Canada has a highly concentrated financial sector with six large Canadian domestic banks holding 93 per cent of all bank assets — one of the highest concentration levels in G7 countries, according to the International Monetary Fund. Perhaps because of this, there is a growing interest by foreign lenders to participate in the Canadian financial sector. Currently, 24 foreign bank subsidiaries and 29 foreign bank branches operate in Canada with a total of C$239-billion assets in Canada, compared to C$4.773-trillion held by Canadian domestic banks, as of December 2015. Foreign banks also participate in the Canadian financial sector by making cross-border bilateral and syndicated loans to Canadian borrowers without maintaining an authorized presence in Canada. In this bulletin, we discuss how Canadian banking laws regulate cross-border lending and how foreign banks and their affiliates can properly structure their lending activities to ensure compliance with Canadian laws and avoid disruptive adverse regulatory action in Canada.
UNDERSTANDING COMPETING POLICY OBJECTIVES
Foreign banks have made loans cross-border to borrowers located in Canada for many years, but the practice became much more prevalent after 2008 when the Government of Canada eliminated the withholding tax on arm’s-length outbound interest payments made by Canadian borrowers to non-resident lenders. The purpose of the elimination of the withholding tax, as Canada’s Department of Finance put it, was to “increase access to foreign capital markets and reduce costs for Canadians and Canadian businesses that borrow from foreign lenders.”
Although this tax disincentive was eliminated, foreign banks without an authorized presence in Canada continue to face a broad legislative prohibition under the Bank Act (Canada) against carrying on business in Canada. As a result, such foreign banks are required to structure their lending activities with residents of Canada cross-border, by maintaining minimal “touch points” with Canada to ensure that they do not carry on business in Canada contrary to the Bank Act.
The discord between the policy reasons underlying the elimination of the withholding tax in 2008 and the Bank Act prohibition against foreign banks carrying on business in Canada (without an authorized presence) reflects a long-standing policy tension between increasing competition in Canada’s financial sector on the one hand, and maintaining a level-playing field between Canadian and foreign banks on the other.
BANK ACT PROHIBITION
The prohibition in respect of foreign bank activities in Canada is set out in the Bank Act, the principal banking legislation. It reads, in relevant parts, as follows:
“510 (1) Except as permitted by this Part [XII], a foreign bank or an entity associated with a foreign bank shall not
(a) in Canada, engage in or carry on
(i) any business that a bank is permitted to engage in or carry on under this Act, or
(ii) any other business;
(b) maintain a branch in Canada for any purpose.”
The effect of this provision is that a foreign bank or an entity associated with a foreign bank is not permitted to engage in, or carry on, any business in Canada or maintain a branch in Canada, except as permitted by Part XII of the Bank Act. Part XII permits a foreign bank to establish certain types of business in Canada or to establish a Canadian branch, subject to satisfying applicable legislative and regulatory requirements. However, where a foreign bank or an entity associated with a foreign bank does not wish to establish authorized presence in Canada, cross-border structuring must be considered.
Although the Bank Act prohibition is broadly drafted, it expressly applies to activities that are carried on in Canada. As a result, a distinction has been drawn between engaging in Canada in an activity (prohibited by theBank Act) and engaging in the same activity from outside Canada cross-border with residents of Canada (permitted by the Bank Act). This distinction has been accepted by Canada’s principal banking regulator — the Office of the Superintendent of Financial Institutions (OSFI) — in a variety of circumstances. A number of OSFI rulings address this issue and provide guidance as to what factors are relevant, although each situation is dependent on the facts. Further, OSFI rulings have confirmed that some activity in Canada by, or on behalf of a foreign bank is acceptable, provided that the activity is ancillary to the main business activity of the foreign bank undertaken from outside Canada. OSFI rulings also indicate that policy concerns may impact OSFI’s determination whether cross-border dealings with Canadians constitute the carrying on of business in Canada. Specifically, in our experience, there is a heightened sensitivity in respect of transactions that include cross-border deposit taking. In addition, consumer lending programs generally have more connecting factors with Canada and they also raise consumer protection issues. For these reasons, consumer lending can be more difficult to structure across the border.
WHO IS SUBJECT TO THE PROHIBITION?
The Bank Act prohibition applies to foreign banks and certain entities associated with them. The following entities are considered foreign banks for the purposes of the prohibition:
- An entity that is a bank according to the laws of the jurisdiction of its incorporation or any jurisdiction in which it carries on business;
- An entity that engages in the business of providing financial services and employs, the word “bank” or “banking” or any corresponding words in other languages to identify or describe its business;
- An entity that is regulated as a bank or as a deposit-taking institution in the jurisdiction of its incorporation or any jurisdiction in which it carries on business. OSFI has indicated that it will generally view an entity to be a foreign bank under this criterion if the entity’s core business comprises deposit-taking or lending activities, and it is subject to a regulatory framework aimed at protecting depositors or other creditors.
