The Canadian government has recently introduced legislation that will amend the Canadian Income Tax Act (the Act) and eliminate Canadian non-resident withholding tax on interest (other than "participating debt interest" as defined) that is paid or credited to arm’s length non-resident lenders (regardless of their country of residence) with effect from January 1, 2008. The legislation received Second Reading in the House of Commons on December 4, 2007 but it is uncertain whether it will be enacted and come into force before January 1, 2008. Because the elimination of the withholding tax will likely take effect for interest paid or credited to arm’s length lenders on or after January 1, 2008 (regardless of when the legislation is enacted and comes into force), Canadian borrowers and non-resident lenders who may be affected by this legislation should carefully consider how they structure their debt obligations and comply with their withholding tax obligations during the interim period.
The proposed changes to the Act will apply without regard to the country of residence of the non-resident lender. Arm’s length lenders who are U.S. residents will not need to rely on the relief from withholding taxes to be provided by the Protocol to the Canada - U.S. Income Tax Convention (the Convention). (See our September 21, 2007 Osler Update – "New Protocol to the Canada - US Tax Treaty Signed "). Legislation to give effect to the Protocol and amend the Convention received Second Reading in the House of Commons on November 26, 2007 but the Protocol is not expected to be ratified in the U.S. until 2008 at the earliest. Therefore, the Protocol will likely not enter into force before 2008 and the relief it affords will therefore have effect from January 1, 2008 at the earliest. However, in the case of U.S. resident lenders who are "related" to the Canadian borrowers (and, therefore, are generally not arm’s length lenders for the purposes of the Act), the Protocol will amend the Convention to reduce and ultimately eliminate withholding taxes on interest (other than certain forms of participating interest as defined) beneficially owned by such lenders, subject to the new comprehensive limitation of benefits provision under the Convention. Assuming the Protocol is ratified by both parties in 2008, the Department of Finance has confirmed that the withholding tax rate applicable to interest paid to U.S. resident lenders who are "related" to the Canadian borrowers will be reduced to 7% under the Convention with effect on January 1, 2008. The rate will be further reduced to 4% in 2009 and then be eliminated altogether for 2010 and subsequent years.
Expanded Eligibility for Withholding Tax Exemption or Relief
Under the current Act, the most important exemption for Canadian borrowers from withholding taxes in Canada is the exemption for debt of corporate borrowers (and certain partnerships) that complies with the "5/25" exemption in the Act and is owed to arm’s length lenders. Consequently, once they come into force, the proposed changes to the Act and the Convention will significantly expand the range of borrowers and debt obligations eligible for exemption or relief from withholding taxes in Canada.
- Borrowers whose debts are eligible for a withholding tax exemption under the Act will no longer be limited to corporations (and certain partnerships) but may include trusts and other entities.
- Medium- and long-term debt obligations will no longer need to comply with the "5/25" exemption under the Act. Short term and revolving debts will also be eligible for the withholding tax exemption under the Act. However, the application of the new exemption is uncertain with respect to amounts paid on (i) debt that is convertible into equity or that is issued at a material discount, and (ii) the transfer by a non-resident of any debt with unpaid accrued interest to a resident of Canada that does not deal at arm’s length with the non-resident. Until this uncertainty is resolved, taxpayers should proceed cautiously in these circumstances and seek advice as appropriate.
- U.S. resident lenders who are "related" to the Canadian borrowers will be eligible for a withholding tax exemption or relief under the Convention (subject to the new comprehensive limitation of benefits provision in the Convention). However, the extent of such borrowings may be limited by Canadian "thin capitalization" considerations under the Act.
Interim Period Considerations
As noted earlier, it is likely that these changes to the withholding tax rules will take effect for interest paid or credited on or after January 1, 2008. However, it is possible that the changes to the Act and the Convention will not be in force for some interim period after January 1, 2008. Consequently, Canadian borrowers and non-resident lenders who may be affected by these changes face a risk that the changes proposed will not be enacted or ratified either as proposed or in a timely manner.
Although the Canada Revenue Agency may not impose penalties for any failure to comply with the Act and the Convention during the interim period, borrowers and lenders would remain liable for any withholding taxes (and, possibly, interest thereon) that are payable if the changes proposed are not enacted or ratified either as proposed or in a timely manner. Canadian borrowers may be required to make appropriate provision for such risks in their financial statements at least until the proposed changes are "substantially enacted." The failure to withhold and remit taxes could result in the Canadian borrowers bearing the cost of such taxes (and, possibly, interest and penalties) if they are unable to recover such costs from the lenders (or if the administrative and other expenses of recovering such costs from creditors are prohibitive).
While we consider it unlikely that the changes proposed will not be enacted or ratified as proposed with effect for interest paid or credited on or after January 1, 2008, no assurances can be provided (particularly if there is a Canadian federal election in 2008).
Addressing Interim Period Risks
These risks should be considered by affected borrowers and lenders in structuring their debt obligations and complying with their withholding tax obligations during the interim period.
Structuring New Debts
Although arm’s length lenders may wish to structure new term debts on a basis that assumes relief from withholding tax with effect from January 1, 2008, it may be prudent for Canadian borrowers to structure their new term debt obligations in a manner that complies with the "5/25" exemption with a "sunset" clause that would apply to certain provisions of the debts once the changes to the withholding tax rules come into force.
Existing Debts to Arm’s Length Lenders
In the case of arm’s length debt obligations, the interest on which would attract withholding tax under the current rules, borrowers who have not agreed to "gross up" interest payments to provide for withholding taxes may continue to withhold and remit taxes on interest paid or credited after January 1, 2008.
Alternatively, where it is practical to do so to preserve business relations or minimize the cost to lenders of seeking refunds of withholding taxes remitted by the Canadian borrowers, it may be possible to enter into arrangements that do not require the Canadian borrowers to withhold and remit taxes to the Canada Revenue Agency and that do not expose them to the risks described (for example, by the lenders providing security or guarantees to the Canadian borrowers or permitting the Canadian borrowers to hold certain amounts in trust during the interim period).
Existing Debts to Related U.S. Resident Lenders
Where the non-resident lenders are related to the Canadian borrowers, it should generally be easier to enter into arrangements (like those described earlier) that do not require the Canadian borrowers to withhold and remit taxes to the Canada Revenue Agency during the interim period. These arrangements should minimize the risks to the Canadian borrowers without incurring the expense of remitting the taxes to, and having the lenders seek refunds of the taxes from, the Canada Revenue Agency.
Monica E. Biringer is a partner in the firm's Toronto office, her practice includes all aspects of corporate income tax with an emphasis on mergers and acquisitions and corporate finance. Scott Wilkie is a senior partner in the Taxation Department of the firm's Toronto office. Gregory Wylie is a partner in the firm's Toronto office where he is a member of the Taxation Department. Brad Warden is an associate in the tax department in the firm's Toronto office.
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.