Close economic ties and interdependence between the US and Canada have been bolstered by free trade policies and intensified global competition, paving the way for continued opportunities for US businesses to tap into the Canadian market. These opportunities have resulted in an active cross-border lending market. In light of this, US lenders who are lending into Canada may encounter, and should be aware of, Canadian-specific legal issues and considerations.
Our guide summarizes the fundamental elements of secured lending in Canada, including regulatory matters, tax, taking security and insolvency and restructuring.
I. Regulatory Matters
Under the Bank Act (Canada) (the “Bank Act”), a “foreign bank” is not allowed to engage in or carry on business in Canada except as authorized by the Bank Act (for example, through a foreign bank subsidiary or an authorized foreign branch). The term “foreign bank” is broadly defined in the Bank Act to include any entity that, in its home jurisdiction, is called a bank, is regulated like a bank, or conducts its business like a bank. It also includes any entity that controls a foreign bank and any entity that provides financial services and is affiliated with a foreign bank.
Despite the above, a foreign bank can lend to a Canadian borrower if the nature and extent of all the foreign bank’s activities in Canada do not result in it engaging in or carrying on business in Canada. Whether or not a foreign bank would be considered to be doing so by reason of making a particular loan to a Canadian borrower would depend on the specific surrounding circumstances. The Bank Act does not enumerate what factors Canada’s bank regulator, the Office of the Superintendent of Financial Institutions, may take into account in making this determination. However, some of the factors that could be relevant include: how the relationship between the foreign bank and the Canadian borrower arose; where the documentation was negotiated and executed; and where the transaction was closed. Generally, where all aspects of the marketing, negotiation, execution and closing of a loan transaction by a foreign bank took place outside Canada, the foreign bank would not be considered to be engaging in or carrying on business in Canada solely by reason of that loan transaction.
Under the federal regulatory framework, a foreign bank wishing to have a presence in Canada has several options to conduct its business:
- A qualifying foreign bank can carry on its wholesale banking business in Canada directly through a branch. Foreign bank branches are regulated in a manner parallel to the domestic regulatory scheme;
- It can establish a foreign bank subsidiary. Foreign bank subsidiaries have the status of Canadian chartered banks and are regulated like their domestic counterparts; or
- It can establish and maintain a representative office in Canada. If the foreign bank maintains a representative office, it will be limited to promoting the services and acting as a liaison with clients of the foreign bank.
a. Withholding Tax
Conventional interest payments made to “arm’s length” lenders that are non-residents of Canada are generally not subject to Canadian withholding tax. This is the case regardless of the lender’s country of residence. Conventional interest payments made to certain non-arm’s length US resident lenders may also be exempt from withholding tax under the Canada-United States Income Tax Convention (1980), as amended.
Non-resident US lenders that are not entitled to the benefits afforded by a bilateral tax treaty may be subject to withholding tax on non-conventional interest payments, levied at a rate of 25%. Non-resident lenders that are resident in a jurisdiction with which Canada has entered into a bilateral tax treaty, and who are entitled to the benefits afforded by that treaty, may be able to claim treaty-reduced rates of withholding tax on non-conventional interest payments.
Lenders should be aware that interest payments made in respect of back-to-back loans (including those between related parties), which are flowed through a third-party intermediary, may be subject to Canadian withholding tax.
b. Thin Capitalization Rules
To discourage the capitalization of Canadian resident corporations with sizable interest-bearing debts from connected, non-resident lenders, in a fashion that allows a portion of the corporation’s profits to escape Canadian taxation, the Canadian government enacted special thin capitalization rules. The thin capitalization rules effectively restrict the deduction of interest arising in respect of the portion of the amount of loans from connected, non-resident lenders that exceeds one-and-a-half times the corporation’s specified equity (retained earnings and share capital and contributed surplus attributable to specified non-residents). Any “excess” interest will generally be treated as a non-deductible dividend and subject to withholding tax at a rate of 25%, subject to any reductions available pursuant to an applicable tax treaty.
In addition, social interest deductibility limitations, known as the “excess interest and financing expense limitation” or “EIFEL” rules, are proposed to take effect. When in force, the EIFEL rules will further limit the ability of certain taxpayers to deduct certain interest expenses when computing taxable income. The thin capitalization rules generally do not apply to a direct loan from an arm’s length US lender.
