- A Primer: Canadian Withholding Tax And The 5/25 Exemption
- A Judicial Setback for the CRA
- Federal Goods and Services Tax – Recent Legislative Announcements
A Primer: Canadian Withholding Tax And The 5/25 Exemption
The Income Tax Act (Canada) (the "ITA") imposes Canadian withholding tax under Part XIII of the ITA ("Part XIII tax") on any amount that a Canadian resident pays or credits (or is deemed to pay or credit) to a non-resident person as, on account of, or in lieu of payment of, or in satisfaction of interest. In the event that the Canadian resident fails to withhold and remit the Part XIII tax, the Canadian resident is liable for the underlying withholding tax plus significant penalties and interest. The general withholding tax rate is 25%, subject to reduction under an applicable tax treaty. Canada's treaty rates for interest are generally 10% or 15%, and Canada has so far resisted attempts by other countries to reduce the rate to zero.
Part XIII tax on interest is subject to certain limited exemptions. The most important exemption is found in subparagraph 212(1)(b)(vii) of the ITA (or as it is commonly referred to, the "5/25 exemption") and is intended to allow Canadian corporations access to foreign capital markets for medium and long-term debt on a cost-effective basis. In order to come within this withholding tax exemption a number of conditions must be satisfied. In very general terms, the exemption applies to debt owing by a Canadian corporation to an arm's length foreign lender and, except where there is an event of default, the Canadian corporate borrower cannot be obligated to pay more than 25% of the principal amount of the debt within five years from the date the debt was issued. As well, the interest rate cannot be dependant upon revenue, cash flow, profit, or similar criteria.
These conditions have been the subject of very little judicial consideration. Accordingly, because of the importance of the withholding tax exemption, tax advisors have frequently consulted the Canada Revenue Agency ("CRA") regarding its interpretation of this exemption or have sought advance income tax rulings in this regard. As a result, a significant body of published CRA administrative practice and policy has developed and it has also become standard practice to rely upon CRA's administrative positions in drafting loan documents and providing withholding tax opinions.
Most of the issues in this regard centre on what are "acceptable" events of default, largely because of concern on the part of the CRA that the parties to a loan not be able to contrive events of default with a view to making what is, in effect, a short term loan appear to qualify under subparagraph 212(1)(b)(vii).
Unfortunately, CRA's numerous published interpretations and advance tax rulings are not always consistent and tend to be ambiguous in some respects. As a result, if there is a covenant in a loan agreement that is reasonable in commercial terms but does not clearly fall within the parameters established by CRA administrative practice and policy, there is often uncertainty as to whether or not the covenant would be accepted by CRA as satisfying its administrative criteria. Uncertainty regarding the potential for assessment of Canadian withholding tax is generally not acceptable to a non-resident lender (particularly in the case of syndicated loans), as Canadian withholding tax may represent a significant cost that may not be fully recoverable by the non-resident lender as a foreign tax credit in the country of residence.
Even if a foreign lender is provided with a high level of comfort (such as an unqualified tax opinion or an advance tax ruling) the lender will normally make it a condition of the loan that the Canadian borrower bear the cost of any Canadian withholding tax by obliging the Canadian borrower to make additional compensatory payments to the lender in the event any Canadian withholding tax liability arises. This protection for the lender is structured as a gross-up and indemnity clause in the loan agreement.
The purpose of a tax gross-up and indemnity clause is to allocate the financial responsibility for Canadian withholding tax and require the borrower to bear the risk of this tax effectively as a cost of financing. The amount of the additional payment made to a lender under a gross-up clause must take into account any Canadian withholding tax on the additional compensatory payments so that the lender receives the same amount as if no Part XIII tax were applicable.
By Gloria J. Geddes
A Judicial Setback for the CRA
Among the anti-avoidance provisions in the Income Tax Act (Canada) (the "ITA") is a provision that, in very general terms, will apply when a taxpayer acquires or disposes of shares of a corporation if it may reasonably be considered that the principal purpose of the acquisition or disposition of shares is to permit the taxpayer to avoid, reduce or defer the payment of Canadian tax. In such a case, the acquisition or disposition will be deemed not to have occurred. This provision is applicable only for the purposes of the subdivision of Part I of the Act which deals with the taxation of shareholders of corporations not resident in Canada or, in other words, foreign affiliate taxation.
Historically it was generally thought that this provision, found in subsection 96(5) of the ITA, was intended to apply in fairly limited circumstances, such as where a taxpayer's holdings in a foreign corporation were not sufficient for it to benefit from the Canadian "exempt surplus" system (which, in general terms, is a form of "participation exemption"), and the taxpayer acquired shares of a special class in order to technically qualify for such benefit. However, this provision seems to have been a recently uncovered weapon of the Canada Revenue Agency ("CRA") and has been used, or threatened to be used, by the CRA in attacks on a number of more or less aggressive foreign corporate structures for Canadian taxpayers, including so-called "tower structures" and "second tier financing" structures, as well as fairly commonplace foreign corporate structures.
