Withholding Tax on Interest to Be Removed
Canadian borrowers are on the verge of gaining unprecedented access to foreign capital. Canada has agreed that it will soon no longer impose withholding tax on interest paid to U.S. residents. Canada has also announced that it will extend this treatment to interest paid to arm’s-length non-residents of any country. Canadian withholding taxes will no longer be a barrier to the free flow of capital between Canada and the United States, and eventually between Canada and the world.
The new broad exemption of Canadian-source interest from Canadian withholding tax will significantly reduce the nuisance of peculiar commercial terms inserted into cross-border loans to ensure that they meet Canada’s existing domestic exemption for five-year corporate debt (the "5/25 Exemption"). Once these changes are implemented, non-resident lenders will be able to offer withholding tax–exempt loans of any term to Canadians and will be able to lend to trusts and partnerships (without having to use complex lending structures or obtain advance tax rulings from the Canada Revenue Agency [CRA]). The proposed changes are also expected to facilitate the use of many new products for Canadians, including financial guarantee insurance on a broader range of loans than exist today, and to facilitate the securitization of Canadian-origin financial assets in U.S. and other foreign capital markets.
New Protocol Applicable to U.S. Residents
On September 21, 2007, Canada and the United States entered into a Protocol to amend the Canada-U.S. Income Tax Convention (1980) (the Treaty). The Protocol will enter into force on the later of January 1, 2008 and the day on which both Canada and the United States have notified each other that they have ratified the Protocol. There may be practical delays in obtaining ratification that could extend the effective date into early 2008. The earliest that there will be relief from Canadian withholding tax on interest that is paid or credited to unrelated U.S. residents is the beginning of the second month following the Protocol’s entry into force. Even if the Protocol is adopted in 2007, the earliest that the interest relief will be effective is March 2008. The Protocol also provides that Canadian withholding tax on interest paid or credited to a U.S. resident that is related or deemed to be related to the payer will be eliminated over a three-year period, commencing the first calendar year ending after the Protocol enters into force.
2007 Budget Announcement of the Elimination of Withholding Tax on Interest
The 2007 Canadian federal budget announced that Canada would amend its domestic laws to eliminate Canadian withholding tax on interest paid (or deemed to be paid) to any recipient not resident in Canada where the recipient of the interest is dealing at arm’s length with the payer. The budget proposed that the exemption would apply to interest paid on or after the date on which the elimination of withholding tax on interest under the Protocol becomes effective, but possibly subject to a three-year phase-in. No draft legislation has been released and no further details have been announced regarding implementation of these proposed amendments.
Existing Rules Hinder Lending to Canadians
Withholding tax has acted as an impediment to non-residents who lend to Canadians. Canada imposes withholding tax at the rate of 25% of the gross amount of interest paid or credited to non-residents. Canada’s bilateral tax treaties generally reduce the rate to 10%. Canada’s existing 5/25 Exemption is the most frequently applied exemption for commercial interest, although certain other limited exemptions are available, including for government and government guaranteed debt. The 5/25 Exemption applies only to corporate borrowings with terms longer than five years, which has reduced the ability of foreign lenders to make revolving loans, make loans for terms shorter than five years and make loans to or invest in loans to trusts, individuals and certain partnerships. The elimination of withholding taxes on interest will remove these restrictions on foreign lenders with regard to the types of loans they may offer into Canada.
Details of the Protocol
The Protocol provides that interest paid or credited to a U.S. resident that is not related, or deemed to be related, to the payer will be exempt from withholding tax. Interest paid to a U.S. resident that is related, or deemed to be related, to the payer will still be subject to withholding tax (currently limited to 10% under the Treaty) but at a reduced rate of 7% in the first year ending after the entry into force of the Protocol and 4% in the second year ending after such time. Thereafter, no Canadian withholding tax will be imposed on interest paid to a U.S. resident.
Canada’s domestic thin capitalization rules will continue to apply to interest paid to "specified non-residents," which may reduce the deductibility of interest paid to a "specified non-resident." These are not affected by the Protocol.
The Protocol contains a limitation that allows Canada to continue to tax interest to the extent it exceeds the amount that would have been agreed upon in the absence of a special relationship between the payer and the beneficial owner or between both of them and some other person.
The Protocol provides that the exemption from Canadian withholding tax on interest will not apply to interest determined with reference to receipts, sales, income, profits or other cash flow of the payer or a related person; to any change in the value of any property of the payer or a related person; or to any dividend, partnership distribution or similar payment made by the payer to a related person. The rate of withholding under the Treaty for these amounts will be 15%. Thus, participating interest will still be subject to tax even under the Protocol.