III. Taking Security in Canada
a. The Legislative Framework
In Canada, provincial legislation generally governs the creation and enforcement of security. With ten provinces and three territories in Canada, there are thirteen sets of legislation which govern the granting of security against real and personal property. Provincial registry and land titles systems govern security against real property, whereas provincial personal property security legislation governs security against personal property. A notable exception is security granted to banks under the federal Bank Act, which is discussed in greater detail below.
i. The PPSA Jurisdictions
Personal property security legislation (the “PPSA”) resembling Article 9 of the United States Uniform Commercial Code has been adopted in every Canadian province and territory other than Québec, which, as discussed below, has adopted a Civil Code.
The creation, perfection and enforcement of a security interest in a debtor’s personal property is regulated by the PPSA. In addition, the PPSA creates a system for determining the priority of security interests in the same collateral. The PPSA applies to any transaction that creates a security interest in personal property, regardless of the form of document used to grant such security interest.
Under the PPSA, “security interest” is defined as an interest in personal property that secures payment or performance of an obligation. “Personal property” encompasses virtually all types of personal property: chattel paper, documents of title, goods (which include equipment and inventory), instruments, intangibles, money and investment property, and includes fixtures. In most cases, the creditor perfects the security interest by registering a financing statement in the applicable Provincial registry.
Most Canadian lenders in PPSA jurisdictions use a general security agreement covering all of the debtor’s existing and after-acquired personal property. A general security agreement typically does not extend to real property. Rather, a separate mortgage of lands commonly secures the real property. To create security in both real and personal property, the creditor may use a debenture, which combines both a real property and personal property charge in the same document. Other security agreements may be limited to specific types of personal property, such as inventory, equipment or receivables.
ii. Québec: The Non-PPSA Jurisdiction
Canada’s only civil law jurisdiction is the Province of Québec, which has a European-style Civil Code codifying the province’s general principles of law. The hypothec, Québec’s main form of security agreement, may be granted by a debtor to secure any obligation, and creates a charge on existing and after-acquired movable or immovable property. It may be made with or without delivery, allowing the grantor to retain certain rights to use the property.
iii. Bank Act Security
Section 427 of the Bank Act provides a particular type of security available only to Canadian chartered banks and foreign bank subsidiaries incorporated under the Bank Act. It entitles each such bank to take security from certain classes of debtors, against items the debtor deals in, produces or uses in the course of its particular business. The debtor classes include manufacturers, wholesale or retail purchasers, shippers or dealers, and farmers, fishers and forestry producers.
When a bank takes security under the Bank Act, it must register the security with the Bank of Canada agent in the province where the debtor has its principal place of business. Before the security is granted, the bank must file a statutory form, the Notice of Intention to Grant a Security Interest. Once filed, Section 427 security is effective across Canada. Lenders may assign their rights and powers in respect of only certain types of property on which Section 427 security has been given.
An advantage of Bank Act security is that it transfers title to the bank, thus allowing the bank to defeat certain claims that would otherwise take priority, such as a landlord’s claim for unpaid rent. There is no clear code governing the relative priorities of competing Bank Act and PPSA security.
b. Selected Issues with Taking Security in Canada
i. Security in Government Receivables
In Canada, asset-based lenders frequently exclude government receivables from the borrowing base. This is largely due to federal legislation, as well as some parallel provincial legislation, which provide that, generally, receivables owed by the federal or provincial government, as applicable, can only be assigned absolutely (i.e. not as security) and with proper notice to the government (as well as acknowledgement of notice from the government). While not optimal, in lending transactions involving significant government receivables, it may be possible to structure an indirect form of security over the receivables.
ii. Security in Deposit Accounts
The PPSA permits a lender to take security over deposit accounts that are treated as receivables owed by the depository to the debtor owner. Consequently, lenders in Canada commonly take a security interest in the credit balance of a debtor’s deposit account. The PPSA provides that security interests in deposit accounts are perfected by registering a financing statement.
