Canada: Armís Length And Back-To-Back Loans

Last Updated: June 1 2005

Article by Bill Maclagan, ©2005 Blake, Cassels & Graydon LLP

This article was originally published in Blakes Bulletin on Taxation - April 2005

One of the critical elements in complying with the 5/25 exemption is that the borrower and lender must act at armís length at the time an interest payment is made. Whether or not parties act at armís length is a mixed question of law and fact. Related persons are deemed not to deal at armís length. It is a question of fact whether other persons deal at armís length.

Because a corporation and the person who controls it are related, a loan from a foreign parent to a Canadian subsidiary cannot fit within the 5/25 exemption. As a result, corporations have from time to time attempted to structure intercorporate debt so as to fit within the 5/25 exemption. Various structures have included "back-to-back" loans where cash is loaned from a foreign parent to an armís length foreign company that then lends to the Canadian subsidiary and loans from a foreign bank to a Canadian subsidiary where the foreign parent has granted a fully cash secured guarantee to support the loan. The Canada Revenue Agency (the CRA) has attacked these structures using various arguments, including the application of the general anti-avoidance rule (GAAR). An example of this is the case Siemens Canada Limited (formerly Westinghouse Canada Inc.) v. Her Majesty The Queen, which is currently being litigated in the Tax Court of Canada.

Facts Of The Case

In Siemens, the facts involve a restructuring of debt in an international group of companies. At the time of the transaction, Siemens Canada Limited was called Westinghouse Canada Inc. (Westinghouse). Westinghouse was a Canadian resident corporation that carried on the business of manufacturing and distributing electrical equipment. Westinghouse was the wholly owned subsidiary of a US resident corporation called Westinghouse Electric Corporation (WEC).

At December 31, 1990, Westinghouse owed $84 million to a related corporation in Switzerland known as Westinghouse Electric S.A. (WELSA). In 1991, WEC determined that Westinghouse needed a $100 million credit facility to support its day to day working capital. WEC thus retained First National Bank in Chicago (First Chicago) as its agent to secure the financing.

First Chicago obtained the required financing from two unrelated French banks (BNP and BBLF) in the amount of $50 million from each bank. BNP and BBLF each agreed to lend Westinghouse $50 million at 9.25% per annum (the Loans). The terms of the Loans were 5 years plus one week, and they were structured to fit the requirements of the 5/25 exemption.

Had the transaction ended there, there would have been no issue, but it did not end there. WEC agreed to guarantee the Loans. To secure the guarantee, WEC deposited and pledged $50 million in cash with each French bank. The deposits earned 9.18% per annum. Effectively, WEC had as much cash committed and at risk as if it had loaned the funds to Westinghouse. Part XIII withholding tax was avoided at a cost of 0.07% per annum.

In 1998, the Minister of National Revenue (Minister) assessed Westinghouse for failure to withhold tax under Part XIII of the Act from the interest payments made to BNP and BBLF. The Minister took the position that the exemption was not applicable.

Westinghouse has appealed to the Tax Court of Canada, but the matter has not yet been heard.

The Arguments

The arguments in the case detail exactly how the CRA will attack a "back-to-back" lending arrangement that is viewed as circumventing the armís length requirement or an arrangement where the parent fully secures the borrowing of a Canadian subsidiary to a foreign bank by putting funds on deposit with the foreign bank.

First, the Minister has argued that BNP and BBLF were not the true lenders but the true lender was WEC. The Minister argued that BNP and BBLF were simply accommodation parties, intermediaries or conduits. If this were the case, of course, Westinghouse would not be acting at armís length with the true lender, because they were related. The Minister argued that the $100 million from BNP and BBLF was loaned to Westinghouse at the same time as $100 million was deposited by WEC with the French banks, and BNP and BBLF would not have loaned the $100 million to Westinghouse if the $100 million deposit had not been made. Of course, the profit made by the French banks (at 0.07%) appears so small that it looks almost like a fee for being a conduit.

This argument will be interesting. Just because BNP and BBLF insisted on a fully secured guarantee does not mean they did not act as lenders to Westinghouse. Presumably, the result will depend on the agreements in place between BNP and BBLF and Westinghouse. If those documents disclose a lender-borrower relationship and no agency, presumably this should not be altered simply because the parent grants a secured guarantee.

