Canada: Cross-Border Debt Financing of Canadian Real Estate – The 5/25 Exemption from Withholding Tax

Last Updated: April 12 2006

Article by Kathleen Penny and Kenneth Snider, ©2006, Blake, Cassels & Graydon LLP

This article was originally published in the Blakes Bulletin on Cross-Border Tax, March 2006

Foreign lenders and capital markets have provided sources of capital for Canadian real estate financing at interest rates and on other terms that are not otherwise available from Canadian lenders and investors.

Generally, the Income Tax Act (Canada) (the Act) imposes Canadian withholding tax at the rate of 25% (unless reduced by applicable treaty) on any amount that a Canadian resident pays or credits to a non-resident as, on account or in lieu of payment of, or in satisfaction of interest. The same Canadian withholding tax applies if a non-resident of Canada pays interest on debt secured by Canadian real estate and the interest is deductible in computing net income subject to tax under the Act. This withholding tax is subject to certain exceptions, the most broadly available of which is discussed below.

Withholding Tax Cost

Canadian withholding tax is a very important commercial issue in connection with indebtedness to a non-resident lender secured by Canadian real estate. It may represent a very significant cost that will make a transaction uneconomic for either the borrower (Realco) or the non-resident lender (NR). As a condition of making a loan, NR typically requires that it will receive interest without a deduction of withholding taxes. Any Canadian withholding tax may add a non-recoverable expense because NR may not, for a variety of reasons, fully claim the Canadian withholding tax as a foreign tax credit. Accordingly, if withholding taxes are or may be applicable, NR will likely require that Realco make an additional payment representing the withholding tax liability. This is typically structured as a gross-up requirement and an indemnity to protect NR. If an exemption from withholding tax will be relied on, often a high level of comfort (such as a "will" opinion or an advance tax ruling) is required by NR and Realco.

Exemptions from Non-Resident Withholding Tax on Interest under The Act

There are a limited number of exemptions in the Act for non-resident withholding tax on interest. In order to improve access to international capital markets and to reduce financing costs, the Canadian federal government introduced a withholding tax exemption for long and medium term corporate debt effective after June 23, 1975. Subparagraph 212(1)(b)(vii) of the Act (or the "5/25 exemption" as it has become known) was enacted and has been amended on numerous occasions.

This exemption contains numerous requirements which must be satisfied in order to qualify for the exemption. Because of the importance of the exemption, tax advisors have frequently sought the advice of the Canada Revenue Agency (the CRA) or advance income tax rulings from the CRA. Consequently, there has developed a large body of CRA administrative policy with respect to the interpretation of the exemption.

Status of Realco

The provision states that for the 5/25 exemption to apply the interest must be payable by a corporation resident in Canada. The CRA has confirmed that the exemption is available to a non-Canadian corporation that is deemed to be resident in Canada with respect to payments of interest, for example in the case of debt secured by Canadian real estate where the interest is deductible in computing net income of the borrower corporation that is subject to Canadian income tax. Also, the CRA has stated that interest paid to NR under an obligation that otherwise satisfied the requirements is not disqualified from the exemption simply because the borrower is a partnership, all the members of which are corporations resident, or deemed by the Act to be resident, in Canada.

Back-To-Back Loans

The requirement that Realco be a corporation or partnership of corporations is a major restriction, precluding the exemption where the borrower from NR is a trust (including a REIT), an individual or a partnership with non-corporate partners. Several recent tax rulings released by the CRA have ruled favourably on back-to-back loan situations, in which NR lends to a corporation, and the corporation on-lends to the non-corporate borrower on virtually the same terms. These include an important ruling that the Canadian general anti-avoidance rule will not be applied to deny the exemption. In each case, the taxpayers had to convince the CRA that there were commercial reasons why the loan transaction was structured in this manner, including reasons why the indirect borrower benefited from access to foreign capital.

The indirect borrowers that have obtained such rulings from the CRA to date include several limited partnerships (the cross-border loan was made to the corporate general partner, and it on-loaned to the limited partnership), a securitization trust sponsored by a Canadian corporation (which formed a new Canadian corporation to borrow cross-border and on-lend to the trust) and, most recently, a partnership of which the main partner was a business trust owned by a public income fund (the business trust incorporated a wholly-owned subsidiary corporation to borrow cross-border and on-lend to the partnership).

There has not yet been a ruling on a back-to-back loan involving a REIT. The recently announced "moratorium" on the issuance of advance income tax rulings to flow-through entities may temporarily preclude any partnership or trust from obtaining a ruling on any type of tax issue. At the present time, CRA is imposing the moratorium very broadly, including to rulings related to the financing of flow-through entities.

Status of Lender

There is no requirement as to the legal personality or status of the lender or the lender’s residency.

Arm’s Length Relationship

The interest must be payable to a person dealing at arm’s length with Realco. If Realco is a partnership, NR must deal at arm’s length with each member of the partnership. Persons who are related for purposes of the Act are deemed not to be dealing at arm’s length, and otherwise it is a question of fact whether persons are dealing at arm’s length.