Standby Fees and Guarantees
The Protocol exempts all interest as currently defined in the Treaty, which includes income that is assimilated to interest such as guarantee fees and standby fees under Canadian tax law. Under existing domestic Canadian law, a standby fee or a guarantee fee paid by residents of Canada to a non-resident of Canada is subject to Canadian withholding tax as though it were interest unless the loan meets the 5/25 Exemption. The Protocol will also exempt these fees from Canadian withholding tax. For financial guarantee insurers or for issuers of credit default swaps in which there may have been some argument that the amounts paid "guarantee" the repayment of a debt owing by a Canadian and thus are subject to withholding tax, it will now be clear that to the extent that such amounts are deemed to be interest, they will be exempt from Canadian withholding tax. Financial guarantee insurers have so far limited their insurance products relating to Canadian borrowings to insuring loans that meet the 5/25 Exemption.
Carrying on Business
Non-resident lenders may still be subject to Canadian tax in respect of loans made to Canadians if such lenders are considered to be carrying on business in Canada through a permanent establishment in Canada. A non-resident lender who engages in certain types of loans may risk being considered to be carrying on business in Canada. For example, it may be difficult for a non-resident to make residential mortgage loans (which are usually originated by a branch network or broker network) directly to Canada. Even if the loans were purchased after they are originated, the degree of activity that may be required to service those loans may cause a non-resident to be considered to be carrying on business in Canada regardless of the exemption of such loans from Canadian withholding tax. Each situation will need to be reviewed. A U.S. lender desiring to invest in Canadian loans may choose to lend to a Canadian conduit that will hold the loans and service them at the conduit level, thus avoiding a permanent establishment in Canada and becoming subject to Canadian taxes.
Treaty to Apply to LLCs
The Protocol also included amendments that will clarify the application of the Treaty to flow through entities such as LLCs (which under current Canadian law would not be eligible for the benefit of the Treaty). Depending on the circumstances, these rules should be reviewed to determine the eligibility of a particular lender for the benefit of the Treaty and for the possible application of relief thereunder from Canadian withholding tax.
Rents Still Subject to Withholding Tax
The Protocol does not apply to rents. Thus payments of rent (which are dealt with under the royalty article of the Treaty) will continue to be subject to withholding tax. Conditional sale-put structures that are economically similar to leases may be attractive alternatives.
Opportunities to Securitize
The elimination of Canadian withholding tax on interest on unrelated loans will facilitate cross-border securitization of Canadian originated financial assets into U.S. and other foreign capital markets. Currently, Canada imposes withholding tax on receivables such as consumer credit cards and consumer loans (including auto loans). Consequently, there are currently administrative issues and the cost of withholding tax if such assets are purchased by a foreign securitization entity and financed outside Canada. In addition, structures that might have permitted a cross-border securitization were often considered to raise anti-avoidance concerns on the basis that they were intended to reduce or avoid Canadian withholding taxes. When the budget changes are fully implemented, these concerns will be alleviated.
Until Canada fully implements a broad domestic exemption, practical issues for syndicated commercial loans may delay the benefit of the Protocol to Canadian borrowers. Many syndicates involve non-U.S. foreign lenders (participating ratably) so that the terms of such loans will need to provide exemption for interest paid to the non-U.S. foreign lenders (causing a persistence of the 5/25 Exemption or creating incentives for non-U.S. foreign lenders to lend through a U.S. related party). Even if non-residents are not involved, lenders often want to ensure that the terms of their loans are salable to as broad a group of buyers as possible to provide for potential liquidity. Without the exception from withholding tax for non-U.S. foreign lenders, loans made by U.S. residents (that do not meet the 5/25 Exemption) will be less salable to non-U.S. foreign lenders.
The amendments eliminating Canadian withholding tax on interest in the Protocol and the 2007 budget will be a welcome change for non-resident lenders who have used the 5/25 Exemption and who have experienced the often restrictive requirements on events of default, the use of excess cash, change-of-control provisions and repayments in certain circumstances. Loans from U.S. residents (and loans made by any non-resident after Canada implements a domestic exemption for arm’s-length loans) will no longer require a term of five years, and will no longer need to meet the arcane and often difficult administrative practices of the CRA with respect to the 5/25 Exemption. The elimination of Canadian withholding tax on interest paid between related parties (even though being phased in over several years) will also have a significant effect on financing Canadian subsidiaries. However, we anticipate that the CRA will be vigilant in reviewing transfer pricing on related party loans.
When Canada first announced several years ago that it intended to eliminate withholding tax on cross-border interest, the announcement garnered much excitement. This step will create many new opportunities and will reduce administrative issues for existing loans.
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.