In an article published in Tax Notes International, Steve Suarez of BLG's Tax Group provides an in-depth analysis of the October 20th version of the back-to-back loan proposals originally announced in the 2014 federal budget. To read Steve's article, please click here.
Relevant to: Canadian corporations and trusts with outstanding debt (and their lenders), if a non-resident of Canada not dealing at arm’s length with the Canadian debtor (“Non-Resident”) either (1) has a receivable owing by the creditor (or a creditor affiliate), or (2) has granted an interest in property to the creditor (or a creditor affiliate), and some connection exists between the Canadian's debt and Non-Resident’s receivable or grant of an interest in property.
Issue: Starting in 2015, such debt may be treated as owing by the Canadian debtor directly to Non-Resident (not the actual creditor), resulting in interest on such debt potentially being subject to (1) Canadian interest withholding tax, and/or (2) restrictions on interest deductibility under Canada’s “thin capitalization” rules.
Discussion: Canada levies 25% non-resident withholding tax on interest paid by a Canadian resident to a creditor who is a non-resident not dealing at arm’s length with the Canadian debtor. The rate of withholding tax is reduced (usually to 10%) where the creditor is resident in a country that has a tax treaty with Canada. The only Canadian tax treaty that reduces the rate of tax to zero is the Canada-U.S. tax treaty.
Canadian corporations and trusts are limited in the extent to which they can reduce their taxable income through tax-deductible interest expense under Canada’s “thin capitalization” rules, which limit the amount of debt that a Canadian entity can incur owing to “specified non-residents” and be allowed to deduct the interest expense on. “Specified non-residents” are essentially non-residents who either are, or do not deal at arm’s length with, 25%+ equity holders of the Canadian debtor. Interest on debt owing to specified non-residents in excess of the permissible limit is non-deductible for Canadian tax purposes, and subjected to dividend withholding tax.
The Department of Finance is concerned with schemes that avoid Canadian interest withholding tax and/or thin capitalization restrictions by inserting an intermediary in between the Canadian debtor and a creditor who is a non-arm’s length non-resident (i.e., a foreign parent or sister company): for example, a loan by Non-Resident to a bank, which agrees to make a corresponding loan to the Canadian debtor. Proposals included in the 2014 federal budget to address this concern went far beyond such “back-to-back loans” as discussed in our previous bulletin (see here).
A revised (and apparently final) version of these rules was issued on October 20, 2014. This revised version is significantly improved, as it generally requires a substantial causal connection between (1) the Canadian entity’s debt to the creditor, and (2) the transaction between the creditor and Non-Resident, in order for the new rules to apply. As such, the scope of the revised rules come much closer to “back-to-back loans” and comparable arrangements. Also, the rules have been amended so as to cause a typical pledge of property by Non-Resident to the creditor in support of the Canadian debtor’s debt (i.e., a secured guarantee) to generally not trigger the new rules, if the creditor’s rights are limited to selling the secured property and applying the proceeds to pay down the debt upon default. In general the revised rules appear to produce appropriate results for the most part, although each case should be reviewed carefully (in particular where a Canadian member of a multi-national group is participating in an external group borrowing).