for determining whether persons are related. For example, if the NR has an option to acquire shares of Canco which would give the NR legal control if the option was exercised, they will be related for purposes of the Act and be deemed not to be dealing at arm’s length. While a pledge of the shares of Canco as security for the loan will normally not result in related party status, this is in reliance on a specific relieving rule. Access to the relieving rule can change over time. For example, if Canco defaults and the NR is permitted to realize on the share pledge, issues can arise as to whether the relieving rule still applies.
Generally, the arm’s length requirement will rarely be an issue at the time a loan is made. However, in financings that involve financial intermediaries, special purpose entities or possible anti-avoidance issues, this requirement must be carefully considered, based on the specific facts.
The transfer by the NR of a debt obligation which qualifies for the exemption to a person who does not deal at arm’s length with Canco will result in the loss of the exemption. Conversely, if the exemption at the time of the issuance of the debt was not available solely because there was a non-arm’s length relationship between Canco and the NR, the exemption will apply if and when the NR or an assignee deals at arm’s length with Canco.
Although there are no reported cases dealing specifically with the issue of whether the arm’s length requirement is satisfied for the purpose of claiming the exemption under subparagraph 212(1)(b)(vii), the courts have considered the issue of factual arm’s length on many occasions and in respect of different provisions of the Act, including other exemptions from Part XIII withholding tax. If the NR is acting merely as an "accommodation party", there will be an issue with the arm’s length requirement. A case on these issues in the context of the 5/25 exemption is expected to be heard this year by the Tax Court of Canada, as discussed later in this Bulletin.
Type of Obligation
The applicability of the 5/25 exemption is not restricted to interest on "borrowed" money. Consequently, it is not just interest payable on a loan made by the NR to Canco which may qualify for the exemption. The exemption may also apply to interest on a debt assumed by Canco and to interest on the unpaid balance of the selling price of property provided all the requirements for the exemption are otherwise met. In the latter case, the CRA has stated that there must be a written purchase and sale agreement that specifies, in addition to the selling price of the property, the balance that remains unpaid by the purchaser. Some tax treaties (such as the Canada-US treaty) also provide for an exemption from Canadian withholding tax for interest on the unpaid purchase price for property or services which may be broader than the exemption provided for under subparagraph 212(1)(b)(vii).
The 5/25 exemption is available for "interest payable by a corporation resident in Canada". Therefore, an amount that is payable in lieu of interest, which is not in fact interest and is not deemed by the Act to be interest, may be subject to withholding tax yet will not qualify for the exemption. Similarly, interest which is paid or credited but which is not "payable" will not qualify for the exemption. An amount becomes payable only if the taxpayer has an unconditional legal liability to pay and the amount of the liability is certain. The CRA takes the position
that "payable" means accrued and owing and therefore prepaid interest is not eligible for the exemption.
An amount that is deemed by the Act to be a payment of interest will qualify for the exemption if the related debt qualifies. Examples include certain standby or commitment fees, guarantee fees and original issue discount.
Terms of Repayment – the 5/25 Requirement
Paragraph 212(1)(b)(vii) of the Act requires that under the terms of the obligation or any agreement relating thereto, the borrower may not under any circumstances, subject to the exceptions discussed below, be obligated to pay more than 25% of the principal amount of the obligation, within five years from the date of issue, subject to the exceptions discussed below. Consequently, interest on a demand loan will not qualify for the exemption. Similarly, revolving loan facilities generally do not qualify for the exemption. Exchangeable debentures under which the debt can be exchanged for securities of a corporation other than the issuer of the debt will not qualify for the exemption if the holder of the debenture has the right to exchange the debenture for the underlying security within five years.
An obligation which otherwise qualifies for the exemption is not disqualified because Canco has discretion to voluntarily prepay more than 25% of the principal amount within five years of the date of issue.
The NR and Canco must be certain as to when the five-year period commences. This period commences when the loan is advanced and not when the loan documentation is signed. While the CRA has taken the administrative position that where the interval of time between the date appearing on the debt instrument and the date it is acquired by a lender is not greater than that reasonably attributable to marketing the debt instrument, the former is the date of issue of the evidence of indebtedness, this position is not normally relied upon in practice.
If the loan contemplates multiple advances, compliance with the 5/25 requirement is normally achieved by ensuring that the loan matures no earlier than five years from the date of the last advance.
While the wording of the exemption likely requires the maturity date of the loan to be greater than five years from the date of advance, the CRA has accepted a maturity date of exactly five years from the date of advance.
The CRA has confirmed that for a loan denominated in non-Canadian currency, the 5/25 requirement can be tested in that currency, so that foreign exchange fluctuations would not, by themselves, result in loss of the exemption provided that required repayments are expressed in that same currency.
