Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, September 2009
Effective January 1, 2008, the Income Tax Act (Canada) (the Act) was amended to generally eliminate withholding tax on interest paid or credited to non-residents of Canada with whom the payor deals at arm's length. However, payments of "participating debt interest" are still subject to Canadian withholding tax.
"Participating debt interest" is defined in the Act to mean interest paid or payable on an obligation, if all or any portion of such interest is contingent or dependent on the use or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion, on or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.
The Act deems the redemption or cancellation of a debt obligation held by a non-resident person to be an assignment of the obligation by a non-resident for certain purposes of the Act. Further, the Act deems the amount (Excess), if any, by which the price for which a debt obligation was assigned (including a deemed assignment) exceeds the price for which the debt obligation was issued to be a payment of interest on the obligation made by a person resident in Canada to a non-resident person. This deeming rule does not apply to an "excluded obligation" which is defined in the Act to include any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation on which the interest would have been exempt under the former subparagraph 212(1)(b)(vii) of the Act as it applied in the 2007 taxation year. The former subparagraph 212(1)(b)(vii) of the Act exempted interest on debt from Canadian withholding tax provided generally that the issuer was not under any circumstance obligated to pay more than 25% of the principal within five years from the date of issue. (This provision was repealed when the general withholding tax was eliminated.)
With respect to a debt obligation that was convertible into shares of an issuer, the concern has been raised that any premium arising on conversion could be viewed as "participating debt interest" because such amount may be based on the value of the underlying shares of the issuer and could be contingent or dependent on one or more of the factors set out in the definition of "participating debt interest". It has therefore been argued that, in such cases, interest on such convertible debt might not benefit from the general withholding tax exemption. As a result, even after the elimination of withholding tax paid to arm's-length parties, convertible debt is still being structured to comply with the former subparagraph 212(1)(b)(vii) of the Act. This position has been significantly weakened by recent jurisprudence, including the Tembec case, but nonetheless, the Canada Revenue Agency (CRA) has not yet acknowledged that as a general matter, interest (and deemed interest) on convertible debt should not be considered participating merely because of the conversion feature.
A recently released technical interpretation provides some comfort that CRA will accept that interest (and deemed interest) on convertible debt will not be regarded as participating if, but only if, some very specific criteria are met. The interpretation was meant to address questions concerning convertible debt raised at the May 2009 International Fiscal Association – Canadian branch conference. The CRA outlined the general principle that the conversion of a "traditional convertible debenture" by its original holder for common shares of an issuer would not result in an Excess under the Act and therefore a deemed payment of interest by an issuer to a non-resident person would not arise for Canadian withholding tax purposes – and consequently, interest (and deemed interest) on such an instrument would not be considered participating. The CRA defined a traditional convertible debenture as one that met the following terms and conditions:
1. The debentures are unsecured subordinated debts;
2. The issuer is a public corporation;
3. The debentures are issued for a fixed amount of money in Canadian dollars that represents the face value of the debentures. The debentures are issued with no original discount;
4. The debentures bear interest at a commercial fixed rate per year calculated on their face value. The interest on the debentures is paid by the issuer at least annually;
5. The debentures are convertible at any time at the holder's option into common shares by the issuer prior to maturity. Some debentures have an initial non-conversion period;
6. The terms of the debenture specifically provides either a fixed conversion price or a fixed conversion ratio. The conversion ratio may be determined by dividing the conversion price into the face value of the debenture. In some cases, the security contract may provide for certain changes in the conversion price or the conversion ratio over time;
7. The conversion price exceeds the price at which the common shares of the issuer could have been purchased on the market at the time the debentures are issued;
8. The debentures have a specified maturity date; and
9. At maturity, the debentures are redeemable by the issuer at the redemption price of 100% of the face value, plus accrued and unpaid interest.
While some of the above conditions are commercially standard for convertible debt issuances (i.e., debentures convertible at the option of the holder into shares), the rationale behind some of the conditions is unclear, such as why the debentures must be unsecured as opposed to secured and why only public corporations may benefit from this administrative position.
Issuers of convertible debt that falls outside any of the above conditions would either need to (i) seek a ruling from the CRA that the Act would not operate to deem any Excess as a payment of interest or (ii) be structured in such a manner so that the debt is considered an "excluded obligation" as defined in the Act (such as an obligation that complies with the former subparagraph 212(1)(b)(vii) of the Act). As a general matter, it may be prudent to continue to rely on the 212(1) (b) (vii) approach until a more principled and consistent administrative position develops.
It is interesting to note that when the Act was amended effective January 1, 2008, it appeared that the Department of Finance's intention was to simplify the rules with respect to withholding on interest and facilitate Canadians' access to borrowing funds outside of Canada. However, the wording of the Act along with the concern raised with respect to the definition of "participating debt interest" and the CRA's subsequent administrative position in this regard, have led to convertible debt offerings continuing to rely on the former subparagraph 212(1)(b)(vii) of the Act. It remains to be seen whether the CRA will issue further guidance on this issue or if the Department of Finance will amend the Act to clarify that the general exemption for withholding tax on interest applies to convertible debt.
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.