iii. Account Control Agreements
Blocked account arrangements (and, at times, lock-box arrangements) are conventional components of cross-border financings. Most Canadian banks have their own form of deposit account control agreement (usually called a “blocked account agreement”). Blocked account agreements are used for cash management purposes in the PPSA provinces of Canada, and do not provide secured parties with perfection by way of control over the subject accounts.
iv. Share Pledges
A secured party can perfect its security interest in shares by registering under the PPSA or taking control over the shares pursuant to the requirements of the Securities Transfer Act, 2006 (Ontario) (the “STA”). Most Canadian provinces and territories have legislation similar to the STA. A security interest perfected by control will have priority over a security interest perfected by registration. In Ontario, the practice is to perfect by both control and registration. Control over certificated shares can be achieved under the STA by taking physical possession of the share certificates, together with a stock transfer power or other form of endorsement. Control over other types of investment property such as book-based securities can be achieved by other means, such as a control agreement with a securities intermediary.
v. Legal Opinions
Canadian lenders generally rely on the legal opinions of debtor’s counsel as to the enforceability of loan and ancillary documents.
In Canada, lenders taking security over real property have the option of relying upon either title insurance or a title opinion from legal counsel. A title opinion states that the debtor has a good and marketable title to the secured property, subject to specific identified encumbrances. Debtor’s counsel or lender’s counsel may provide the opinion.
vi. Environmental Liability
Secured lenders face three major risks under federal and provincial environmental laws. First, the debtor’s financial stability may be threatened by environmental liabilities. Second, the debtor’s environmental liabilities may impair the value of the lender’s security. Finally, the lender may itself face exposure for environmental liabilities. This can arise if the lender actually participates in, or exercises control over, the day-to-day operations or financial management of the polluting business (before or after the appointment of a receiver) or becomes the owner of a contaminated site by foreclosure or similar action.
vii. Interest Rates
1. Interest Act (Canada)
Under the Interest Act (Canada), a contract or agreement may stipulate any rate of interest. However, the contract or agreement must contain an annual interest rate or, in the case of contracts or agreements where the rate or percentage is for a period of less than one year, an express statement of the equivalent annual interest rate. Failure to include an annual interest rate or an equivalent annual interest rate will result in the imposition of an interest rate not to exceed 5% per year. In addition, where contracts or agreements are secured by a mortgage on real property, a higher rate of interest cannot be recovered on amounts in arrears.
2. Criminal Rate of Interest
Under section 347 of the Criminal Code (Canada), it is a criminal offence to receive interest at an effective rate exceeding 60% per year. Interest is defined broadly in the Criminal Code (Canada) – it includes interest, fees, commissions and similar charges or expenses that a borrower pays in connection with a loan. In case law, section 347 has arisen almost exclusively in civil, rather than criminal, cases where a borrower seeks to avoid repayment by arguing that the contract for credit is illegal. The courts have not been clear on which contractual provisions, if any, remain enforceable when a contract imposes a criminal rate of interest.
viii. Corporate Guarantees
In Canada, corporate law permits a corporation to give financial assistance by way of guarantee or otherwise to any person for any purpose. In certain provinces, such financial assistance is required to be disclosed to shareholders, but the failure to do so does not impact the validity of the underlying transaction. However, the corporate laws in certain Atlantic provinces and two territories prohibit financial assistance to intercompany group members, subject to certain exceptions, if there are reasonable grounds to believe that the corporation would be unable to meet solvency tests after giving the assistance. Also, in some cases, granting a guarantee in a manner that disregards the interest of creditors or minority shareholders could be challenged under the oppression provisions of Canadian corporate legislation.
ix. Enforcing Security
Before enforcing on its security, a lender must demand that the debtor repay the loan and give the debtor reasonable time to do so. The lender must comply with these requirements even if the debtor waived these rights in the loan and security documents. The lender (and any receiver it may appoint) must act in good faith and in a commercially reasonable manner when selling or otherwise disposing of the secured assets. The lender must also provide advance notice of its intention to realize on security. If the lender fails to meet these obligations at any stage of the enforcement process, it may be liable to the debtor or other creditors for damages.
x. Priority Issues
1. Priming Liens
In Canada, a number of statutory claims may “prime” or take priority over a secured creditor. Priming liens commonly arise from a debtor’s obligation to remit amounts collected or withheld on behalf of the government (for example, unremitted employee deductions for income tax, pension plan contributions and employment insurance premiums and unremitted federal goods and services taxes and provincial sales taxes), or the debtor’s direct obligations to the government (for example, municipal taxes and workers’ compensation assessments). The relative priority of statutory claimants and secured creditors is greatly affected, and in some cases, reversed by the debtor’s bankruptcy. US lenders should consult Canadian counsel on the risk of priming liens and the reporting that should be required of borrowers in the loan documents. Please also see our discussion of the pension plan contributions liens later in this guide.
