The 2014 federal budget included measures (Budget Measures) intended to eliminate the use of back-to-back loans to avoid the thin capitalization rules and/or withholding tax on interest paid to non-arm’s length non-residents so as to protect the Canadian tax base from erosion by limiting the extent to which foreign investors may take profits out of their Canadian affiliates without incurring Canadian tax.
The thin capitalization rules in the Income Tax Act (Canada) (Act) generally deny the deduction by a corporation or trust of interest payable on outstanding debts to specified non-residents to the extent that a debt-to-equity ratio is exceeded (currently 1.5:1). In the case of a corporation, “outstanding debts to specified non-residents” consist of debts and obligations owed by the corporation to:
- a non-resident shareholder who, alone or together with persons who do not deal at arm’s length with such non-resident, owns shares representing 25% of more of the votes or value of the corporation’s shares; or
- a non-resident who does not deal at arm’s length with a shareholder who, alone or together with persons who do not deal at arm’s length with such shareholder, owns shares representing 25% of more of the votes or value of the corporation’s shares.
Such persons are referred to in this note as “Subject Non-Residents”. Similar rules apply in determining outstanding debts to specified non-residents of a trust except that the 25% ownership threshold applies only in relation to the value of interests in the trust. The disallowed interest is deemed to be a dividend that is subject to Canadian withholding tax of 25%, subject to reduction under a tax treaty.
Although the Act contains a specific anti-avoidance provision to discourage taxpayers from making back-to-back loan arrangements to avoid the thin capitalization rules, as well as the general anti-avoidance rule, the government decided to enhance the existing specific anti-avoidance rule and to introduce a new specific anti-avoidance rule in respect of withholding tax on interest payments. For a discussion of the Budget Measures, please see our publication February 12, 2014 “Economic action plan 2014 – international tax planning under continued assault”.
Concern was expressed that the Budget Measures were overly broad and would apply to many ordinary commercial transactions with no tax avoidance purpose, such as where a non-Canadian entity that does not deal at arm’s length with a Canadian borrower provides security for the Canadian borrower’s debt (for example, a secured guarantee).
On August 29, 2014, the Department of Finance (Canada) released for consultation draft legislation (August Proposals) which contained significant revisions to the Budget Measures. In certain respects, the August Proposals address concerns expressed regarding the Budget Measures but in other ways may broaden the scope of the rules.
Thin Capitalization Rules
The August Proposals set out the following conditions for the application of the revised back-to-back loan proposals in the context of the thin capitalization rules:
- a taxpayer has an outstanding obligation (borrower debt) owing to a person or partnership (intermediary);
- the intermediary is neither a Canadian resident with whom the taxpayer does not deal at arm’s length nor a Subject Non-Resident; and
- the intermediary or a person or partnership that does not deal at arm’s length with the intermediary has an outstanding obligation owing to a Subject Non-Resident (intermediary debt) that meets any of the following four conditions:
- recourse in respect of the intermediary debt is limited in whole or in part to the borrower debt,
- the intermediary debt was entered into on condition that the borrower debt be entered into,
- the borrower debt was entered into on condition that the intermediary debt be entered into, or
- it can reasonably be concluded that if the intermediary debt did not exist, all or part of the borrower debt would not be outstanding or its terms or conditions would be different, or
- the intermediary or a person or partnership that does not deal at arm’s length with the intermediary had a specified right in respect of a particular property that was granted directly or indirectly by a Subject Non-Resident and either
- the existence of the specified right is required under the terms and conditions of the borrower debt, or
- it can reasonably be concluded that if the specified right were not granted, all or a portion of the borrower debt would not be outstanding or its terms and conditions would be different.
A specified right in respect of a property means a right to use, mortgage, hypothecate, assign, pledge or in any way encumber, invest, sell or otherwise dispose of, or in any way alienate, the property.
The August Proposals contain a “safe harbour” in that the revised back-to-back loan rules will not apply where the total of the outstanding intermediary debt and the fair market value of property in which a specified right was granted in respect of a borrower debt is less than 25% of the borrower debt. In this situation, the borrower debt is considered not to be funded by the intermediary from the Subject Non-Resident. Further, where the borrower debt is part of a corporate group borrowing from an intermediary, the 25% test also includes amounts outstanding to the intermediary by group members under the same agreement as the borrower debt or a connected agreement where the intermediary has a security interest securing the payment of the borrower debt and the other group debt.
The explanatory notes set out examples where relief is available where an intermediary enters into multiple cross-collateralized debts owing to the intermediary by multiple group entities, including a notional cash pooling arrangement. The examples make it clear that a cross-guarantee and a general security interest against all property held by each member of a group, securing payment of debt owing by all group members, will not, in and of themselves, cause the back-to-back loan rules to apply. Rather, cash collateral deposited with a bank or marketable securities provided as security, where the person holding such securities has the right to pledge or assign them (i.e., as a means of raising capital), will generally cause the back-to-back loan rules to apply, subject to the 25% de minimis test.