The efforts of the CRA in this regard seem to have been dealt a blow in the recent Tax Court of Canada decision in the Univar case. In Univar, a Canadian subsidiary of a U.S. parent corporation capitalized a Barbados financing subsidiary with equity in the form of cash. The Barbados subsidiary used this equity to purchase related party loans from Univar's U.S. parent. The Canadian taxpayer filed its tax returns on the basis that interest received by the Barbados subsidiary was included in the "exempt surplus" of the Barbados subsidiary and that dividends received by the Canadian taxpayer from the Barbados subsidiary were effectively exempt from Canadian tax as being sourced from that exempt surplus. However, the CRA challenged this treatment under both subsection 95(6) and the so-called "general anti-avoidance rule" (or "GAAR") in section 245 of the Act.
One of the foundations of the CRA's challenge was that the taxpayer's position should be compared with what its position would have been had it acquired the related party loans itself, rather than those loans having been acquired by the Barbados subsidiary. The Tax Court strongly rejected this position, and quoted the Federal Court of Appeal in the recent Canadian Pacific case wherein the court stated that:
[a] transaction cannot be portrayed as something it is not, nor can it be recharacterized in order to make it an avoidance transaction,
and the Supreme Court of Canada in the recent Canada Trustco case wherein the court stated that GAAR:
does not permit a transaction to be considered to be an avoidance transaction because some alternative transaction that might have achieved an equivalent result would have resulted in higher taxes.
Accordingly, the Tax Court concluded that in this case, there was no tax otherwise payable to avoid, reduce or defer. Therefore, subsection 95(6) could not apply. As well, for these same reasons there could not have been a "tax benefit", which is a prerequisite for GAAR to be applicable. Accordingly, GAAR could not apply.
The decision in Univar is comforting and is consistent with previous decisions of the Courts in applying GAAR. In particular, these decisions have been consistent in holding that the introduction of GAAR into the Canadian tax system does not mean that taxpayers are prevented from adopting effective tax structures. One can only hope that the CRA will learn from another loss before the Courts, and will rethink their aggressive approach to the application of subsection 95(6). We would note that the CRA has not appealed this decision. Does that mean that they have learned from it?
By Tim Wach
Federal Goods and Services Tax – Recent Legislative Announcements
Reduction in GST/HST rates
The federal government has reduced the rate of the goods and services tax ("GST") from 7% to 6% effective July 1, 2006. The GST is a value-added tax that applies to most supplies of property and services made in Canada, as well as most imports of goods into Canada.
In conjunction with this reduction in the GST rate, the federal government has also reduced the rate of the harmonized sales tax ("HST") from 15% to 14%. The HST is a value added tax like the GST, but applies only to supplies of property and services made or deemed to be made in the Atlantic Provinces of New Brunswick, Nova Scotia, and Newfoundland and Labrador.
Consumers will benefit principally from the reduction, as they are unable to recover the GST/HST incurred on retail purchases. By contrast, most businesses are able to recover the GST/HST incurred on inputs of property and services, such that the reduction in rates has simply created additional compliance challenges.
However, some businesses that are not entitled to fully recover GST/HST incurred on inputs, including financial services providers, insurers, health care providers and lessors of residential real property, will benefit from the reduced rates on all property and services acquired as inputs into their businesses.
It remains to be seen whether the Provinces of Quebec and Prince Edward Island, both of which impose their sales tax on the GST-included value of property and certain services, will amend their provincial sales tax rates to maintain tax revenues.
New GST/HST rules for financial institutions
In the November 17, 2005 federal budget, the previous federal government announced new GST/HST rules affecting financial service providers that qualify as "financial institutions" or "FIs". Most banks, lenders, credit unions, licensed trustees, insurers, credit card businesses and any person, including a partnership, trust or individual, that has revenues from interest, dividends or financial services exceeding certain thresholds, will qualify as an FI.
The legislation governing the GST/HST has an existing provision requiring an FI to self-assess for GST/HST on transfers of personal property and services rendered by a foreign head office to a branch operation in Canada. Such self-assessed GST/HST would result in an unrecoverable expense to an FI. However, the Tax Court of Canada's decision in State Farm Mutual Insurance Company in 2003 rendered this provision essentially inoperative by determining that a mere allocation of head office expenses was insufficient to establish a taxable "supply" and the requirement for an FI to self-assess for GST/HST.
The federal government has announced amendments to "clarify" that the self-assessment of GST/HST applies to services and intangible property relating to Canada by ensuring that such supplies are deemed to have been supplied to a Canadian branch. These amendments are to be retroactive from the introduction of the GST/HST in December 1990.
Furthermore, these provisions will be replaced by an entirely new self-assessment regime for FIs effective November 17, 2005. This new regime will apply to FIs, whether operating domestically, by way of a branch in Canada, or from outside Canada.
The new regime will require FIs to self-assess for GST/HST on most expenses incurred outside Canada that are in respect of the FI's Canadian activities. This self-assessment of GST/HST will be required for all expenses allowable as a deduction, an allowance or an allocation for a reserve under the Income Tax Act (Canada) in computing the FI's income for a taxation year (or that would be so allowed if the FI were required to pay Canadian income tax). Also included in the self-assessment base will be otherwise non-taxable services of employees operating primarily outside of Canada and any part of the consideration for a non-arm's length financial service, such as insurance or a loan, that is in respect of certain expenses or a profit margin of the related supplier.
Although both recent federal budgets promised the text of the legislation to govern FIs to be released in the near future, no such detailed provisions have been released to date.
By Michael Bussmann
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.