Interest Payable

The 5/25 exemption is available for "interest payable by a corporation resident in Canada". Therefore, an amount that is payable in lieu of interest, which is not in fact interest and is not deemed by the Act to be interest, may be subject to withholding tax yet will not qualify for the exemption. Similarly, interest which is paid or credited but which is not "payable" will not qualify for the exemption. An amount becomes payable only if the taxpayer has an unconditional legal liability to pay and the amount of the liability is certain. The CRA takes the position that "payable" means accrued and owing and therefore prepaid interest is not eligible for the exemption.

An amount that is deemed by the Act to be a payment of interest will qualify for the exemption if the related debt qualifies. Examples include certain standby or commitment fees, guarantee fees and original issue discount.

Terms Of Repayment – The 5/25 Requirement

Paragraph 212(1)(b)(vii) of the Act requires that under the terms of the obligation or any agreement relating thereto, the borrower may not under any circumstances, subject to the exceptions discussed below, be obligated to pay more than 25% of the principal amount of the obligation, within five years from the date of issue, subject to the exceptions discussed below. Consequently, interest on a demand loan will not qualify for the exemption. Similarly, revolving loan facilities generally do not qualify for the exemption.

An obligation which otherwise qualifies for the exemption is not disqualified because Realco has discretion to voluntarily prepay more than 25% of the principal amount within five years of the date of issue.

NR and Realco must be certain as to when the five-year period commences. This period commences when the loan is advanced and not when the loan documentation is signed. If the loan contemplates multiple advances, compliance with the 5/25 requirement is normally achieved by ensuring that the loan matures no earlier than five years from the date of the last advance. While the wording of the exemption likely requires the maturity date of the loan to be greater than five years from the date of advance, the CRA has accepted a maturity date of exactly five years from the date of advance.

The CRA has confirmed that for a loan denominated in non-Canadian currency, the 5/25 requirement can be tested in that currency, so that foreign exchange fluctuations would not by themselves result in loss of the exemption provided that required repayments are expressed in that same currency.

Special issues in connection with the 5/25 requirement can arise in connection with cash reserve or deposit accounts that the lender requires the borrower to establish. The CRA’s view is that an obligation to repay more than 25% of a loan may exist if the borrower is required to irrevocably place more than 25% of the principal amount with an independent trustee or third party, notwithstanding any limitations on the lender’s ability to access these funds before a defined event of default.

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, and the funds are not expected to be tied up long enough to create an "economic compulsion" to prepay. Similarly, subject to the same caveats, reasonable cash reserves for the purpose of funding insurance premiums, real property taxes, tenant inducements, capital expenditures and the like are normally acceptable. With the possible exception of cash reserves to pay insurance premiums and taxes, the funds would have to be held by a third party, e.g., in a blocked bank account of a bank unrelated to the lender, not by the lender.

Exceptions from the 5/25 Requirement

There are certain circumstances in which Realco may be obligated to pay more than 25% within five years, without loss of the exemption. The permitted circumstances for payment of more than 25% within the first five years are:

  1. in the event of a failure or default under the terms of the agreement;
  2. if the terms of the obligation or any agreement relating thereto become unlawful or are changed by virtue of legislation or by a court, statutory board or commission;
  3. if the person exercises the right under the terms of the obligation or any agreement relating thereto to convert the obligation into, or exchange the obligation for, a "prescribed security", or
  4. in the event of the death of the lender.

Events of Failure or Default

The question of what is a permissible event of failure or default for the purpose of the 5/25 exemption has been the subject of considerable analysis by tax advisors and the CRA. Any condition which would require repayment of the principal of the debt is not necessarily viewed as a permissible event of failure or default for purposes of the exemption. Defining the events of default, the occurrence of which would require immediate payment of the principal of the debt, is a vitally important commercial issue, and there may be tension between what may be viewed as commercially reasonable and what is needed to qualify for the exemption. In some instances, there will be a conflict between the commercial objectives and the objective that the interest qualify for the exemption. The expression "event of a failure or default" in subparagraph 212(1)(b)(vii) has not been judicially considered. Accordingly, the administrative policies of the CRA in respect of what it considers a permissible event of default provide very important guidance to taxpayers.

The CRA has published many statements regarding what it considers to be an acceptable event of default. Any particular event of default must be examined carefully. The CRA's view is that in order to be acceptable for purposes of paragraph 212(1)(b)(vii), an event of failure or default must (i) have commercial reality; (ii) be beyond the control of the lender; and (iii) not be contrived.

Other relevant positions of the CRA include the following:

  • Cross-default provisions may be acceptable if the default of the other party impairs the security for the obligation and the lender does not have discretion to trigger the default.
  • Events that are the consequence of an act by persons not party to the agreement, such as governments, regulatory bodies, or courts, who are under no obligation pursuant to the agreement, cannot generally be considered "failure or default under the ... terms of agreement." For example, a change in internationally recognized interest rates or commodity prices is not, in and by itself, an event that is a "failure or default under the ... terms of agreement."
  • In this context, the expression "terms of agreement" can be interpreted to mean "terms of the obligation or any agreement relating thereto".