As the August Proposals apply to taxation years that begin after 2014, existing loan and security arrangements should be reviewed to determine whether an intermediary or a person or partnership that does not deal at arm’s length with an intermediary has a specified right. Although the explanatory notes are helpful in confirming that an intermediary will not be considered to have a specified right in respect of a property solely by virtue of having been granted a security interest in the property, it would be preferable if this exclusion were contained in the legislation itself. TEI has made submissions suggesting that this could be accomplished by defining specified right to exclude a “security interest”, a newly-defined term in the August Proposals. Subsections 248(4) and 248(5) of the Act provide similar examples by expressly providing that an interest in real property (or a real right in an immovable) do not include an interest as security only (or a security right) derived by virtue of a mortgage (or hypothec), agreement for sale or similar obligation. However, if the obligor defaults such that the intermediary has the right to realize on its security interest by disposing of the property, presumably what was a mere security interest would become a specified interest.
Further, in light of the new conditions to the application of the rules (“it can reasonably be concluded that” if the intermediary debt did not exist or if the specified right had not been granted, all or a portion of the borrower debt would not have been outstanding or its terms or conditions would have been “different”), financing arrangements of all non-resident persons or partnerships who do not deal at arm’s length with the borrower need to be scrutinized to determine whether they may affect the borrower debt. The TEI Submissions suggest that “it can reasonably be concluded” should be replaced with a principal purpose test similar to the one found in paragraph 95(6)(b) of the Act, as these conditions are highly subjective. Moreover, in the authors’ view, the requirement that the terms of the borrower debt are “different” because of the existence of the intermediary debt is a very low threshold.
Where the back-to-back loan rules apply, all or a portion of the borrower debt is deemed to be outstanding to the Subject Non-Resident creditor in respect of the intermediary debt or grantor of the specified right and not to the intermediary. In the case of multiple intermediary debts and/or particular properties in respect of which specified rights were granted, an allocation rule applies. To the extent that, by reason of the application of the thin capitalization rule, a portion of the interest on the borrower debt is not deductible, that interest is deemed for the purpose of Part XIII of the Act, subject to the application of subsections 214(16) and (17), to be payable to the Subject Non-Resident. Subsection 214(16) generally deems such amount paid by a corporation to be a dividend.
The Act imposes no withholding tax on interest paid by a resident of Canada to a non-resident person with whom the payer deals at arm’s length, provided that the interest is not paid on a participating debt obligation. If the payer does not deal at arm’s length with the non-resident person, the withholding tax rate is 25%, subject to reduction under a tax treaty.
The Budget Measures introduced a specific anti-avoidance rule in respect of withholding tax where certain back-to-back loans are made, which rule largely paralleled the new back-to-back loan rules for purposes of the thin capitalization rules. The August Proposals make similar amendments to the specific anti-avoidance rule.
The new rule ensures that Canadian withholding tax applies to a financing arrangement in which a non-resident provides debt funding through an intermediary, instead of directly, to a taxpayer resident in Canada. The new rule only applies if the interposition of the intermediary results in a reduction of the withholding tax that would otherwise have been payable if the interest were paid or credited directly to the non-resident, and not the intermediary. Thus, where the non-resident is a qualifying person under the Canada-U.S. tax treaty, which provides a full exemption from Canadian withholding tax for interest on non-arm’s length debt, the new rule would not apply. Interest for purposes of the application of the new rule is determined without reference to any amount disallowed under the thin capitalization rules. On the other hand, the test is purely a “results” test and does not take into account whether a main, or any, purpose was to achieve such result.
The other conditions for the application of the back-to-back loan rules in the withholding tax context closely mirror those in respect of thin capitalization including the 25% safe harbour. However, the intermediary may be a resident of Canada with whom the taxpayer does not deal at arm’s length and may be any non-resident person, not just a Subject Non-Resident. The specific anti-avoidance rule is therefore broader in its application in respect of withholding tax than in respect of thin capitalization to the extent the intermediary may be any non-resident person.
If the conditions of application are met in respect of an amount of interest paid or credited to an intermediary, the payer is deemed to pay interest to the non-resident person to whom the intermediary is indebted or has an obligation to pay an amount or who granted the intermediary a specified right in property. The amount of interest that is deemed to be paid is determined by a formula which takes into account (i) the amount paid by the payer as interest to the intermediary, (ii) the amount of the intermediary debt and value of property in which the intermediary has a specified right, (iii) the amount that is deemed to be a dividend under the thin capitalization rules and (iv) the withholding tax that would have been payable if the interest were paid or credited directly to the non-resident, and not the intermediary, and the amount of withholding tax imposed on the interest actually paid or credited to the intermediary. In determining the withholding tax that would have been payable if the interest were paid or credited directly to the non-resident person, regard will be had to whether the non-resident deals at arm’s length with the payer and whether the non-resident is entitled to benefits under a tax treaty, taking into account any relevant limitation of benefits provision.
Importantly, the back-to-back rules do not purport to affect the withholding tax required on actual payments of interest to the intermediary.
It is interesting to see that this specific anti-avoidance rule, which is in effect a specific anti-treaty shopping measure, was not postponed in the way that the proposed general anti-treaty shopping rule introduced in the Budget Measures was postponed in the August Proposals. The reason for postponing the general anti-treaty measure – to await further work by the OECD and G20 in relation to their Base Erosion and Profit Shifting (BEPS) initiative – arguably would equally apply. The material released by the OECD on September 16, 2014 in respect of BEPS and treaty abuse, refers to the use of domestic anti-treaty shopping rules, and the need to address the relationship between domestic rules and tax treaty provisions.