2. Subordinated Liens
In Canada, senior secured lenders commonly permit another lender to hold a subordinated security interest in the same collateral. However, the existence of a subordinated lien can complicate matters in a number of ways. First, should the senior lender realize on its security, it must do so in a commercially reasonable manner. While the existence of a junior lender in no way alters that obligation, as a practical matter, another lender (other than the unsecured creditors) is more likely to challenge the senior lender’s actions. Moreover, the junior lender possesses certain technical rights that may otherwise affect realization (for example, notice of disposition of the collateral).
Finally, the junior lender might make it more difficult to successfully reorganize the indebtedness of the debtor. For example, corporate reorganization statutes divide the debtor’s creditors into classes. Generally, the secured lender has an advantage by being in a class by itself, as this provides the lender with complete control. In most reorganizations, a senior and junior lender are placed in separate classes. However, under some circumstances the senior and junior lender may be placed in the same class. Additionally, a junior lender may ask the court to lift a stay of proceedings granted pursuant to corporate reorganization legislation (whether at the application of the debtor or the lender), and thereby effectively end the reorganization attempt.
IV. Insolvency And Restructuring
a. The Legislative Framework
Canada’s two principal insolvency statutes are the Bankruptcy and Insolvency Act (the “BIA”) and the Companies’ Creditors Arrangement Act (the “CCAA”). In Canada, reorganizations analogous to Chapter 11 proceedings can be conducted under the BIA (through the statute’s proposal regime) or under the CCAA. Liquidations akin to Chapter 7 proceedings can be conducted under the BIA or under certain Provincial legislation.
In Canada, reorganizations can be conducted under the BIA or, for a company or income trust with at least Cdn$5 million in debt, under the CCAA.
Each Act provides that creditors may be stayed from enforcing their claims. Canadian courts also have the power to coordinate local proceedings with any foreign insolvency proceedings involving the debtor.
i. Bankruptcy and Insolvency Act
The restructuring process begins by the debtor filing either a definitive proposal for compromising claims of creditors or a notice of intention to make a proposal. Once a notice or proposal is filed, all proceedings against the debtor are stayed automatically. Secured creditors are stayed from enforcing their security unless they gave a notice of intention to enforce security more than ten days before the debtor’s notice or proposal was filed. Unless an extension is granted, the debtor must file a definitive proposal within 30 days of filing the notice of intention to make a proposal. A debtor who fails to do so is automatically deemed bankrupt. However, it is common for debtors to apply to court and be granted an extension in order to advance the liquidation or restructuring of the business.
The proposal under the BIA may be put to all creditors together, or to unsecured and secured creditors arranged in classes. Secured creditors with a “commonality of interest” must be in the same class. Although the proposal need not include all secured creditors, those excluded from the debtor’s proposal are not bound by it and may enforce their security during the restructuring process.
The proposal must be accepted by a double majority of the creditors (one-half in number and twothirds in value) and approved by the court. Once approved, it immediately binds (a) all classes of unsecured creditors with provable claims that arose before the proposal’s filing date, as well as (b) those included secured creditors in classes which vote in favour of the proposal. If the proposal is rejected by the creditors or the court, the debtor is automatically deemed bankrupt.
Although a BIA proposal requires shareholder approval, the sale of all, or substantially all, of a debtor’s assets during the proposal proceeding only requires court approval. It is not uncommon for debtor companies to seek refinancing or a sale of their assets during a proposal proceeding as an alternative to continuing the proposal.
ii. Companies’ Creditors Arrangement Act
Subject to certain exceptions, protection under the CCAA is available to an insolvent Canadian corporation that has assets or carries on business in Canada if total claims against it exceed Cdn$5 million. Affiliated companies’ debts may be included to meet the threshold.