The definition of an entity associated with a foreign bank is more complex. It is defined to include entities that control or are controlled by a foreign bank and entities that are controlled by the same person as the foreign bank. There are, however, important carve-outs from this broad definition, some of which are tied to materiality thresholds established under the Bank Act. This is an area where care needs to be taken to consider whether a non-bank entity that has a foreign bank in its corporate group would be viewed as an “entity associated with a foreign bank” under the Bank Act before engaging in any business in Canada.
The Bank Act prohibition also extends to the activities in Canada carried out by an agent or nominee of a foreign bank or an entity associated with a foreign bank. As a result, the foreign bank or the entity associated with the foreign bank cannot circumvent the Bank Act prohibition by enlisting agents or nominees in Canada and carrying out the prohibited activities through them. The term “agent” in this context refers to a common-law relationship of agency, while the term “nominee” does not have an established meaning in the Canadian jurisprudence and may be interpreted more broadly.
Importantly, the Bank Act prohibitions discussed above apply only to foreign banks and entities associated with them. If a lender is not a foreign bank or an entity associated with a foreign bank within the meaning of the Bank Act, then the lender would not be subject to the Bank Act prohibition, although certain licensing requirements under Canada’s provincial laws may apply.
A number of considerations have emerged from OSFI rulings and case law that help determine whether a cross-border activity of a foreign bank or an entity associated with a foreign bank constitutes the carrying on of business in Canada contrary to the Bank Act. As previously noted, this determination is highly fact-specific and often a single connecting factor (or its absence) is not dispositive of the issue. Rather, the considerations set out below outline the factors that OSFI will likely consider in determining whether a foreign bank or an entity associated with a foreign bank is carrying on business in Canada in contravention of the Bank Act. For ease of reference, we use the term foreign bank to refer both to foreign banks and entities associated with foreign banks in the discussion below.
Office or Employees in Canada
Maintaining a place of business or establishment in Canada, such as an office that is regularly used for an extended period of time by a foreign bank’s employees, nominees or agents is a significant adverse factor in the carrying on business determination. Maintaining an office in Canada will also likely contravene the Bank Actprohibition against opening a branch in Canada (other than an authorized branch).
Trips to Canada by Foreign Bank’s Employees
Regular visits to Canada by the employees of a foreign bank are also an adverse factor. However, limited visits to Canada to conduct due diligence, audits and inspections or visits occasioned by realization situations are likely to be permitted. Even limited visits, however, when combined with other significant connecting factors, may result in a carrying on business determination. Visits for the purpose of the solicitation of business are particularly sensitive and call for careful analysis in light of any other expected commitments to Canada.
Contract Formation and Negotiations
OSFI will consider where the material business contracts are negotiated and executed. Material contracts will include loan documents, such as commitment letters, terms sheets, credit agreements, and security documents, as well as service agreements that a foreign bank enters into with Canadian service providers in certain permitted circumstances. Negotiations that take place in person in Canada will have a significant adverse impact on the carrying on business determination. Therefore, all material negotiations should be conducted by persons located outside of Canada at the times they are negotiating, such as by telephone or by electronic means of communication. Although the foreign bank may engage local Canadian legal counsel to assist with the cross-border transaction, the foreign bank should be careful not to delegate material decision-making authority on business matters to the Canadian counsel. This is to ensure that the Canadian counsel are not viewed as agents or nominees negotiating in Canada on behalf of the foreign bank. In addition, because the Canadian common-law rules of contract formation generally consider a contract to be executed in the jurisdiction where it was last signed, the foreign bank should ensure that it signs all agreements outside Canada and, if the counterparty signs in Canada, the foreign bank should sign last. The importance of this distinction has, however, diminished in the era of email exchanges of PDF signature pages.
OSFI has accepted that foreign banks may utilize limited services in Canada in connection with cross-border loans if the services are incidental to the lending otherwise carried on from outside Canada. This can be explained in two ways. First, the activity carried out in Canada by the local service provider is such that even if undertaken by the foreign bank, the activity would not amount to carrying on business in Canada. Second, in some cases, OSFI has recognized that because the services carried out in Canada by the local service providers are incidental in nature, the service providers are not considered as agents or nominees of the foreign bank. In such cases, in order for a servicing arrangement to be permitted, it should be carried out by independent Canadian service providers that are not affiliated with the foreign bank and do not work exclusively for the foreign bank. Other permitted services could include valuation services, receivership services and legal services.