Thus, in analyzing cross-default provisions, if the default is by a person other than Realco which affects the security Realco has provided or Realco's creditworthiness, such a default should constitute an acceptable event of default of Realco. Defaults of material subsidiaries having this effect will generally be regarded as permissible events of default. Similarly, a default by the guarantor of Realco’s debt and its material subsidiaries should also be generally acceptable. Defaults or acts of the parent (if not a guarantor) may not be acceptable events of default of Realco unless it is clear that they affect Realco’s creditworthiness or security.

NRs often require that they be entitled to accelerate the repayment of a debt in the event of a change of control of Realco because control of Realco may be a very important credit risk factor. Fortunately, the CRA has adopted the position that where a loan agreement states that a change of control of the borrower is an event of default, such event is generally considered a permitted event of default. Caution should be exercised in determining whether the particular change of control clause is acceptable in the circumstances. For example, the CRA has accepted clauses designed to identify changes in voting control or changes in the ability to appoint the board of directors.

It is often desirable to draft a change of control provision so as to avoid triggering cross defaults. To accomplish this in a manner that satisfies the requirements of the withholding tax exemption, the loan agreement will typically provide that a change of control is not, of itself, an event of default. Instead, the change of control would initiate a "triggering event" whereby Realco would be obligated to offer to prepay the loan. Failure to make the offer to prepay would constitute an event of default, which would trigger repayment. The CRA has accepted this as a valid mechanism. Other "triggering events" have been accepted by the CRA, such as a material asset sale and a failure to maintain a minimum level of EBITDA.

The policy of the CRA concerning events of failure or default has continued to evolve. One contentious issue is whether a "material adverse change" is an acceptable default. If the determination of whether such a change has occurred is stated to be in the opinion of the lender, the CRA’s view is that this gives the lender an unacceptable level of control over whether the debt will become due, and makes the 5/25 exemption unavailable. The more objectively and precisely the clause is worded, the more likely it is to be acceptable to the CRA.

Excluded Interest

Where all or any interest payable on an obligation is contingent or dependent upon the use or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or by any other similar criterion or by reference to dividends paid or payable to shareholders of any shares of a corporation, the interest is deemed not to be interest for the purpose of the exemption. Consequently, all the interest payable under a "participating" real estate loan will not qualify for the 5/25 exemption.

The question has arisen whether the timing of interest payments is dependent on the criteria referred to above and would disqualify the interest for the exemption. The CRA has confirmed that where interest amounts are fixed and payable pursuant to a legal obligation to pay interest at a fixed rate, the fact that the timing of the interest payments is variable will not prevent the exemption from applying. All unpaid interest should be due no later than the due date of the obligation.

Changes in Terms of Debt Obligations and Novation

The terms of debt obligations are often amended, either because such amendments are contemplated by the loan documentation or Realco requires an accommodation. Where the changes to the debt are significant, the CRA may take the position that there has been a disposition of the debt obligation in consideration of a new debt obligation. The administrative views of the CRA in respect of changes in terms of a debt obligation that result in a disposition are very contentious. Any amendment to the terms of a debt, the interest on which qualifies for the exemption, should be carefully reviewed. Also, some instances there may be a novation of the debt obligation resulting in the termination of the old debt and the creation of a new debt. A novation will arise when the debt is being assumed and the lenders provide a release to the original borrower. The Act does, however, contain a saving provision where a corporation in financial difficulty issues a new debt (a "replacement obligation") in exchange or substitution for an obligation that meets the 5/25 exemption. In certain cases, the replacement obligation will be deemed to have been issued on the date the original obligation was issued, thus preserving the 5/25 exemption (if the replacement debt otherwise satisfies its requirements).

If there has been a disposition of the debt obligation and the issuance of a new debt obligation as a result of significant amendments or a novation, consideration must be given to whether interest on the "new" debt obligation qualifies for the exemption. For instance, if there was such a disposition and issuance, the exemption would not apply if the term of the "new" loan did not comply with the 5/25 requirement discussed above. A recent case illustrates the importance of this point. In General Electric Capital Equipment Finance Inc. v. The Queen, the Court considered whether the 5/25 exemption was available after a series of amendments to certain notes. The Court stated that the fundamental terms of the particular notes were the identity of the debtor, the principal amount, the interest rate and the maturity date. All but one of these (the principal amount) had been changed. The result was that, in view of the Court, the terms of the notes were so materially altered that a new obligation was created. The new obligation did not meet the requirements of the 5/25 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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Events from this Firm
14 Nov 2018, Speaking Engagement, Ontario, Canada

Join members of the Blakes Environmental and Enterprise Risk & Crisis Response groups for a discussion of hot topics and trends in Canadian environmental law.

15 Nov 2018, Webinar, Toronto, Canada

Join us for a live webcast with partners from our Employment & Labour and Litigation & Dispute Resolution groups as they discuss employment-related challenges and considerations surrounding the recent legalization of recreational cannabis in Canada.

15 Nov 2018, Webinar, Toronto, Canada

Join us for a live webcast with partners from our Employment & Labour and Litigation & Dispute Resolution groups as they discuss employment-related challenges and considerations surrounding the recent legalization of recreational cannabis in Canada.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions