Canadian withholding tax must always be considered in any cross-border financing. A failure to fully appreciate and mitigate the potential withholding tax risks can have significant adverse tax and cash flow implications to the parties, including personal liability for the directors of a corporate borrower.
Withholding tax will not always apply to cross-border interest payments, but the precise circumstances in which it either will or will not can be ambiguous. In many instances the analysis will be straightforward and the risks low or non-existent; however, one factual nuance in an otherwise "plain vanilla" transaction can significantly change the withholding tax implications.
The complexity of any given withholding tax analysis will vary from financing to financing, but the fundamental process or roadmap for dissecting and tackling the issues will be the same. Parties should invest the time at the planning stages of the financing to walk through this process, so as to properly assess any potential withholding tax risk and facilitate the implementation of any reasonable steps to manage any exposure.
Any withholding tax analysis must progress through the following steps, each of which will have its own unique subset of issues and considerations (a brief flowchart can be found at the end of this article):
- Does withholding tax apply under domestic Canadian tax law?
- Does a tax treaty apply to reduce or eliminate any Canadian withholding tax?
- Who is responsible for withholding and remitting and what potential liability arises?
- What indemnification or gross-up mechanics are (or should be) in place to address potential withholding tax?
- What other tax issues might arise from the financing?
Does Withholding Tax Apply Under Domestic Canadian Tax Law?
Canada levies withholding tax of 25 percent on interest paid or credited by a resident of Canada to a non-resident generally where either: (i) the payer and recipient (or the person to whom the underlying debt obligation is owed) are not dealing at "arm's length"; or (ii) the interest is "participating debt interest".
The analysis therefore requires confirmation of a number of legal and factual issues relating to the identity and tax-residency of the relevant parties, the relationships between the parties and the characterization of the interest payments.
Where are the Parties Resident?
The first threshold questions are whether (i) the payer of interest is a resident of Canada; and (ii) whether the recipient is a non-resident of Canada. While confirmation of residency is typically a straightforward analysis, the potential application of statutory deeming rules and the interaction of Canadian law with foreign law may trigger unexpected results in certain circumstances. For example:
- A corporation that is incorporated under the laws of Canada or a Canadian province/territory is by default a resident of Canada for Canadian tax purposes; however, such a corporation may also be resident in an foreign country pursuant to local law, in which case the relevant tax treaty may provide a determinative tiebreaker rule.
- A non-resident corporation (i.e., not incorporated in Canada or a province/territory) may be a resident of Canada for Canadian tax purposes if its mind and management is situated in Canada. It can be surprisingly easy for a foreign-incorporated corporation to cross this line if board meetings or other management activities occur in Canada. The terms of the relevant tax treaty should be reviewed to seek a resolution to any dual-residency issue.
- A non-resident person can be deemed in certain circumstances to be a resident of Canada for withholding tax purposes in respect of interest that it pays to another non-resident generally where the payer is either (i) carrying on business in Canada; or (ii) the indebtedness upon which the interest is paid is secured by real property situated in Canada.
- A partnership that has even one non-Canadian partner will be deemed to be a non-resident of Canada for withholding tax purposes if it receives interest from a resident of Canada. Similarly, a partnership will be deemed to be a resident of Canada for withholding tax purposes if it makes an interest payment to a non-resident that is deductible in computing the partnership's Canadian tax liability.
- Certain foreign banks are deemed to be residents of Canada for withholding tax purposes in respect of amounts paid or credited to or by the bank in the course of its Canadian banking business.
Are the Parties Dealing at "Arm's Length"
The next threshold question is whether the relevant parties are dealing at "arm's length". Where corporate entities are involved, the classic legal threshold in this respect is whether one party directly or indirectly holds sufficient voting shares of the other party to control the election of a majority of the board of directors. However, the analysis cannot stop here; rather, "arm's length" is both a legal and factual concept requiring a review of all the facts and circumstances that may have some bearing on the influence and control that one party may effectively have over the other. The line can easily be crossed where the lender has the ability to effectively control the borrower's board decisions or has significant influence over the operation of the borrower's business by virtue of its status as a significant creditor.
Is the Interest "Participating Debt Interest"?
Even if the parties are dealing at arm's length, Canadian withholding tax may nevertheless apply if the interest is "participating debt interest". Under Canadian tax law, participating debt interest is broadly defined to include interest payable on a debt where all or any portion of the interest is computed with reference to revenue, profit, cash-flow, commodity prices, dividends, or similar criterion. In simple terms, it is interest that resembles a return on an equity investment. Participating debt interest may also be deemed to arise in the context of debt that (i) is convertible into shares of the borrower or (ii) may be sold or assigned by the lender at a "premium" (i.e., at an amount exceeding the principle amount of the debt).
Participating debt interest and the circumstances in which it may be a concern can be extremely complicated and a tax lawyer should always be consulted to assess and mitigate any risks.1
Does a Tax Treaty Apply to Reduce any Canadian Withholding Tax?
