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.
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.
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:
- in the event of a failure or default under the terms of the agreement;
- 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;
- 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
- 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.
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.