The Department of Finance today released proposed legislation to overturn three decisions of the Federal Court of Appeal.
Withholding Tax on Stripped Interest
The first decision overturned is Lehigh Cement, 2010 FCA 124. In Lehigh, the taxpayer was indebted to a related person and the interest payments were subject to Canadian withholding tax. Through a series of transactions, the debt obligation was amended to permit the interest to be stripped from the principal and to ensure that the interest qualified for exemption from Canadian withholding tax. The interest coupons were sold to an arm’s length foreign bank. The Federal Court of Appeal overturned the decision of the Tax Court and held that Canadian withholding tax did not apply to the interest payments made to the foreign bank.
Today, the Department of Finance proposed to amend the Income Tax Act (Canada) so that Part XIII withholding tax will apply to interest paid or credited by a resident of Canada to a non-resident person in respect of a debt that is owed to a non-resident person who does not deal at arm’s length with the payor. This proposal will apply to interest paid or payable after March 16, 2011 other than (a) in respect of a debt or obligation incurred by the payor before March 16, 2011; and (b) to a recipient that acquired the entitlement to the interest as a consequence of an agreement or other arrangement entered into by the recipient, and evidenced in writing, before March 16, 2011.
Interest provisions in Canada’s income tax conventions are unaffected by the proposal. For example, stripped interest payable to a U.S. resident who is a qualifying person under the Canada-US Income Tax Convention should be exempt from Canadian withholding tax.
Limitation on Expense Deduction
The second decision effectively overturned was Collins v. The Queen, 2010, FCA 12. The sole issue in the case was the deductibility of interest. The terms of a debt obligation were amended to provide that:
a) 10% simple interest was payable annually but the borrower had the option to make minimum annual interest payments of $20,000 before August 1 of each year,
b) at the end of the 16th year any unpaid interest was immediately due and payable,
c) however the borrower had the option before maturity to elect to pay $100,000 (plus the 15 annual $20,000 payments) in full satisfaction of all the interest owing on loan.
The Tax Court of Canada held that interest in excess of $20,000 per year was not deductible but the Federal Court of Appeal reversed the Tax Court and held that interest of 10% per annum was deductible on an accrual basis.
The draft legislation will clarify that where a taxpayer has a right to reduce an amount in respect of an expenditure, the amount deductible for tax purposes is the reduced amount. This proposal will apply in respect of taxation years ending after March 16, 2011.
Insurance Policy Reserves
The third case overruled was The Queen v. National Life Insurance Company of Canada, 2008, FCA 14. This decision determined that certain policy reserves of an insurer may be computed without reference to any liabilities of an insurer in respect of a segregated fund, other than liabilities in respect of an obligation on the part of a life insurer to make a guarantee payment.
The Department of Finance proposed to amend the Income Tax Regulations to ensure that policy reserves computed under sections 1404 and 1405 of the Income Tax Regulations are computed excluding only the reserves of the insurer in respect of a benefit that is payable to a policyholder from a segregated fund. This proposal will apply to the 2010 and subsequent taxation years.