On December 14, 2007, the Income Tax Act (Canada) ("ITA") was amended to eliminate withholding tax on interest paid by a Canadian resident to a non-resident creditor or lender who deals at arm's-length with the payer, regardless of the recipient's country of residence. This change to Canada's domestic tax rules became effective as of January 1, 2008, and applies generally to arm's length interest payable by a Canadian resident to any non-resident, with the exception of "participating debt interest". Generally speaking, "participating debt interest" is interest that is contingent or dependent on the use of, or production from, property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.
As a result of this amendment, U.S. residents to whom arm's-length interest is paid or credited by Canadian residents no longer need wait for proposed changes in the Fifth Protocol to the Canada-U.S. Income Tax Convention (the "Protocol") for relief from withholding tax. Draft amendments to the ITA released on October 2, 2007 provided that the withholding tax exemption in the ITA would apply only after the Protocol was in force. Because the U.S. has not yet ratified the Protocol (although Canada did so in December 2007), it was uncertain as to when the exemption in the ITA would become effective. This has now been settled with Canada's move to amend the ITA effective January 1, 2008 except that a U.S. resident who does not deal at arm's length with the Canadian resident will continue to wait for the U.S. to ratify the Protocol before withholding taxes on interest (other than "participating debt interest", as defined) are reduced or ultimately eliminated. Interest paid between related Canadian and U.S. persons will be fully exempt as of the third year after the Protocol comes into force. For the first and second years, the tax rate will be reduced from 10% to 7% and 4%, respectively.
A number of new opportunities have emerged as a result of this recent amendment. Prior to this amendment to the ITA, the "5/25" exemption was relied upon by most foreign lenders with respect to debt issued by Canadian corporate borrowers. Under that exemption, arm's-length interest was exempt from withholding tax if less than 25% of the principal amount of the debt was payable within five years of issuance (except in the case of default or illegality). Structuring of repayment terms often required quite strained adjustments to the lender's usual requirements to prepay on the happening of events such as an insurance payment. This will no longer be required. Also, the change will allow more flexibility in a lender corporate group as to which entity will be able to lend to Canada, improving the cost of funds and simplifying treasury management. In addition, not relying on the 5/25 exemption means that operating and revolving credit facilities can be provided by a wider range of foreign lenders directly, subject to regulatory requirements. Borrowers who are not Canadian corporations, such as REITs and other income trusts, will now have improved access to foreign sources of capital.
Care must be taken in structuring inbound U.S.-Canada cross-border financing arrangements to take into account other tax issues, such as U.S. income under subpart F of the Internal Revenue Code. Canadian regulatory restrictions, for example under the Bank Act (Canada), remain in place and may also need to be considered in structuring.
For more information on the Protocol, please see our previous bulletins entitled New Protocol to the Canada-U.S. Income Tax Convention, and New Effective Date for Proposed Exemption from Withholding Tax under the Income Tax Act (Canada)