Tax efficiency is a key element in any successful cross-border investment. In acquiring or investing in a Canadian business, finding a tax-efficient transaction structure and working through the tax consequences of potential financing arrangements are critical steps. This two-part series examines some of the tax issues that typically influence decisions about how to structure and finance acquisitions of, or investments in, Canadian businesses. In this second installment, we consider how tax considerations can influence how investments and acquisitions from outside Canada are financed. (See Part 1 of the series here.)
Part 2: Financing issues
Cross-border investments often provide opportunities to shift tax deductions and income between jurisdictions in order to maximize global tax efficiency. There are many tax and commercial factors that go into financing decisions and options will vary depending on the nature of the investor, its residency and overall tax situation, including applicable tax rates. The following is a summary of the some of the Canadian tax considerations that impact financing by foreign investors.
- Equity financing by a non-resident
- Canadian corporations can return "paid-up capital" (PUC) without triggering non-resident withholding tax. Generally speaking, PUC is the amount of a corporation's invested capital. Unlike in the United States, there is no requirement to pay out earnings before returning capital. Accordingly, provided the investment is properly structured, non-resident investors should be able to get their investment back without paying any Canadian withholding tax.
- Dividends paid by Canadian subsidiaries to non-resident shareholders will be subject to non-resident withholding tax at a rate of 25%, subject to reduction under an applicable tax treaty as discussed below.
- Because PUC is determined on a class-by-class basis, a non-resident making an investment in a Canadian corporation (in contrast to acquiring shares from existing shareholders) should subscribe for a new class of shares. This ensures that all of the capital invested by the non-resident is reflected in the class of shares held by that investor, instead of being averaged across a class that includes shares previously issued to other investors at a lower price. For the same reason, if a vendor is getting shares of a Canadian purchaser on a rollover basis, the non-resident investor should get a separate class of shares because shares issued on a rollover basis will normally have lower PUC than shares issued in a taxable transaction. There are important corporate law issues of class voting and approval rights that need to be considered when separate classes of shares are being considered, however, these issues are generally manageable.
- Debt financing by a non-resident
- The amount of debt (as compared to equity) that a non-resident puts into Canada to fund the acquisition of a Canadian business will depend on the non-resident's overall tax situation. Subject to the thin-capitalization and transfer pricing rules discussed below, interest paid by the Canadian corporation going forward to the non-resident investor will generally be deductible in Canada, but may be subject to tax in the non-resident's home jurisdiction. Depending on foreign tax rates it may be preferable to pay tax in Canada (i.e. fund the acquisition with less debt), instead of shifting income into a higher tax jurisdiction. Investors that are exempt from tax in their home jurisdiction will typically prefer to put as much debt into Canada as possible.
- Interest paid to non-resident investors who do not deal at arm's length with the payor is subject to 25% non-resident withholding tax, subject to reduction under an applicable tax treaty (as discussed below). The Canada-U.S. Tax Treaty, for example, eliminates withholding tax on all interest (excluding participating debt interest), including interest between non-arm's length parties.
- Thin-capitalization rules: The thin-capitalization rules in the Income Tax Act limit the proportion of debt to equity that significant non-resident shareholders (and certain related persons) can invest in Canadian corporations. The permitted debt to equity ratio is 1.5:1. If the debt to equity ratio is exceeded the Canadian corporation will not be able to deduct interest in respect of the excessive debt, and interest payments will be treated as dividends and therefore subject to non-resident withholding tax. Similar rules exist for trusts, partnerships and foreign corporations. The thin-capitalization rules are complex, and should be carefully considered in the context of any cross-border funding.
- Transfer pricing: Payments, including interest payments, made by Canadian residents to non-arm's length non-residents must comply with Canada's transfer pricing rules. This means that interest paid by a Canadian corporation to a non-arm's length person must reflect an arm's length rate of interest.
- Hybrid debt: Hybrid instruments are structures that are treated as debt or equity in one country and the opposite in another country. The mismatch in tax treatment can provide opportunities to increase a corporate group's global tax efficiency. Hybrid debt and other types of hybrid instruments may be used to efficiently fund cross-border investments into Canada (or out of Canada) in certain situations.
- Third-party financing to fund an
- A non-resident investor may have the option of borrowing in Canada or in its home jurisdiction to fund the acquisition of a Canadian business. This decision will likely depend (at least in part) on where it can get the most value out of the interest deduction.
- If a decision is made to borrow from a third party in Canada generally interest on funds borrowed to acquire shares or assets should be deductible. If shares are acquired the interest deduction can typically be pushed down into the operating entity either through an amalgamation or, if necessary, a more complex loss-consolidation structure. This is necessary because Canada, unlike the U.S. and certain other countries, does not allow consolidated group tax reporting.
- Interest paid to an arm's length non-resident lender is not subject to non-resident withholding tax unless it is "participating debt interest", or the interest is not deductible pursuant to the thin capitalization rules. Generally speaking, "participating debt interest" is a debt where all or part of the interest is contingent or dependent on the use or production of property or is computed with reference to revenue, profit or certain similar criteria. Accordingly, interest paid to commercial lenders under typical lending arrangements is not usually subject to a Canadian withholding tax.
- Tax treaties
- Canada has a wide network of tax treaties which reduce the circumstances in which non-residents may be subject to Canadian income tax, and which reduce the withholding tax rates on payments made to non-residents, for example the Canada-U.S. Tax Treaty may reduce tax on dividends from 25% to as low as 5% in certain circumstances. Most of Canada's tax treaties reduce the withholding tax rate applicable to interest, dividends and royalties.
- Typically treaties apply to anyone who is a resident for tax purposes of the relevant country. The Canada-U.S. Tax Treaty is unique in that it contains a "limitation on benefits" rule which restricts the ability of certain people to rely on the treaty. The application of this rule is very complex and needs to be considered on a case-by-case basis.
- Depending on the nature of the investment and the status of the investor, it may be beneficial to structure the investment in a way that gives access to a favourable tax treaty. In the 2014 federal budget, the Department of Finance announced that it would be introducing new rules to combat "treaty shopping". To date, no specific changes have been announced.
In many situations cross-border transactions provide unique opportunities to implement structures that minimize a group's global tax rate. In addition, there are a number of complex Canadian tax rules that will limit or influence the options in any cross-border financing. For this reason, Canadian and foreign tax considerations will always be an important consideration when foreign investors acquire a Canadian business.
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.