The following is an update of current Canadian tax matters that may be of interest to corporate groups with Canadian members:
New Back-to-Back Loan Rules in effect on January 1, 2015
The Canadian Government released revised “back-to-back” loan rules on October 23rd. The back-to-back loan rules are meant to address situations in which indirect arrangements are used to avoid the application of the Canadian withholding tax rules applicable to interest payments and/or the application of the Canadian “thin capitalization” rules. The back-to-back loan rules are proposed to apply, with respect to Canadian withholding tax, to amounts paid or credited after 2014, and with respect to the Canadian thin capitalization rules, with respect to taxation years that begin after 2014. Multinational groups with Canadian members should review existing debt financing arrangements involving Canadian group members to determine whether the back-to-back loan rules could apply and, if so, whether changes to existing arrangements are required.
A brief description of the Canadian withholding tax rules applicable to interest payments, the Canadian thin capitalization rules and the application of the back-to-back loan rules is below.
The Income Tax Act (Canada) (the “ITA”) imposes a 25% withholding tax on interest paid by a Canadian resident to a non-resident if (i) the non-resident does not deal at arm’s length with the Canadian resident payer; or (ii) the interest is “participating debt interest”. This 25% rate may be reduced, typically to 10%, if
the recipient is entitled to the benefits of a tax treaty between Canada and the country in which the recipient is fiscally resident. The Canada-US Tax Convention generally eliminates withholding tax in respect of all interest, other than participating interest.
The ITA also contains “thin capitalization” rules that may limit the deductibility of interest paid by a Canadian corporation (and certain other entities) to a non-Canadian group member if the amount of debt owing by the Canadian corporation to non-Canadian group members exceeds 150% of the Canadian corporation’s equity. The non-deductible interest is treated as a dividend (not interest) for Canadian withholding tax purposes.
In the absence of anti-avoidance rules, the Canadian withholding tax rules applicable to interest and the Canadian thin capitalization rules could be circumvented through the use of an intermediary to make loans to the Canadian debtor. For example, a non-Canadian parent company (“Forco”) might make a loan to an arm’s length intermediary on condition that the intermediary make a loan to Forco’s Canadian subsidiary (“Canco”). Such an arrangement may have the objective of (i) reducing/eliminating the Canadian withholding tax that would otherwise have applied if the interest payments had been made directly by Canco to Forco; and/or (ii) excluding the debt owing by Canco to the intermediary from the application of the Canadian thin capitalization rules. However, if the back-to-back loan rules apply, the Canadian debtor (i) may be deemed to pay some or all of the interest to the underlying creditor (and not to the intermediary) for Canadian withholding tax purposes, thus increasing the Canadian withholding tax applicable to the interest; and (ii) may be deemed to owe some or all of the debt to the underlying creditor (and not to the intermediary) for purposes of the thin capitalization rules.
Very generally speaking, the back-to-back loan rules may apply, in the context of Canadian withholding tax on interest, to arrangements in which a reduced withholding tax rate would otherwise be available in respect of interest paid or credited by the Canadian entity to an intermediary and:
(i) a loan has been made by a non-resident of Canada to the intermediary and recourse in respect of the loan to the intermediary is limited to the debt owing by the Canadian entity to the intermediary;
(ii) a loan has been made by a non-resident to the intermediary and it can reasonably be concluded that the loan made by the intermediary to the Canadian entity was made because of the loan to the intermediary; or
(iii) the intermediary has been granted a “specified right” by a non-resident member of the Canadian entity’s group in respect of the Canadian entity’s debt to the intermediary (a specified right in respect of a property is a right to mortgage, hypothecate, assign, pledge or encumber the property to secure payment or a right to use, invest, sell or dispose of the property).
Similar rules apply in the context of the Canadian thin capitalization rules.
Anti-Treaty Shopping Proposal on Hold
The Canadian Government proposed a domestic anti-treaty shopping rule in its 2014 Budget. This anti-treaty shopping rule provided that a treaty benefit would not be provided in respect of an amount of income, profit or gain if it is reasonable to conclude that one of the main purposes for undertaking a transaction is to obtain the benefit of the treaty. The Canadian Government has now announced that it has decided that rather than advancing the domestic treaty shopping initiative at this time, it will instead await further work by the OECD and the Group of 20 (G-20) in relation to the their Base Erosion and Profit Shifting (“BEPS”) initiative.
Don’t Forget to File…the GST/HST Section 156 Election
Certain closely related corporations and partnerships are able to make a joint election under section 156 of the Excise Tax Act (Canada) (the “ETA”) that generally deems supplies of property and services between them to be made for nil consideration. As a result, while the election is in effect, goods and services tax/harmonized sales tax (“GST/HST”) will generally not apply to intercompany supplies between them. Corporations and partnerships contemplating the election must be resident in Canada, registered for GST/HST purposes, engaged exclusively (90% or more) in commercial activities (i.e., taxable activities) and meet a 90% common ownership test.