To initiate proceedings under the CCAA, the debtor files an application with the court. The application requests an order permitting the debtor to file a proposal for reorganization and granting a stay of proceedings. The initial stay cannot exceed 10 days. While the stay is not automatic, generally the court has exercised its discretion to allow a full 10-day stay. If the court grants a stay, it will appoint a monitor to supervise the debtor’s business and financial affairs.
In certain circumstances, a shareholder or lender may also initiate proceedings under the CCAA, although it is not common.
Like the BIA, the CCAA allows creditors to be separated into different classes. The creditors must meet and vote on the debtor’s proposed plan of reorganization, which must be accepted by the same double majority of creditors that the BIA requires. Like the BIA, the CCAA also provides the option to liquidate the business, subject to court approval.
Although restructuring under the CCAA is usually more expensive and time-consuming than under the BIA, larger corporate debtors tend to use the CCAA because there is greater flexibility to deal with complex reorganizations or complex business or regulatory issues.
b. Selected Issues in Bankruptcy
Bankruptcy proceedings under the BIA are analogous to Chapter 7 proceedings. Debtors become bankrupt in Canada in one of the following three ways:
- by filing a proposal for reorganization that is either refused by the creditors, or accepted by the creditors and rejected by the court (as discussed above);
- by making an assignment for the general benefit of the creditors (voluntary bankruptcy); or
- by being petitioned into bankruptcy by one or more creditors (involuntary bankruptcy).
i. Voluntary Bankruptcy
Debtors can make an assignment in bankruptcy only if they are “insolvent.” Under the BIA, debtors are insolvent if:
- they cannot meet their obligations as they generally become due;
- they have stopped paying their current obligations in the ordinary course of business as they generally become due; or
- the value of their property is insufficient to satisfy their debts.
ii. Involuntary Bankruptcy
A creditor can apply for a bankruptcy order in respect of a debtor who owes at least Cdn$1000 and has committed an “act of bankruptcy” (as defined in the BIA) within the six months preceding the application.
Most commonly, the application is filed because the debtor has ceased to meet its liabilities generally as they become due. Should the debtor dispute the application, the matter is referred to a judge for a hearing. Where the facts alleged in the application have been proven, the court will enter a bankruptcy order, adjudging the debtor bankrupt.
An under-secured creditor may apply for a bankruptcy order for strategic reasons. For example, priorities between a secured creditor and some statutory claimants (as discussed above) may be “reversed” in certain circumstances if the debtor becomes bankrupt.
iii. Effect of Bankruptcy
A bankruptcy stays the claims of all creditors, except secured creditors. A trustee-in-bankruptcy is appointed and all of the debtor’s assets vest in the trustee. The assets are sold and the proceeds are distributed among the debtor’s creditors, in accordance with priorities determined by the BIA. Secured creditors, however, are generally not affected by these proceedings and are entitled to exercise their rights over the collateral in which they have a security interest, although secured creditors may allow the trustee to liquidate their collateral.
iv. Investigations and Reviewable Transactions
Bankruptcy proceedings are sometimes used by a creditor as a means to investigate a debtor’s affairs. The trustee has a statutory right to obtain possession of the bankrupt’s books and records, to examine under oath the officers of the bankrupt or any other person reasonably thought to have knowledge of the bankrupt’s affairs, and to require such a person to produce any documents in his or her possession or power relating to the bankrupt, the bankrupt’s dealings or the bankrupt’s property. These powers may be important if there are concerns that the debtor has attempted to conceal certain assets or to conceal the transfer of certain assets.
Bankruptcy proceedings can also be invoked to allow the trustee to attempt to reverse certain transactions entered into within prescribed periods prior to the bankruptcy, such as a preferential payment or a transaction completed to defeat the claims of creditors.
v. Debtor-In-Possession Financing
Courts have express authority under both the BIA and the CCAA to approve debtor-in-possession financing (“DIP”), subject to statutory guidelines. Under both Acts, the court can grant fresh security over a debtor’s assets to DIP lenders, in priority to existing security interests and up to a specified amount as approved by the court.
