Canada: Cash Collateral Requirements

Last Updated: June 1 2005

Article by Leslie Morgan, ©2005 Blake, Cassels & Graydon LLP

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

The Canada Revenue Agency (the CRA) has developed administrative practices concerning the possible impact of cash collateral on the requirement for the 5/25 exemption that the Canadian borrower may not under any circumstances be obligated to repay more than 25% of the principal amount of the obligation within five years from the date on which the principal amount is advanced.

Account Controlled by the Borrower

The borrower may set aside funds in contemplation of the eventual repayment of its obligation. The CRA takes the position that a borrower can be required to make deposits in excess of 25% of the total principal amount within five years to a sinking fund or other account controlled by the borrower without being considered by the CRA to be obligated to pay more than 25% of the principal amount for purposes of the 5/25 exemption. For commercial reasons, it is not often the case that a lender is willing to allow for a cash collateral account to be "controlled by the borrower".

Account with Third Party

It is, however, the CRA’s view that an obligation to pay more than 25% of the principal amount within five years may exist if the borrower is required to irrevocably place more than 25% of the principal amount of an obligation with an independent trustee or third party within the five-year period, notwithstanding any limitations that are placed on payments which the trustee or third party may be required to make to the lender. A requirement for temporary cash collateral, for example during a period of low cash flow, does not appear to violate this rule as long as there are reasonable prospects that the funds will be released to the borrower.

The CRA also takes the position that the requirement to place amounts in a sinking fund or cash collateral account in the event of a contingency that is not expected to occur and that is entirely beyond the control of the lender, will not disqualify the interest from the exemption. The example given in the CRA’s Interpretation Bulletin IT-361R3 is that of an obligation that is secured by a building as collateral, and insurance or expropriation proceeds on the destruction or taking of the building are not used to rebuild the building. In that case, a requirement in the terms of the obligation that the funds be set aside as collateral for the obligation will not by itself result in a loss of the exemption. In effect, the CRA is accepting the cash as a change in security and an appropriate form of collateral.

CRA’s Constructive Repayment And Economic Compulsion To Prepay Theories

The basis for the CRA’s concern with cash collateral appears to either be that the lodging of cash with a trustee under the lenders’ control amounts to a constructive repayment of the loan or that the requirement to pledge cash collateral in this fashion creates an economic compulsion to repay. Usually when funds are set aside in collateral accounts, the ability of the borrower to direct the manner in which the funds are invested is limited to eligible investments, which are generally government bonds or other highly secure investments that earn a low return in comparison to the rate of interest payable under the cross-border loan. Where, as is often the case, the borrower has a right to prepay the loan, the CRA is concerned that the borrower will almost certainly prepay the underlying obligation and there is an effective "requirement" to repay.

Accordingly, the requirement to deposit cash collateral with a third party in specified events, other than those known to be accepted by the CRA, such as receipt of insurance or expropriation proceeds, can cause a concern with the availability of the exemption. Arrangements with third party trustees have been developed where the borrower controls the funds, directs the manner in which the funds are invested and there is a sufficiently extensive menu of potential investments that it is appropriate to conclude the borrower would not be economically compelled to repay the loan. In these circumstances, the cash collateral requirements may be acceptable. In addition, cash collateral may be acceptable where it is held by a third party trustee and invested by the borrower even if the investments are more limited, if the borrower is not permitted to prepay the loan within five years from the date of draw down. These alternatives are generally less than fully satisfactory from the perspective of either party. However, except in the case of expropriation, destruction or loss resulting in the receipt of proceeds and other limited, highly fact-sensitive situations, an obligation to irrevocably set aside cash collateral to be held by anyone other than the borrower in excess of 25% of the principal amount (together with any other "required" repayments) within the first five years may result, at least in view of the CRA, in the loan not qualifying for the 5/25 exemption from Canadian 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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