The services provided by an independent Canadian agent bank on a syndicated loan should also fall within the foregoing category of permitted services, although this issue has not been specifically considered in published OSFI rulings.
OSFI rulings also indicate that the use of Canadian service providers for certain aspects of loan servicing or enforcement alone would not be considered carrying on business in Canada. Specifically, in a 2004 ruling, OSFI held that a foreign bank offering secured commercial loans to Canadian borrowers from outside Canada did not breach the Bank Act by reason only that the foreign bank appointed a Canadian receiver to liquidate the assets in Canada of a defaulting Canadian borrower. OSFI held that these measures taken by the foreign bank to realize on its security in Canada were ancillary to the foreign bank’s lending activities outside Canada and were therefore permitted. However, a foreign bank that considers realizing on security in Canada by directly taking ownership of assets in Canada should seek legal advice from Canadian counsel on possible implications for the carrying on business determination and the Bank Act investment restrictions.
Maintaining bank accounts in Canada to advance loans and receive loan repayments is a significant factor in the carrying on business determination. To reduce the impact of this factor, foreign banks should ensure that loan advances and repayments are made outside of Canada or through wire payments. Where this is not possible or practical, such as when the loan is funded in Canadian currency, the foreign bank may consider using flow-through correspondent-banking accounts, rather than general-use accounts, with financial institutions in Canada.
Although Canadian courts have held that advertising in Canada does not by itself amount to carrying on business in Canada, advertising that is specifically directed at Canadian residents is a factor that OSFI will likely consider in the carrying on business determination. Therefore, while having a website that is accessible from Canada is not problematic, advertising or solicitation carried out specifically targeting Canadian borrowers will be a relevant factor.
OTHER CROSS-BORDER ACTIVITIES
Where a foreign bank engages in other types of cross-border activities, such as deposit-taking, trade finance or securities trading, OSFI will take into account other factual, policy and legal considerations in determining whether the activity would be permitted. In addition, cross-border financial activities may trigger regulatory obligations under other Canadian legislation. For example, while the Bank Act focuses on the type and frequency of activities that foreign banks and their associated entities engage in in Canada, the provincial securities legislation in Canada takes broader jurisdiction over cross-border securities transactions. In particular, cross-border securities trading, underwriting or investment advisory activities that are conducted by a foreign institution entirely from outside Canada with a customer or counterparty ordinarily resident in Canada are activities that could be subject to provincial securities regulation. To trade in securities with a resident of Canada, a foreign institution must normally be registered as a dealer in Canada or obtain a registration exemption. Although exemptions are available in many instances, these require specific fillings, fees and other obligations. Where a foreign bank lends against real property, it is also necessary to consider the requirements of mortgage-broker legislation in some Canadian provinces, where a licence (or an exemption) is required to hold a loan secured by real property. Depending on the nature of the cross-border financial activity, therefore, considerations outside the Bank Act regime may also be relevant.
PENALTIES FOR CONTRAVENTION
Contravention of the Bank Act prohibitions is punishable by civil and criminal penalties. In particular, a foreign bank or an entity associated with a foreign bank contravening the Bank Act prohibition may be subject to administrative monetary penalties of up to C$500,000 or may face up to C$5-million in criminal penalties on indictment. Criminal prosecutions, however, are rare, and civil penalties are not normally OSFI’s preferred enforcement tool in dealing with the carrying on business prohibition. Rather, where a potential violation of section 510 of the Bank Act comes to OSFI’s attention, OSFI normally first requests the foreign bank to explain how its activities do not result in a violation. In the course of discussing such explanation, OSFI may identify particular aspects of the activity that should be changed. Alternatively, OSFI may conclude that the cross-border program as a whole is in breach of the Bank Act and must be discontinued if it cannot be remedied by eliminating only some of the connecting points with Canada.
OSFI RULING PROCESS
Contravening the Bank Act prohibition may have a significant disruptive effect on a foreign bank’s cross-border lending activities in Canada. OSFI is generally open to discussions with foreign banks on whether a proposed cross-border lending program will be permitted under the Bank Act. Foreign banks may also formally request a ruling from OSFI on the proposed program. Although it would be unusual to request a ruling in respect of straightforward commercial loans made to borrowers in Canada and many situations can be addressed by Canadian counsel, foreign banks that wish to consider more complex cross-border programs may initiate discussions with OSFI and potentially request a formal ruling on the proposed plan.
The measures discussed above are aimed at ensuring that cross-border lending activities with Canadian borrowers are structured in accordance with Canada’s banking legislation and the expectations of the bank regulator. Properly implemented, these measures can minimize the likelihood and the severity of an adverse regulatory action. Proactive planning in this area normally requires less time and resources than responding to a potentially disruptive OSFI investigation.