Under the BIA and Provincial law, a secured creditor can apply to the court for the appointment of a receiver to take possession of all, or substantially all, of the inventory, accounts receivables or other property of an insolvent person. A receiver may also be authorized to operate the business of a debtor where it is necessary or advisable. The appointment of a receiver is an equitable remedy and is a matter of discretion for the court. Once appointed by court order, a receiver is a court officer and owes a duty to all stakeholders. The court-appointed receiver is not an agent of the secured party and does not take instructions from the secured party.
A secured creditor may not apply for the appointment of a receiver or receiver and manager without first providing the debtor with reasonable notice and, where applicable, ten-days notice as prescribed by the BIA.
The appointment of a receiver by the court can also be a useful alternative where the debtor or third party will not allow a secured creditor or private receiver access to the collateral. A court-appointed receiver can also be useful if the secured creditor wants to have the disposition of the collateral approved by the court, as the court can establish sale procedures and approve the terms of the sale.
The primary disadvantages of a court-appointed receivership are the costs and loss of control by the secured creditor. Costs can be significantly higher in a court-appointed receivership because the secured creditor must initiate a court proceeding in order to obtain the appointment of the receiver and that proceeding may be challenged by the debtor or other interested parties. In addition, a court-appointed receiver is usually required to report to the court and seek the court’s approval for significant actions, such as a sale of all, or substantially all, of the debtor’s assets.
vii. Repossession of Goods by Suppliers
A lender who finances goods that a supplier provides to a debtor may be at risk if the debtor becomes bankrupt or insolvent within 30 days of receiving those goods. Under the BIA, unpaid suppliers may repossess goods delivered within 30 days before a bankruptcy or receivership if they make a demand for repossession within 15 days of the date of bankruptcy or receivership. However, among other things, if the purchaser altered or resold the goods, or the goods cannot be identified, the rule does not apply.
viii. Wage Earner Protection
Under the Wage Earner Protection Program Act, an employee whose employer becomes bankrupt or subject to receivership is entitled to receive payments from a federal Wage Earner Protection Program on account of any outstanding wages that were earned in the six months immediately prior to bankruptcy or the first day of receivership in an amount up to seven times the maximum weekly insurable earnings under the Employment Insurance Act (Cdn$8,278.83 for 2023).
Similarly, the BIA provides that an employee whose employer is bankrupt or in receivership has a priority charge on the employer’s “current assets” for unpaid wages and vacation pay (but not for severance or termination pay). This charge secures unpaid wages and vacation pay for the six-month period prior to bankruptcy or receivership to a maximum of Cdn$2,000 per employee (plus up to Cdn$1,000 for expenses for “traveling salespersons”). The priority charge ranks ahead of all other claims, including secured claims, except unpaid supplier rights.
ix. Pension Plan Contributions Lien
The BIA also grants a priority charge in bankruptcies and receiverships for outstanding current service pension plan contributions. This priority charge ranks behind the wage earners priority, but otherwise has the same priority as is accorded to that lien. The pension contribution priority does not just cover current assets – it extends to all assets and is unlimited in amount.
The pension charge secures the following:
- Amounts the employer deducts from employee wages as pension contributions but does not contribute to the plan prior to a bankruptcy or receivership; and
- Amounts the employer is required to contribute to a pension plan for “normal costs”.
Notably, the priority does not extend to unfunded deficits which arise upon a defined benefit plan winding up. The priority should also not include any scheduled catch-up or special payments an employer is required to make due to a solvency deficiency.
A recently passed law has further expanded pension plan contribution priority treatment in Canada. Bill C-228, the Pension Protection Act (Canada) became law on April 27, 2023. The Bill amended the BIA and the CCAA to provide that, upon an employer’s filing under proceedings under the BIA or CCAA, any and all of the employer’s defined benefit pension obligations (including unpaid special payments, amounts required to liquidate an unfunded liability or solvency deficiency) will be granted a form of priority treatment and will rank ahead of a lender’s security interest. The priority treatment will be effective April 27, 2027. This new lien and priority treatment underscores the importance of effective reporting and monitoring of pension contributions by the borrower, as well as other employee obligations, such as vacation pay.
Our guide summarizes the unique features of and legal issues with respect to Canadian secured lending transactions. Understanding the fundamentals of secured finance in Canada is essential for US lenders who are planning and implementing cross-border financing transactions.