Article by Chris Van Loan, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Taxation - April 2005
Most of the withholding tax exemptions relating to interest paid to non-residents contained in paragraph 212(1)(b) of the Income Tax Act (Canada) (the Act), including the 5/25 exemption, are subject to the limitations set out in the post-amble to paragraph 212(1)(b). The post-amble provides that where interest is payable on an obligation and "all or any portion of the interest is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any similar criterion, or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation" interest on such obligation is deemed not to be interest that can be paid free of withholding tax pursuant to the relevant withholding tax exemption, including the 5/25 exemption. Where a portion of interest payable on a particular debt obligation is found to contravene the restrictions contained in the post-amble, the effect is to make all interest payable on that particular debt obligation and not just that portion that falls within the post-amble ineligible for the withholding tax exemption.
The possible application of the post-amble will be of greatest concern where a debt obligation in question carries some sort of a participation feature. The language of the post-amble, however, means that its possible implications must be considered wherever the return on a debt obligation is linked to an external reference factor such as stock indices, commodity prices, foreign currency fluctuations and other criteria.
The Canada Revenue Agency (the CRA) has stated that the purpose of the post-amble is to limit the availability of withholding tax exemptions where the underlying economic substance of the payment under the debt obligation represents a distribution of earnings rather than interest. Thus, the withholding tax exemption under subparagraph 212(1)(b)(vii) will generally not be available to all interest paid on a loan with a participation feature such as one based on the revenue, earnings or profitability of the borrower.
Interest Rate Linked to EBITDA
The CRA’s administrative position, as reflected in technical interpretations and rulings, has not always reflected a purposive approach that focuses on disguised profit distributions. On occasion, the CRA has demonstrated a slavish adherence to a literal reading of the words of the post-amble, ignoring its acknowledged purpose. In a technical interpretation issued in 2003, the CRA took the view that a loan agreement that called for a reduction in the interest rate where the borrower’s global earnings before interest, taxes, depreciation and amortization (EBITDA) increased beyond a stipulated threshold could be caught by the post-amble. This position would effectively mean that a provision meant to catch distributions of profit by way of participating interest would actually be used where the terms of the loan did precisely the opposite (i.e., the interest payable by the borrower would decrease if EBITDA increased).
It is not uncommon for a loan agreement to provide that where a borrower’s EBITDA increases, the interest rate under the loan decreases. The purpose of such provision is to recognize that the borrower’s financial situation has improved and, thus, the lender’s credit risk has been reduced. Rather than the lender being entitled to more interest when the borrower’s profitability improves, such a provision of a loan agreement would result in a lower interest rate where the borrower was more profitable and posed a lower credit risk.
The nature of such interest rate adjustment may not have been fully appreciated by the CRA in the technical interpretation referred to above. In a subsequent ruling, the CRA reversed the position taken in that earlier technical interpretation. This subsequent ruling recognised that this type of interest rate adjustment mechanic was, in fact, the opposite of participating debt and should not run afoul of the post-amble in paragraph 212(1)(b) of the Act. Consequently, the CRA reiterated its previously stated purposive interpretation of the words of the post-amble. Nonetheless, the different positions taken on this issue illustrate the danger of how the CRA may interpret the broad words of the post-amble.
Interest Rate Linked To Stock Index Or Portfolio
Debt obligations that pay interest that is linked to the performance of a reference stock index or portfolio may also be issued to non-residents with the expectation that interest paid on such instruments will qualify for a withholding tax exemption, including the 5/25 exemption. The applicability of the post-amble in this context must also be considered.
In the context of the post-amble, the CRA has stated that where a debt instrument includes a return that is based on an external reference stock index or portfolio, the post-amble should not be applicable, provided that such reference stock index or portfolio cannot be viewed as a proxy for the profitability of the issuer of the debt. The CRA does leave open the possibility that there may be instances where payments that are limited to the performance of an external reference stock index or portfolio could be an accurate indicator of a borrower’s profitability. In these circumstances, such a feature might be viewed as a proxy for a profit distribution feature and be caught within the post-amble.
Generally speaking, this should not be a concern for most structured notes. There may, however, be instances, such as where a structured note issued by a bank pays a return equal to the performance of a basket of a financial institution shares, where the post-amble may be considered to apply to disqualify interest paid on the note from qualifying for a withholding tax exemption.
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.