Cross-Border Securitization: 10 Things To Know About Securitizing Canadian Assets Into The U.S. - Withholding Tax

Cross-Border Securitization

Cross-border securitizations involving Canadian assets can take various forms. For example:

A U.S. originator may have sold products to Canadian customers and wants to include the related receivables (owing by Canadians) as part of an otherwise U.S. securitization.
A Canadian originator may complete a Canadian securitization (selling to a Canadian special purpose entity (SPE)) but wants to fund it with notes sold in whole or in part to U.S. investors.
A Canadian originator may sell its assets directly to a U.S. SPE, perhaps in conjunction with parallel sales by its U.S. affiliates.

Although the Canadian and U.S. legal systems largely share a common heritage, there are some important differences to note when securitizing Canadian assets on a crossborder basis.

This paper focuses on 10 important Canadian law considerations that apply to "southbound" securitizations of Canadian assets into the U.S.

Other Canadian legal issues arise in a "northbound" sale of U.S. assets or asset-backed securities into Canada, including regulatory, tax and securities law considerations. We do not address those in this paper. Also, we do not cover U.S. law considerations arising under "southbound" securitizations of Canadian assets into the U.S.

01 |Regulatory Considerations

Canada's federal banking laws impose restrictions on foreign banks, and certain entities associated with foreign banks, that carry on business in Canada, including through a nominee or agent. If a U.S. entity involved in a cross-border securitization is a "foreign bank" or an "entity associated with a foreign bank," it will be important to determine whether the foreign bank or the associated entity is carrying on business in Canada and, if so, whether any of the restrictions set out in Canada's federal banking laws apply.

The analysis of whether a foreign bank or an entity associated with a foreign bank is carrying on business in Canada is fact driven and subject to the decision of the Superintendent of Financial Institutions, the primary regulator of federal financial institutions in Canada. In most cases, the mere fact that a U.S. entity establishes a relationship with a Canadian originator will not, in and of itself, result in a contravention of Canada's banking laws, provided that the U.S. entity avoids certain Canadian-related activities. For example, the U.S. entity should avoid visits to Canada; negotiate, execute and deliver the agreements outside Canada; fund from outside Canada; and not receive any payments under the relevant agreements in Canada. Where it is not practical to structure a transaction in this way, it may be acceptable to obtain certain ancillary services in Canada, but this should be discussed with counsel.

Similar regulatory restrictions apply to other types of foreign financial institutions carrying on certain types of business in Canada (e.g., insurance and trustee services). As with foreign banks, however, it is usually possible to structure their activities to avoid a violation of these restrictions.

Other Canadian federal and provincial laws may apply in specific circumstances, including privacy, anti-spam, antimoney laundering and sanctions, consumer protection, disclosure of cost of credit requirements, motor vehicle dealer licensing legislation and mortgage broker legislation. Generally, these other regulatory laws would not prevent a cross-border transaction, but they may impact the structure and documentation for a cross-border securitization.

02 | Tax

Achieving tax neutrality is a key goal in most cross-border securitization structures. Canadian (and U.S.) tax issues can significantly impact the optimal structure of a transaction, including:

(a) Canadian Withholding Tax

Despite Canadian withholding having been largely eliminated on most cross-border payments of interest, there are still some important withholding tax considerations that should be addressed.

Withholding Tax on Rent, Lease Payments and Certain Other Payments. Withholding tax still applies to certain cross-border payments, including rent or lease payments (subject to certain exceptions for aircraft leases and rolling stock) and dividends. Accordingly, it is most common for a Canadian originator to securitize lease receivables in a two-step transaction: first, by selling the lease receivables and the underlying leased equipment within Canada to a Canadian SPE and, second, by funding the SPE with a crossborder loan. If lease receivables are sold directly to a U.S. SPE, "back-to-back" and "character substitution" rules may, in certain circumstances, deem lease payments to be made directly to investors in the U.S., which could result in a higher withholding tax rate than would apply to the lease payments themselves.
Deemed Dividend for Cross-Border Notes. Canadian withholding tax may arise where a Canadian originator of financial assets that is ultimately owned by a non-Canadian sells financial assets to a U.S. SPE for consideration that includes a promissory note payable by the acquiring U.S. SPE. Unless the Canadian originator holds shares in the U.S. SPE, which may raise other Canadian tax issues, the entire amount of the intercompany note can be deemed to be a dividend under Canadian tax rules if it remains outstanding over a year-end. Since dividends are still subject to Canadian withholding tax, that "deemed dividend" will also be subject to Canadian withholding tax. While that tax would be refundable when the promissory note is ultimately repaid, the refund would be without interest so there would be an indirect cost. There are ways to structure a transaction to address such withholding taxes, but they need to be contemplated at the outset. For example, such withholding taxes may be avoided if the Canadian originator elects to include in its income for Canadian tax purposes interest on the promissory note at a prescribed quarterly rate (currently 9.16%).
Services Rendered in Canada. Withholding tax applies to amounts paid to a non-Canadian in respect of services rendered in Canada. The withholding tax is 15% of such payment. For services rendered in the province of Quebec, there is an additional 9% withholding. This withholding tax will need to be considered where the service-fee component of any receivables is sold cross-border to a non-Canadian purchaser if the service fee was for services rendered in Canada.
Withholding Tax on Interest. Withholding tax will generally not apply on interest paid from a Canadian on a debt owing to an arm's length person. Withholding tax will, however, apply on certain cross-border payments of interest between related parties. For example, withholding taxes may arise if a U.S. entity who is not entitled to the benefits of the Canada-U.S. Tax Convention lends to a related Canadian person. In addition, certain domestic tax rules limit the deductibility of interest paid by a Canadian person, and in certain circumstances where the deduction is denied on interest paid to a non-resident, the interest is deemed to be a dividend for withholding tax purposes.