The rate of domestic Canadian interest withholding tax may be subject to a reduction under a tax treaty, but the potential rate reduction varies from treaty to treaty. For example, while the majority of Canada's tax treaties reduce the withholding rate to as low as 10 percent, the treaty between Canada and the United States completely exempts most types of interest from withholding but maintains a 15 percent rate on certain forms of participating interest.
The availability of reduced treaty withholding tax rates depends on a number of potentially complicated factors relating to the identity of the recipient and the applicability of any of a handful of treaty "anti-abuse" rules. Additional complications may arise in determining the entitlement to treaty benefits where the non-resident recipient of the interest is a partnership or other "flow-through" entity that has multiple members potentially in a variety of jurisdictions.
The availability of reduced withholding tax rates under a tax treaty should not be assumed. The Canadian government has recently indicated that it is pursuing legislative measures to limit treaty benefits in certain circumstances, although ambiguity persists as to the precise application of any such measures. There are a variety of steps that both the payer and recipient of interest can take, depending on the circumstances, to mitigate the withholding risks.
Compliance Obligations and Liability for Withholding Tax
Both the payer and the recipient of interest are liable for any unremitted withholding tax, although in practice it is often more straightforward from an administrative perspective for the CRA to pursue an assessment against the Canadian-resident payer. Penalties and interest may also be applicable. Moreover, the directors of the payer are jointly and severally liable for any withholding tax that should have been deducted and remitted during the time of the director's tenure on the board.
The payer must exercise reasonable diligence in determining its withholding obligations. Particular care is required when withholding at a lower rate pursuant to a tax treaty. In each case, the payer will need to ask the right questions and act on the information that is provided by the recipient of the interest. The payer may request that the recipient complete certain government-issued information forms to assist in determining the payer's withholding obligation.2
Indemnification / Gross-Up
If withholding tax is a real or perceived risk, the parties should be explicit as to the precise implications that any such withholding tax may have on the economics of the particular financing transaction. If withholding is required by law, the payer must withhold and remit or else face the consequences described above. This withholding liability cannot be contractually overridden, although the parties may agree to gross-up any interest payments such that the recipient receives, net of withholding tax, the amount that is was expecting to receive.
The negotiation of gross-up clauses and exclusions from the gross-up can take many forms depending on the terms of the business deal and the parties' understanding of the likelihood of exposure to withholding tax. Such negotiations should address eventualities such as (i) changes of law; (ii) changes in the tax position of the parties (i.e., residency); and (iii) changes in the identity of the parties (i.e., assignment of rights and obligations under the financing).
Not Out of the Woods – Other Relevant Tax Issues
Even if the above questions have been addressed in a manner suggesting that Canadian interest withholding tax should not be applicable or otherwise problematic, the parties must be aware of a number of other potentially adverse tax consequences that could arise from the financing, all of which should be considered by the parties' tax advisors in addition to any relevant foreign tax implications. These issues include:
- Thin Capitalization: Where a Canadian corporation's debt to equity ratio in respect of certain cross-border debt exceeds 1.5 to 1, a portion of the interest that it pays may be recharacterized as a dividend subject to a completely different Canadian withholding tax regime. Moreover, a portion of the payer's interest expense may not be deductible where the "thin cap" threshold is crossed.
- Transfer Pricing: The rate of interest on certain cross-border debt to non-arm's length persons must be carefully considered to determine whether there is any risk that the tax authorities (Canadian or foreign) would seek to adjust the rate for tax purposes, which could trigger a variety of different income and interest/dividend withholding tax issues.
- Deemed Interest or Dividends: Various non-arm's length cross-border loans may trigger deemed interest or dividends that may attract Canadian income or withholding tax. Examples include loans by a Canadian corporation to its non-resident parent that remain outstanding for more than one year following the year in which the loan was made.
- Taxable Repatriation of Profits to Canada: Certain loans from foreign affiliates of a Canadian company can trigger adverse income tax consequences to the Canadian company on the basis that the loan is characterized as a taxable repatriation of income from the foreign affiliate.
- Back-to-Back Loans and Cross-Border Security: There is a risk of triggering adverse Canadian thin capitalization and withholding tax issues (described above) where a non-resident person enters into certain back-to-back or collateralization transactions with an intermediary that has advanced money to a resident of Canada. Examples would include a lender that has made an advance to a Canadian-resident borrower on condition that a non-resident affiliate of the borrower (i) loan an amount to (or place an amount on deposit with) the lender; or (ii) provide the lender with an immediate right (i.e., not contingent on the Canadian-resident's default) to pledge, assign or sell certain assets of the non-resident person. Most forms of "traditional" security or collateralization covenants and guarantees in an arm's length financing should not be problematic but should be reviewed to ensure these rules are not engaged.
1. For prior coverage, see http://www.casselsbrock.com/files/file/ConvertibleDebt-MPeters-Summary-FINAL.pdf
2. See, e.g., Canada Revenue Agency Form NR 301 – Declaration of Eligibility for Benefits under a Tax Treaty for a Non-Resident Taxpayer.
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.