Exceptions from the 5/25 Requirement
There are certain circumstances in which Canco may be obligated to pay more than 25% within five years, without loss of the exemption. The permitted circumstances for payment of more than 25% within the first five years are:
- in the event of a failure or default under the terms of the agreement,
- if the terms of the obligation or any agreement relating thereto become unlawful or are changed by virtue of legislation or by a court, statutory board or commission,
- if the person exercises the right under the terms of the obligation or any agreement relating thereto to convert the obligation into, or exchange the obligation for, a "prescribed security", or
- in the event of the death of the lender.
Events of Failure or Default
The question of what is a permissible event of failure or default for the purpose of the 5/25 exemption has been the subject of considerable analysis by tax advisors and the CRA. Any condition which would require repayment of the principal of the debt is not necessarily viewed as a permissible event of failure or default for purposes of the exemption. Defining the events of default, the occurrence of which would require immediate payment of the principal of the debt, is a vitally important commercial issue, and there may be tension between what may be viewed as commercially reasonable and what is needed to qualify for the exemption. In some instances, there will be a conflict between the commercial objectives and the objective that the interest qualify for the exemption. The expression "event of a failure or default" in subparagraph 212(1)(b)(vii) has not been judicially considered. Accordingly, the administrative policies of the CRA in respect of what it considers a permissible event of default provide very important guidance to taxpayers.
The CRA has published many statements regarding what it considers to be an acceptable event of default. Any particular event of default must be examined carefully. The CRA’s view is that in order to be acceptable for purposes of paragraph 212(1)(b)(vii), an event of failure or default must (i) have commercial reality; (ii) be beyond the control of the lender; and (iii) not be contrived.
Other relevant positions of the CRA include the following:
- Cross-default provisions may be acceptable if the default of the other party impairs the security for the obligation and the lender does not have discretion to trigger the default.
- Events that are the consequence of an act by persons not party to the agreement, such as governments, regulatory bodies, or courts, who are under no obligation pursuant to the agreement, cannot generally be considered "failure or default under the ... terms of agreement." For example, a change in internationally recognized interest rates or commodity prices is not, in and by itself, an event that is a "failure or default under the ... terms of agreement."
- In this context, the expression "terms of agreement" can be interpreted to mean "terms of the obligation or any agreement relating thereto".
Thus, in analyzing cross-default provisions, if the default is by a person other than Canco which affects the security Canco has provided or Canco’s creditworthiness, such a default should constitute an acceptable event of default of Canco. Defaults of material subsidiaries having this effect will generally be regarded as permissible events of default. Similarly, a default by the guarantor of Canco’s debt and its material subsidiaries should also be generally acceptable. Defaults or acts of the parent (if not a guarantor) may not be acceptable events of default of Canco unless it is clear that they affect Canco’s creditworthiness or security.
NRs often require that they be entitled to accelerate the repayment of a debt in the event of a change of control of Canco because control of Canco may be a very important credit risk factor. Fortunately, the CRA has adopted the position that where a loan agreement states that a change of control of the borrower is an event of default, such event is generally considered a permitted event of default. Caution should be exercised in determining whether the particular change of control clause is acceptable in the circumstances. For example, the CRA has accepted clauses designed to identify changes in voting control or changes in the ability to appoint the board of directors.
It is often desirable to draft a change of control provision so as to avoid triggering cross defaults. To accomplish this in a manner that satisfies the requirements of the withholding tax exemption, the loan agreement will typically provide that a change of control is not, of itself, an event of default. Instead, the change of control would initiate a "triggering event" whereby Canco would be obligated to offer to prepay the loan. Failure to make the offer to prepay would constitute an event of default, which would trigger repayment. The CRA has accepted this as a valid mechanism. Other "triggering events" are discussed later in this bulletin.
The policy of the CRA concerning events of failure or default has continued to evolve.
One contentious issue discussed later in this bulletin is whether a "material adverse effect" or "material adverse change" clause is an acceptable default.
Generally, a debt that is convertible to shares within five years of its issue is not eligible for the exemption unless the debt is convertible only into a "prescribed security". A prescribed security must be a share of the issuer of the debt. A share will lose its status as a prescribed security if within five years of the date of issue of the debt obligation, among other things, the share is redeemable at the option of the holder within five years from the date of issue or a person not dealing at arm’s length with the issuer may be required to purchase the shares within five years from the date of issue, or there is any form of "loss protection" given to the shareholder.
It is important to note that a prescribed security must be a share of the issuer of the debt. If the debt is assumed by another corporation, the shares of the assuming corporation will not, then, be a prescribed security. Thus, on an assumption of the debt (assuming there is no novation as discussed below) the exemption would be lost. Thus, a lender should ensure either that a convertible debt is not assumable (unless a favourable tax ruling is obtained) or that a gross-up for withholding taxes exists.
