Relevant to: Canadian entities with debt, if the creditor (or a creditor affiliate) has received an interest in property of a non-resident as security for that debt; and lenders to a Canadian debtor seeking security from foreign entities related to the debtor.
Issue: Starting in 2015, such debt may be treated as owing by the Canadian debtor directly to the non-resident whose property is securing the debt (not the creditor), resulting in interest on such debt potentially being subject to (1) non-resident interest withholding tax, and/or (2) restrictions on interest deductibility under Canada’s “thin capitalization” rules.
Canada levies 25% non-resident withholding tax on interest paid by a Canadian to a creditor who is a non-resident not dealing at arm’s length with the Canadian debtor. The rate of withholding tax is reduced (usually to 10%) where the creditor is resident in a country that has a tax treaty with Canada. The only Canadian tax treaty that reduces the rate of tax to zero is the Canada-U.S. tax treaty.
Canadian entities are prevented from reducing their taxable income through tax-deductible interest expense under Canada’s “thin capitalization” rules, which limit the amount of debt that a Canadian entity can incur from “specified non-residents” and be permitted to deduct the interest expense on. “Specified non-residents” are essentially non-residents who either are, or do not deal at arm’s length with, 25%+ shareholders of the Canadian debtor. Interest on debt incurred in excess of this limit is non-deductible for Canadian tax purposes, and subjected to dividend withholding tax.
The Department of Finance is concerned with schemes that seek to avoid the application of these limitations by inserting an intermediary in between the Canadian debtor and a non-resident creditor: for example, a loan by the non-resident to a bank, which agrees to make a corresponding loan to the Canadian debtor. Proposals included in the 2014 federal budget to address this concern go far beyond such “back-to-back loans” however, to include situations in which a non-resident has merely provided an interest in its property to the creditor (or an affiliate of the creditor) as security for the Canadian entity’s debt, (i.e., a secured guarantee). In such instances, the non-resident providing the security is effectively treated as having made a direct loan to the Canadian debtor (ignoring the real creditor), potentially (1) triggering interest withholding tax (where the non-resident does not deal at arm’s-length with the Canadian debtor and is not a U.S. resident entitled to the withholding tax exemption under the Canada-U.S. tax treaty) on debt that would otherwise be withholding-tax exempt (e.g., bank debt); and/or (2) causing otherwise “good” debt for thin capitalization purposes to be subject to the thin capitalization limitations (e.g., where the non-resident providing the security is, or does not deal at arm’s length with, a 25% shareholder of the Canadian debtor). These over-broad proposals (which will be effective starting in 2015) apply to a wide range of ordinary commercial transactions with no tax avoidance motive, and are particularly likely to apply where the non-resident providing security for the Canadian entity’s debt is a foreign parent, sister or subsidiary of the Canadian debtor. It is understood that the Department of Finance is considering revisions to these proposals to address the inappropriate results they produce.