Canada: The Corporate Borrower Requirement And Back-To-Back Loans

Article by Kathleen Penny, ©2005 Blake, Cassels & Graydon LLP

The Canada Revenue Agency (the CRA) has recently issued several administrative income tax rulings which expand the possible application of the 5/25 exemption for interest paid by Canadian corporate borrowers, by blessing back-to-back loan arrangements. The rulings confirm that the general anti-avoidance rule (GAAR) would not be applied to deny the 5/25 exemption in the circumstances presented.

The 5/25 exemption is not available if the Canadian debtor borrowing from the non-resident lender 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 5/25 exemption is not available for partnership debt held by a non-resident.

The CRA had in the past frowned upon suggestions that the 5/25 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" and the position was that the loan to the Canadian corporation may be considered a misuse or abuse of the withholding tax exemption, so that GAAR would apply to deny the exemption.

Several recently released tax rulings confirmed that GAAR would not be applied to deny the 5/25 exemption in the case of back-to-back loans involving limited partnerships. In each case, the direct borrower from the non-resident lender was the existing corporate general partner of the partnership, a Canadian resident corporation. The corporate general partner on-loaned to the partnership, earning a small spread on the interest rates.

Favourable GAAR rulings were granted. In each case, the taxpayer gave commercial reasons why the loan transaction was structured in this manner, including reasons why the limited partnership benefitted from access to foreign capital, and why the direct borrower from the non-resident was the corporate general partner rather than the partnership. These commercial reasons were important to the CRA’s conclusion that GAAR did not apply.

Another recently released tax ruling appears to be the only publicly-disclosed 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 5/25 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 decisions in the first cases on GAAR heard by the Supreme Court of Canada. There is also a pending Tax Court of Canada case that may deal with the issue of whether GAAR applies to a back-to-back loan arrangement, discussed in another article in this Bulletin. 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.