On May 17, 2010, the Federal Court of Appeal (“FCA”) rendered its judgment in Lehigh Cement Limited v. R., 2010 FCA 124 (“Lehigh”), in which it found that the transaction in issue entered into by the corporate taxpayer, Lehigh Cement Limited (“LCL”), did not result in a misuse of the Canadian non-resident withholding tax provision applicable to interest payments in subparagraph 212(1)(b)(vii) of the Income Tax Act (Canada) (the “Act”) such that the general anti-avoidance rule (“GAAR”) did not apply to the transaction. This was a unanimous decision of the FCA overturning the Tax Court of Canada’s decision of April 2009.
Now repealed subparagraph 212(1)(b)(vii) included an exemption from Canadian non-resident withholding tax applicable to interest payments made before 2008 by a Canadian resident borrower to a non-resident lender that dealt at arm’s length with the Canadian resident borrower (the “Exemption”). This Exemption (often referred to as the 5/25 exemption) was only available if, among other things, the borrower was not obligated to repay more than 25% of the principal amount of the loan within five years from the date of the loan advance except in specific circumstances including in the event of failure or default under the terms of the loan agreement. Effective January 1, 2008, the Act was amended to eliminate Canadian non-resident withholding tax on interest paid by a Canadian resident borrower to a non-resident lender that deals at arm’s length with the Canadian resident borrower where the interest in not “participating debt interest” within the meaning of the Act.
LCL was a resident of Canada and a member of a related group of companies controlled by a German publicly traded company (the “HZ Group”). In 1986, LCL borrowed $140 million from a consortium of Canadian banks (the “Lehigh Debt”). Through a series of transactions occurring in 1994, the right to receive principal and interest under the Lehigh Debt was assigned to CBR International Services SA (“CBR IS”), a Belgian company and a member of the HZ Group. As a result of this assignment, LCL was required to withhold and remit Canadian non-resident tax at a rate of 15% on the interest paid to CBR IS under the Lehigh Debt pursuant to subparagraph 212(1)(b)(vii) of the Act.
The Lehigh Debt bore interest at a floating rate based on the Canadian prime rate. The Lehigh Debt was restructured in August 1997 in anticipation of an increase in the Canadian prime rate in order to avoid the imposition of Canadian withholding tax on interest on the Lehigh Debt under subparagraph 212(1)(b)(vii). The terms of the Lehigh Debt were amended such that CBR IS was given the right to sell to a third party all or any portion of the right to be paid interest thereon. In addition, the amended terms provided, among other things, that the interest on the Lehigh Debt would be fixed at 7% for the first five years and that Lehigh would not be obligated to repay more than 25% of the principal amount of the Lehigh Debt within five years of the date upon which the new terms were agreed to. This latter term was included to ensure that the Lehigh Debt met the conditions for the application of the Exemption.
In August 1997, CBR IS transferred its rights to receive interest on the Lehigh Debt to Bank Brussels Lambert (“BBL”), an arm’s-length Belgian bank. LCL took the position that the Exemption applied to interest paid by LCL to BBL on the Lehigh Debt after this transfer and did not withhold any Canadian non-resident tax from such interest payments. The Minister of National Revenue did not dispute that the arm’s length test and the 5 year test in subparagraph 212(1)(b)(vii) were met after such transfer. However, the Minister took the position that LCL was obligated to withhold and remit Canadian non-resident tax on interest paid to BBL on the basis that subparagraph 212(1)(b)(vii) was misused and that GAAR applied to the transaction.
In particular, the Crown argued that the Exemption was not intended to benefit a non-resident person who is legally entitled to be paid interest on a debt as a result of a transaction whereby the right to be paid interest is split from the right to be paid the principal amount. The Crown further asserted that the transaction in issue was inconsistent with the underlying fiscal policy of the Exemption because LCL did not access funds in an international capital market. In other words, the transactions entered into did not generate any funds for Lehigh. The Crown only produced an excerpt from the 1975 Budget Papers when the Exemption was proposed to explain its rationale for the underlying policy of the Exemption. In the Crown’s view, the following sentence in the 1975 Budget Papers explained the underlying fiscal policy of the Exemption: “The proposed relief from withholding tax is intended to increase the flexibility of Canadian business to plan long-term debt financing and facilitate access to funds in the international capital markets.”
The FCA assessed the Crown’s argument on the basis of this excerpt and determined that the above-noted sentence was a “shaky foundation” for an assessment under GAAR. The FCA noted that the Crown’s argument was inconsistent with the Crown’s concession that the Exemption would have applied and there would have been no reason to raise GAAR if CBR IS had also transferred its rights to receive the principal on the Lehigh Debt to BBL. In this situation, there would also have been no impact on LCL’s financial situation in the sense that LCL would not have received any funds.
In arriving at its decision, the FCA made certain important observations which are also relevant to the application of the new exemption from Canadian non-resident withholding tax on interest which came into force on January 1, 2008. First, the language of subparagraph 212(1)(b)(vii) is broad enough to include any interest payable by a corporation resident in Canada to a non-resident, no matter how the non-resident may have become entitled to receive that interest including by way of an interest bearing loan to a corporation resident in Canada, a sale of property to a corporation resident in Canada where the unpaid portion of the purchase price bears interest, or a purchase of the right to be paid interest on a debt obligation of a corporation resident in Canada with or without the right to be paid principal on the debt. Second, the arm’s length test in 212(1)(b)(vii) must only be met in respect of the relationship between the person required to pay the interest and the person entitled to be paid such interest. There is no requirement that this arm’s length test be met in respect of the person required to pay the principal and the person entitled to receive such payments. Third, the splitting of interest has long been a normal aspect of commercial financing transactions. With respect to the third observation, the FCA indicated that the Crown had not provided evidence that there is anything commercially “unusual”, in form or substance, about the splitting transaction under review. Depending on the circumstances, these observations may be useful in structuring the financing of a Canadian resident borrower in a non-arm’s length context.
The Lehigh decision also sheds further light on the burden of proof that the Crown must discharge in establishing that a transaction results in the misuse of a particular provision of the Act. In the Courts’ view, the Crown could not discharge this burden by asserting that the transaction was not foreseen or that it exploits a previously unnoticed legislative gap or by relying solely on an excerpt from the 1975 Budget Papers to explain the policy underlying the Exemption. The Court held that claiming an exemption in an unforeseen or “novel” manner did not necessarily mean that there is a misuse of the particular exemption. The Court found that the fiscal policy underlying the Exemption could not be explained only by a sentence in the 1975 Budget Papers as argued by the Crown.
We may not have heard the last word on Lehigh since the Crown has sought leave to appeal the FCA decision to the Supreme Court of Canada.