The second issue that the Minister has raised is the issue of whether or not BNP and BBLF were acting at armís length with Westinghouse. It appears to be the Ministerís position that because of the secured guarantee, BNP and BBLF were merely facilitating a transaction whereby a related corporation was able to lend to Westinghouse and take advantage of the 5/25 exemption. Westinghouse has, of course, argued that BNP and BBLF and Westinghouse were clearly not related and, therefore, were not deemed to be acting at non-armís length. Further, Westinghouse has argued that the loans were negotiated through hard bargaining between Westinghouse and BNP and BBLF. All of the interests of Westinghouse were opposite to those interests of BNP and BBLF. To further support its argument, Westinghouse pointed to the fact that First Chicago was engaged to obtain financing for Westinghouse and received a fee of $340,000 to obtain it. This issue will simply be a question of fact for the trial judge to determine looking at all of the circumstances and facts involved.

The final argument the Minister relied on was GAAR. The Minister argued that even if the transaction otherwise qualified for the 5/25 exemption, the transaction with BNP and BBLF was an avoidance transaction within the meaning of GAAR. The Minister argued that the transaction resulted in a tax benefit to Westinghouse, being the avoidance of Part XIII tax, and was not undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit of avoiding Part XIII tax. The Minister argued that the transaction would result in a misuse of subparagraph 212(1)(b)(vii) of the Act or an abuse having regard to the provisions of the Act read as a whole including Part XIII of the Act. As a result, the Minister assessed Westinghouse by recharacterizing the transaction as a loan from WEC.

The counter arguments of Westinghouse are interesting in this case. First, Westinghouse argued there is a procedural problem in that they were not properly notified that the CRA would apply GAAR. Second, Westinghouse argued that it did not receive a tax benefit as a result of the transaction. "Tax benefit" is defined in section 245 of the Act as "a reduction, avoidance or deferral of tax or other amount payable under this Act or an increase in a refund of tax or other amount under this Act".

Under subsection 212(1) of the Act, it is the non-resident that has the primary liability for the tax under Part XIII of the Act. Westinghouse or any other payor of interest withholds and remits for the account of the non-resident. Thus, Westinghouse has argued that if there was any tax benefit obtained in the situation, it was obtained by the non-resident lenders (or possibly WEC) not by Westinghouse and, therefore, GAAR is not properly applicable to Westinghouse.

Third, Westinghouse has stated that it did not engage in an avoidance transaction. Westinghouse has stated that it entered into the Loan transactions for bona fide purposes other than to obtain a tax benefit. Westinghouse argues that it required additional working capital and that is why it engaged First Chicago to find the necessary $100 million financing, which First Chicago did. Westinghouse also argued that prior to the Loan transactions, it borrowed the amount of $84 million from WELSA. Westinghouse argued that, under the United States of America and Switzerland Income Tax Convention, there is a reduced withholding tax rate from 35% to 5% on dividends paid from WELSA to WEC if the following conditions were met: (a) The US shareholder owned 95% or more of all the voting shares of the Swiss company; and (b) Not more than 25% of the gross income of WELSA was derived from interest and dividends excluding interest and dividends from a subsidiary.

Because Westinghouse was not a subsidiary of WELSA, interest earned from its $84 million loan was not excluded from the calculation in (b) set out above. Westinghouse thus argued that one of the reasons why there was a desire to change lending arrangements was that if WELSA provided further working capital to Westinghouse, it would risk increasing the Switzerland withholding tax on dividends. Consequently, Westinghouse had a bona fide purpose (other than obtaining a Canadian tax benefit) in restructuring its credit facility, being attempting to ensure that the withholding tax between WELSA and WEC did not increase from 5% to 35%. This, Westinghouse argued, is not a tax benefit for the purposes of GAAR. Westinghouse also has stated that, as a matter of fact, the entering into the guarantee Deposit and the Pledge Agreement between WEC, BNP and BBLF allowed Westinghouse to secure a lower borrowing rate than existed with the previous debt to WELSA. As such, it resulted in a significant economic benefit to Westinghouse.

It will be interesting to see how the court deals with this situation, especially the argument that the Part XIII tax is a tax on the non-resident and, therefore, the avoidance of the Part XIII tax did not result in any tax benefit to Westinghouse.

The case will be of significant importance given the CRAís stance that these facilitated loans or "back to back" loan transactions do not fit within the provisions of subparagraph 212(1)(b)(vii) of the Act or, if they do, will be subject to GAAR. To the extent the court finds for the taxpayer, the case may make it easier for international groups to structure financing into Canada and reduce withholding tax.

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.

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