The normal withholding tax rate for related-party interest, rents, lease payments and dividends, where it applies, is 25% unless reduced by treaty. Where a U.S. payee is entitled to the benefits of the Canada-U.S. Tax Convention (note that not all U.S. payees are entitled to these benefits), the rates are typically 0% for interest, 10% for rents on tangible personal property (e.g., equipment lease payment) and 15% for dividends, unless the recipient owns at least 10% of the voting stock of the company paying or deemed to be paying the dividend, in which case the dividend withholding tax rate is reduced to 5%. In cases where withholding taxes apply, a Canadian resident payor is required to withhold the applicable percentage of the interest (or other applicable amount being paid, such as rent) and remit the withheld amount to the Canadian tax authorities. If the payor fails to do so, both it and the non-resident payee (e.g., a U.S. conduit or investor) will be jointly and severally liable for the amount that should have been withheld. While a U.S. payee may be able to claim certain U.S. tax credits on withheld amounts, those credits may not be a full answer.

(b) Taxes on Income From Carrying on Business in Canada

U.S. investors and U.S. asset purchasers in a cross-border securitization (e.g., U.S. SPEs) may be liable for Canadian income tax and/or be required to file a Canadian tax return, if and to the extent that they are considered to be "carrying on business in Canada." Merely holding Canadian debt should not give rise to such liability or requirements, but the complete answer will turn on what else the investor is doing (or has done) in Canada and what type of entity it is. Generally, so long as the investor does not already have a presence in Canada, and provided that the securitization transaction does not itself create an agency relationship between the investor/purchaser and a Canadian entity, there should not be a "carrying on business in Canada" issue. For example, a U.S. purchaser of Canadian assets that are serviced by a Canadian servicer may raise questions regarding the existence of such an agency relationship. In such cases, it is best to address the underlying servicing relationship at an early stage to address potential concerns.

(c) Sales Tax

Depending on the types of assets that are being securitized and where they are located, sales taxes may arise as a result of a Canadian securitization. In Canada, value-added taxes are imposed at the federal level (goods and services tax (GST) or, in provinces that have harmonized their sales taxes with the GST, harmonized sales tax (HST)) and in Quebec (Quebec sales tax or QST). There are also single-stage sales taxes applicable in three provinces (provincial sales tax or PST).

For example, in a typical lease securitization, where leased equipment is sold to an SPE, GST/HST and QST will generally apply to the sale (based on the province in which the equipment is situated), unless an election applies. As such, sales taxes may ultimately be recoverable by the SPE through the claiming of input tax credits or refunds, and the impact of a securitization can usually be managed through proactive planning. The SPE should be registered for all applicable sales taxes. The SPE must charge and collect any GST/HST, QST and PST from obligors in connection with the leased equipment that it purchases. Such sales taxes are held in trust for the government and must be remitted to the tax authorities; they cannot form any part of the monies paid to noteholders or other stakeholders.

While no sales tax will apply to a sale of financial instruments to an SPE, such as trade receivables or loans, a securitization may still raise important sales tax considerations. For example, sales taxes payable by the obligor are often included in the amount owing under a trade receivable. Care should be taken to ensure that special deeming rules will be available to relieve an SPE purchaser from any potential obligation to remit the sales tax component of the acquired receivable. Also, servicing fees charged by a servicer to an SPE may attract GST/HST. Since such tax amounts would be unrecoverable where the securitized assets are financial instruments, it will be important to consider whether these potential taxes can be addressed in structuring the securitization. For example, the judicial concept of a "single supply" may be relied upon to characterize the transaction as the sale of an exempt "fully serviced" financial instrument, although this characterization may have some risk associated with it, depending on the circumstances.

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