On September 21, 2007, Canada and the United States signed the widely anticipated 5th protocol (the “Protocol”) to the Canada-U.S. Tax Treaty (the “Treaty”). Once it has been ratified by both countries, the Protocol will ultimately eliminate withholding tax on conventional interest payments made by Canadian taxpayers to U.S. residents. The eventual elimination of this withholding tax may create more opportunities for U.S. lenders to lend to Canadian borrowers. However, any U.S. lender making a loan to a Canadian borrower should ensure that its activities in Canada do not contravene any Canadian law. For example, if the U.S. lender is a “foreign bank” within the broad meaning of that term as defined in the Bank Act (Canada), it should ensure that its activities in Canada do not amount to engaging in or carrying on business in Canada in contravention of the Bank Act (Canada) (see comments below).
Under the Income Tax Act (Canada), non-resident lenders are generally subject to a 25% tax on the gross amount of interest they collect from Canadian resident borrowers. Non-resident lenders that are entitled to the benefits of an income tax treaty are generally subject to a reduced rate of 10% on such interest payments. The law requires the Canadian borrower to withhold the tax from payments made to the lender and remit the tax to Canada’s taxing authority, the Canada Revenue Agency. Withholding tax can be a significant factor in structuring transactions and can influence whether debt is raised wholly in Canada or wholly or partly outside Canada.
The Income Tax Act (Canada) currently provides a limited number of exemptions for non-resident withholding tax on interest payments. One of the most significant exemptions is the “5/25 exemption” that generally applies if a loan is between arm’s-length parties, the term of the obligation is greater than five years and no more than 25 per cent of the principal amount of the loan is required to be repaid within five years (except through the failure or default of the borrower). However, the utility of the 5/25 exemption is limited because it applies only to long and medium-term debt and it does not apply in the case of revolving credit.
In practice, where a withholding tax exemption is not available, withholding tax on interest payments is an additional financing cost, which is either borne by the non-resident lender, or passed on to the Canadian borrower by means of a “gross-up” clause in the loan document. The “gross-up” clause basically requires the borrower to pay additional interest to compensate for the withholding tax. This can represent a significant transaction cost to the parties and it can make transactions with non-resident lenders less competitive than transactions with domestic lenders.
Eliminating Withholding Tax on Interest
The Protocol will enter into force once it has been ratified by both the Canadian and United States governments. The Government of Canada intends to proceed with a Bill at the earliest opportunity. The earliest date on which the Protocol could enter into force is January 1, 2008. This would require both countries to ratify the Protocol in 2007.
The Canadian government has announced that upon ratification of the Protocol, the Income Tax Act (Canada) will also be amended in order to eliminate the withholding tax on interest paid to all arm’s length non-residents, regardless of their country of residence.
The current Treaty provides that U.S. lenders who are entitled to the benefits of the Treaty are generally required to pay a withholding tax of 10% on interest payments. This amount is withheld by the Canadian borrower and remitted to the Canada Revenue Agency on the lender’s behalf. Under the new regime introduced by the Protocol, withholding tax on interest payments between arm’s length persons will be eliminated as of the second month after the Protocol enters into force. Withholding taxes on interest payments between non-arm’s length persons will be phased out over a three-year period.
The proposed changes will be welcomed by both U.S. lenders and Canadian borrowers. The result in many cases will be to lower the cost of borrowing for Canadian borrowers that borrow from U.S. lenders. The change should also facilitate greater access to foreign debt financing by Canadian borrowers and may introduce additional competition in the Canadian corporate debt markets. However, U.S. lenders contemplating greater access to the Canadian market should take note that the Protocol does not eliminate all of the obstacles for U.S. lenders that want to lend into Canada – there are regulatory restrictions that should not be overlooked.
Regulatory Restrictions on a “foreign bank” Carrying on Business in Canada
Under the Bank Act (Canada), a “foreign bank” shall not engage in or carry on business in Canada except as authorized by the Act (i.e. through a foreign bank subsidiary or an authorized foreign branch or some other approved entity). The term “foreign bank” is broadly defined in the Act to include any entity that is called a bank or that is regulated as or like a bank. It also includes any entity that controls a foreign bank and any entity that provides financial services and is affiliated with a foreign bank.
This prohibition against engaging in or carrying on business in Canada would not prohibit a foreign bank from making a loan to a Canadian borrower as long as the nature and extent of all the foreign bank’s activities in Canada do not amount to engaging in or carrying on business in Canada. Whether a foreign bank would be considered to be engaging in or carrying on business in Canada by reason of making a particular loan to a Canadian borrower would depend on all the surrounding circumstances. Some of the factors that could be relevant include: how the relationship between the foreign bank and the Canadian borrower arose; where the documentation was negotiated and executed; and where the transaction was closed. Generally, where all aspects of the marketing, negotiation, execution and closing of a loan transaction by a foreign bank took place outside Canada, the foreign bank would not be considered to be engaging in or carrying on business in Canada solely by reason of that loan transaction.
Opportunities and Impacts
The area where the elimination of non-resident withholding tax on interest will likely have the greatest impact, and creates the greatest opportunity, is in the market for participants in syndicated loans. The changes will make it more competitive for U.S. lenders to participate in syndicated loans and thereby lend directly into Canada through an office outside of Canada. A U.S. lender that participates in a syndicated financing transaction generally would not be considered to be engaging in or carrying on business in Canada solely by reason of its participation in the syndicated transaction.