Recent initiatives to eliminate certain withholding taxes on payments to lenders outside of Canada should make it easier for Canadian energy companies to access foreign debt capital to help finance their operations.
The Canadian energy sector has always had significant foreign participation, particularly the holdings of foreign corporations in Canadian oil and gas assets and mining properties. Much of this foreign investment in the Canadian energy sector is structured as debt financing.
Recent amendments to the Income Tax Act (Canada) (the "Act") have eliminated Canadian withholding tax on conventional interest payments made after 2007 to arm's length non residents. In addition, when the Fifth Protocol to the Canada-U.S. Income Tax Convention (the "Protocol") is entered into force it will generally eliminate withholding tax on conventional interest payments made by Canadian residents to both arm's length and non-arm's length U.S. lenders.
Elimination of Withholding Tax on Interest to Arm's Length Non Resident Lenders
Under the Act, non-resident lenders are generally subject to a withholding tax of 25% on the gross amount of interest they collect from Canadian resident borrowers. However, this withholding tax is generally reduced to a rate of 10% for non-resident lenders that are entitled to the benefits of an income tax treaty. The law requires the Canadian borrower to withhold any such tax from payments made to the lender and remit the tax to the Canada Revenue Agency.
The effect of this withholding tax has been that Canadian borrowers have faced demands from non-resident lenders to "gross-up" interest payments to compensate them for the imposition of withholding tax. The elimination of Canadian withholding tax on conventional interest paid to arm's length non resident lenders will reduce borrowing costs of Canadian borrowers.
From a lending standpoint, non-Canadian lenders will no longer be restricted to lending into Canada on a 5/25 basis (where no more than 25% of the principal is mandatorily repayable within the first five years). This will allow for more flexibility for cross-border term loans.
Canadian withholding tax on payments to non-residents has not been completely eliminated. It will continue to apply to lease payments, dividends, royalties and certain other cross-border payments. The new rules will not apply to either "participating interest" (generally interest payments determined by reference to the borrower, revenue, profit or cash-flow or contingent on production) or interest on certain convertible debt.
Withholding Tax on Interest to Non-Arm's Length U.S. Lenders to be Phased Out
Under the new regime introduced by the Protocol, withholding taxes on interest payments to non arm's length U.S. lenders will be phased out over a three-year period following the second month after the Protocol enters into force.
Click here for a table showing the details of the phasing out.
The Protocol will enter into force once it has been ratified by both the Canadian and United States' governments. Although the Canadian government ratified the Protocol on December 14, 2007, it has yet to be ratified in the United States. The Protocol must first be considered by the Senate Foreign Relations Committee but the President has yet to refer the Protocol to the U.S. Senate for that purpose.
Although the elimination of withholding tax on interest payments will benefit both non-resident lenders and Canadian borrowers, any future tax planning in this area must take into account, among other things, the general anti-avoidance rule in the Act and the limitation of benefits provision found in the Protocol. Non-Canadians lending into Canada still need to be careful to avoid unintentionally "carrying on business in Canada" for tax purposes. The structuring of international loan transactions continues to require careful tax planning.