One of the issues which has long been a source of frustration for both borrowers and lenders in cross-border loan transactions relates to the imposition of withholding tax on non-resident interest payments.
The existence of such a tax has often forced parties to structure their deals in specific (and limited) ways; worse still, this tax has often served as a roadblock for certain lenders and borrowers to enter into deals together. With certain proposals made in the March 19, 2007 Federal Budget (the “Federal Budget”), relief may be on the way.
Currently, Canada’s domestic rate of withholding tax on interest paid to non-residents is 25%. This rate is generally reduced to 10% for residents of countries with which Canada has tax treaties, such as the United States. Canadian cross-border debt financings are generally structured to take advantage of an exemption from nonresident withholding tax, which is available if the borrower is not obliged to repay more than 25% of the principal amount of the loan within five years except in the event of default (the “5/25 exemption”). The 5/25 exemption cannot be used for a loan with a term of less than five years and requires compliance with constantly evolving administrative policies of the Canada Revenue Agency (“CRA”) with respect to acceptable terms and conditions in loan agreements.
The Federal Budget announced that an agreement in principle has been reached between Canadian and U.S. negotiators regarding changes to the Canada-U.S. Income Tax Convention (the “Canada-U.S. Treaty”), which include the elimination of withholding tax on interest paid on both arm’s length and non-arm’s length debt. It is expected that the final negotiations will conclude in the “very near future.” The Federal Budget indicates that withholding tax on interest payments on arm’s length loan transactions would be eliminated at the start of the calendar year following the coming into force of the changes to the Canada-U.S. Treaty, while withholding tax on non-arm’s length interest payments would be phased out over a period of three years.
Taking it one step further, the Federal Budget proposes that Canada will unilaterally eliminate withholding tax on interest on all arm’s length debt, regardless of the recipient’s country of residence. Such elimination will be made effective when the Canada- U.S. Treaty exemption comes into effect.
Also of importance to U.S. lenders is the announcement in the Federal Budget that the benefits of the Canada-U.S. Treaty will be extended to U.S. limited liability companies (“LLCs”). The CRA’s administrative position is that LLCs are generally not entitled to the benefits of the Canada-U.S. Treaty, with the result that amounts such as interest, dividends and royalties paid to an LLC are subject to Canadian withholding tax at the rate of 25%. This change should encourage a flow of capital into Canada from U.S. venture capital firms which operate as LLCs.
The elimination of withholding tax on arm’s length interest payments is dependent on the successful conclusion of the Canada- U.S. Treaty negotiations and the legislative implementation of the changes to the Canada-U.S. Treaty.
These proposed changes are welcome news to borrowers and lenders, who will be more able to structure their transactions in ways that are aligned with the business objectives of the parties, rather than being dictated by the legislative framework. Furthermore, the changes may result in new sources of capital becoming available for companies on both sides of the Canada-U.S. border.