The CRA has considered the issue of whether a debenture convertible at the option of the holder for shares of Canco, based on a formula using the most recent stock exchange trading prices, qualifies for the exemption. Upon the exercise of the conversion right by the debenture holder, Canco may, at its option, either issue the requisite number of shares or pay cash of equal value to the debenture holder. The CRA stated that provided the share qualifies as a prescribed security, the fact that Canco could, at its option, choose to pay cash to the NR which exercised its right to exchange the obligation for such shares, would not cause the denial of the exemption.
However, the CRA has taken the position that some types of anti-dilution clauses and similar protections for the holder of convertible debt can result in loss of the exemption. Accordingly, great care must be taken in structuring and drafting these protections to comply with the requirement that the debt only be convertible into a prescribed security.
Where all or any interest payable on an obligation is contingent or dependent upon the use or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or by any other similar criterion or by reference to dividends paid or payable to shareholders of any shares of a corporation, the interest is deemed not to be interest for the purpose of the exemption. This is discussed in an article later in this Bulletin.
The question has arisen whether the timing of interest payments is dependent on the criteria referred to above and would disqualify the interest for the exemption. The CRA has confirmed that where interest amounts are fixed and payable pursuant to a legal obligation to pay interest at a fixed rate, the fact that the timing of the interest payments is variable will not prevent the exemption from applying. All unpaid interest should be due no later than the due date of the obligation.
The arm’s length requirement is a major restriction of the availability of the exemption, and precludes the exemption in direct related party financing situations. Also, the requirement that Canco be a corporation or partnership of corporations is another major restriction, precluding the exemption where the borrower from the NR is a trust, an individual or a partnership with non-corporate partners. It has occasionally been proposed that these requirements may be satisfied by using a back-to-back loan. Issues relating to back-to-back loans are discussed in two later articles in this Bulletin.
Changes in Terms of Debt Obligations and Novation
The terms of debt obligations are often amended, either because such amendments are contemplated by the loan documentation or Canco requires an accommodation. Where the changes to the debt are significant, the CRA may take the position that there has been a disposition of the debt obligation in consideration of a new debt obligation. The administrative views of the CRA in respect of changes in terms of a debt obligation that result in a disposition are very contentious. Any amendment to the terms of a debt, the interest on which qualifies for the exemption, should be carefully reviewed. Also, in some instances there may be a novation of the debt obligation resulting in the termination of the old debt and the creation of a new debt. A novation will arise, for instance, when the debt is being assumed and the lenders provide a release to the original borrower. The Act does, however, contain a saving provision where a corporation in financial difficulty issues a new debt (a "replacement obligation") in exchange or substitution for an obligation that meets the 5/25 exemption. In certain cases, the replacement obligation will be deemed to have been issued on the date the original obligation was issued, thus preserving the 5/25 exemption (if the replacement debt otherwise satisfies its requirements).
If there has been a disposition of the debt obligation and the issuance of a new debt obligation as a result of significant amendments or a novation, consideration must be given to whether interest on the "new" debt obligation qualifies for the exemption. For instance, if there was such a disposition and issuance, the exemption would not apply if the term of the "new" loan did not comply with the 5/25 requirement discussed above. A recent case illustrates the importance of this point. In General Electric Capital Equipment Finance Inc. v. The Queen, the Court considered whether the 5/25 exemption was available after a series of amendments to certain notes. The Court stated that the fundamental terms of the particular notes were the identity of the debtor, the principal amount, the interest rate and the maturity date. All but one of these (the principal amount) had been changed. The result was that, in view of the Court, the terms of the notes were so materially altered that a new obligation was created. The new obligation did not meet the requirements of the 5/25 exemption.
Form of the Transaction
A loan transaction may be designed in different ways. Depending on the particular capital market Canco is seeking to access, the NR could acquire the debt obligations of Canco through the issue of bonds on a private placement basis or as part of a public issue or there may be a syndicated bank loan.
Short term capital markets cannot be directly accessed because of the 5/25 exemption. However, various transactions have been developed to facilitate meeting the five year term requirement while at the same time permitting access to the short term market. These transactions include the following:
- Canco may borrow from the NR for a five year term, which the NR funds by successive borrowings from other NR’s. The rate of interest payable by Canco will float with the interest rates payable from time to time by the NR. Care is needed to ensure that the interest is not excluded interest for purposes of the exemption.
- A single purpose financial intermediary may be established and owned and controlled by the NR. It lends funds to Canco for at least five years and borrows successively on the short term market. The intermediary may support the borrowings by a bank line of credit, and in some instances, by a guarantee.
- Canco could issue floating rate notes to a group of NR banks. The latter would grant "put" options whereby the holder of the option has a right to put the notes to such group of banks, on an interest payment date. These notes would be marketed. The group of NR banks would agree to hold the notes for a fee if the notes could not be remarketed below a stipulated interest rate.
- A "Dutch auction" repricing approach has been used. Canco will issue five year debt obligations through an underwriter which will organize a group of NRs that will "bid" from time to time to determine the interest rate for the subsequent interest period. The interest rate is then adjusted to reflect the rate established by this process.
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.