Currently, the parties do not have to file the election with the Canada Revenue Agency (the “CRA”). Rather, the electing parties must retain copies of the election form on file in the event of audit. However, as announced in the February 2014 Budget, and pursuant to amendments to the ETA which received Royal Assent on June 19, 2014, parties to a new section 156 election made on or after January 1, 2015 will be required to file a new election form RC4616 with the CRA by the earliest date on which any of the parties to the election is required to file a GST/HST return for the period that includes the day on which the election becomes effective.
A filing requirement will also apply for section 156 elections made prior to January 1, 2015. These existing elections will only remain in effect for intercompany supplies made on or after January 1, 2015 if the parties file Form RC4616 with the CRA between January 1, 2015 and December 31, 2015. In addition to the filing requirements, the amendments to the ETA also provide that electing parties will be jointly and severally, or solidarily, liable with respect to GST/HST liability that may arise in relation to supplies made between them on or after January 1, 2015. As a result of the filing of this election in 2015, the CRA will become aware of registrants who have previously relied on the election and not charged GST/HST on intercompany supplies in the past. GST/HST registrants who have made the election before 2015 are encouraged to ensure that the conditions for making the election were satisfied at the time the election was made and continue to be satisfied. GST/HST registrants are also encouraged to note their section 156 election filing obligation in their 2015 calendar.
Time Runs Out on January 1, 2015 if your Real Estate Joint Venture Operator is a Bare Trust or Nominee Corporation
A joint venture is not considered to be a “person” for GST/HST purposes and therefore cannot register and account for GST/HST in its own right. In the absence of the election discussed below, each co-venturer would have to separately account for and report its proportionate share of the joint venture’s GST/HST.
However, section 273 of the ETA allows co-venturers in certain types of joint ventures to simplify their GST/HST accounting obligations by electing to have a “participant” in the joint venture act as the “operator” and assume responsibility for the joint venture’s GST/HST accounting obligations. If the co-venturers make the election, the joint venture is treated as if it were a “person” and effectively files its own GST/HST returns through the operator, thus easing the compliance burden of the co-venturers.
The term “participant” is not defined in the ETA. Unfortunately, the CRA interprets “participant” narrowly for purposes of the joint venture election, as:
(a) a person who, under a joint venture agreement evidenced in writing, makes an investment by contributing resources and takes a proportionate share of any revenue or incurs a proportionate share of the losses from the joint venture activities; or
(b) a person, without a financial interest, who is designated as the operator of the joint venture under an agreement in writing and is responsible for the managerial or operational control of the joint venture.
Therefore, if a person does not contribute resources to the joint venture, it must have managerial or operational control of the joint venture to be a “participant”. Moreover, the CRA has taken the position that a person must have authority to manage the joint venture’s daily activities without requiring input from or the approval of the other participants in order to have managerial and operational control of the joint venture.
This narrow interpretation has created problems, particularly for the real estate industry, where legal title to a joint venture’s property is frequently held by a bare trust or nominee corporation, without independent powers, discretion or responsibilities. Notwithstanding the CRA’s narrow interpretation, it is not uncommon for co-venturers to make the joint venture election and appoint the bare trust or nominee corporation as the joint venture operator who accounts for GST/HST on behalf of the joint venture even though it would not be eligible according to the CRA.
Bare trusts and nominee corporations acting as operators may have exposure for input tax credits incorrectly claimed and individual co-venturers may have exposure for GST/HST not collected in respect of supplies made by the joint venture.
However, the CRA announced earlier this year that it would exercise administrative tolerance and not assess joint ventures whose operators are bare
trusts or nominee corporations for reporting periods ending before January 1, 2015 as long as all returns have been filed, all amounts have been remitted and the joint venture participants are otherwise fully compliant.
However, the CRA indicated that its auditors will once again be free to assess joint venture operators and co-venturers where a joint venture operator does not meet the CRA’s interpretation of “participant” in reporting periods commencing on or after January 1, 2015.
Real estate co-venturers who have made the GST/HST joint venture election are strongly encouraged to ensure that the operator of the joint venture qualifies as a “participant” for purposes of the election and, if not, should appoint a joint venture operator that meets either the investment or managerial and operational control criteria. In considering the operator’s eligibility, it is worth noting that the CRA recognizes that the terms “nominee corporation” and “bare trust” may be used somewhat loosely by businesses. As a result, it is possible that a so-called nominee corporation or bare trust may, in fact, have a sufficient level of power and authority to meet the CRA criteria to be a “participant”.