This article was originally published in Blakes Bulletin on Taxation - April 2005
In determining whether an event of failure or default is acceptable for purposes of the 5/25 exemption, the Canada Revenue Agency (the CRA) has repeatedly stated that an acceptable event of failure or default must have commercial reality, must be beyond the control of the lender and must not be contrived. One type of event of failure or default on which the CRA has commented is the occurrence of a "material adverse change" in (sometimes referred to as an event which has a "material adverse effect" on) the financial situation of the borrower, or in some cases, a party related to the borrower.
CRA Technical Interpretation
In a 2001 technical interpretation, the CRA considered whether two hypothetical events of default would preclude the availability of the withholding exemption. The first was "the occurrence or threatened occurrence of an event which, in the opinion of the lender, has a material adverse effect on the financial situation of the borrower", and the second was "the occurrence or threatened occurrence of an event which has a material adverse effect on the financial situation of the borrower". The CRA took particular exception to the first scenario on the basis that if the decision to recall an obligation was left to the lender’s own opinion with respect to a particular event of failure or default, it would amplify the discretion of the lender and would give it control as to when a debt could be called. As a result, the CRA’s view was that the inclusion of the words "in the opinion of the lender" in a sentence describing an event of default, would generally preclude that event of default from being acceptable for the purposes of the withholding tax exemption. The CRA went on to suggest that in both cases the wording was ambiguous, and could give the lender "virtually an open-ended opportunity to recall the obligation for reasons which they consider material". On this basis, the CRA expressed the opinion that the presence of either event of default would preclude the availability of the exemption.
Reasonableness of CRA Position
The CRA’s position with respect to the first scenario described above is not unreasonable. The CRA’s longstanding position is that an acceptable event of failure or default for purposes of the exemption must be beyond the control of the lender, which would not be the case where the lender has sole discretion to determine when such an event has occurred. This position clearly prevents some possible abuse of the exemption. However, the same cannot be said of the second scenario. While the occurrence or threatened occurrence of an event which has a material adverse effect on the financial situation of a borrower may be theoretically ambiguous or subjective, in practice it would not be commercially realistic for a lender to attempt to enforce the early repayment of an obligation by taking the position that there had been an event of default, unless there was substantial evidence that such an event had actually occurred. The consequences (and potential damages) to a borrower when a lender commences enforcement following an alleged event of default are significant, and as a practical matter it is understood that lenders, generally, only seek to enforce on the basis of an event of failure or default in circumstances where there is little or no argument that such event has not occurred (e.g., the breach of quantifiable financial ratios).
There is some evidence that the CRA may have backed away from its position with respect to material adverse changes. In a 2003 ruling, it confirmed the availability of the withholding tax exemption in circumstances where the events of failure or default included "the occurrence of a ‘material adverse change’ which is defined [to deal] with a change in the financial situation of [parties related to the borrower]".
Events of failure or default in a loan agreement are heavily negotiated as between the borrower and the lender, and have typically been developed over time based on experience; the lender seeks to protect its money and the borrower seeks to obtain maximum financial flexibility. Where such an event is the product of such arm’s length negotiations and is not contrived, it should be acceptable to the CRA and should not taint the availability of the 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.
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