On January 1, 2008, the Canadian government amended the Income Tax Act (Canada) to eliminate withholding taxes on interest payments for arm’s length loan transactions so long as the interest payments are not dependent or computed by reference to revenue, profit, cash flow, commodity price or any similar criteria (“Participating Debt”). This removal of withholding taxes was not extended to lease payments under a lease or rental agreement. The impact of this amendment to the equipment finance industry was anticipated to cause an increase in international finance companies providing financing for discrete Canadian transactions. While trends in 2008 are hard to gauge owing to the uncertainty created in the last half of the year anecdotal experience has seen an increase in U.S. finance companies in Canada but no real change from non-U.S. lenders. Part of this explanation may be that non-U.S. lenders (and for that matter, many U.S. lenders) not being aware of this change. This short article will discuss the change and its likely impact.
Prior to the amendment to the Act and subject to certain specific exceptions, any payment of interest by a Canadian company to a lender that is not an authorized foreign bank, as defined by the Act, is subject to the borrower withholding 25 per cent of the interest payment. This percentage was reduced in certain cases depending on any tax treaties which Canada had entered into with another country (For instance, the Canadian/U.S. Tax Treaty reduced the rate to 10 per cent.). This withheld amount was delivered to the Canadian government on behalf of taxes to be paid by the lender. In cases of equipment lease payments, the amount to be withheld is 25 per cent of the entire lease payment (again, which would have been reduced by a tax treaty). The amendment did not eliminate withholding tax on equipment lease payments.
Typically, prior to the amendment, a lender would require a Canadian borrower to gross-up the amount of the re-payment such that the actual dollar amount received by the lender would be the same absent the withholding tax. Clearly, these structures make a foreign lender less competitive than its Canadian counterpart. In order to avoid such non-competitive situations, internationally oriented lenders set up cross-border subsidiaries in Canada or used some of the exemptions under the Act/Tax Treaty, if applicable.
The amendment eliminates withholding tax on interest payments to all arm’s length parties so long as the debt is not Participating Debt. There is now no difference between lenders from countries that have treaty with Canada. Under some earlier proposed amendments to the Act, it was expected that the elimination of withholding tax would be extended only to the U.S. The actual amendment was much broader than expected and applies to all foreign lenders. As this was not anticipated, it may not have been properly communicated to the global community and as such, the impact of the elimination of withholding tax may have been more limited.
What did not change in the Act
Lease payments will continue to be subject to withholding tax. There is currently no legislation being proposed that will eliminate withholding tax in this environment.
The rules relating to whether a foreign entity is carrying on business in Canada have not been amended. As will be discussed below, this will may reduce but not eliminate the impact of the amendment.
Regulatory and Tax Overview
In addition to the withholding tax issue, a lender is also concerned that its overall tax position not be negatively affected. A lender would likely be unwilling to enter into Canadian transactions if its operations were to become subject to Canadian tax.
If an entity is deemed to by carrying on business in Canada (which is a very wide concept), it is subject to tax in Canada on all of its Canadian related income unless the entity is party to a tax treaty within Canada and it does not have a Permanent Establishment (“PE”) in Canada. The rules as to what constitutes a permanent establishment are complex but, speaking generally again, if a lender were simply to undertake the odd one-off transaction with a Canadian borrower where they did not solicit the Canadian borrower’s business in Canada, then it would not likely be deemed to be carrying on business in Canada and this should not be taxable in Canada. On the other extreme, if the lender had employees in Canada and was actively soliciting business in Canada, then it would be most likely viewed as carrying on business in Canada via a PE and thus could be taxable in Canada. Needless to say, most companies fall somewhere between these two examples.
From a regulatory perspective, the PE rules are more significant for a bank. If the lender is a bank in the national jurisdiction and is seen as transacting business in Canada, it must ensure that it does not have a permanent establishment for the purposes of the Bank Act; otherwise it becomes subject to the Canadian banking regulatory environment. Complying with Canadian banking regulations is both complex and expensive. Clearly, it would not be desirable unless there is a systematic plan for entering into Canada. The rules as to what constitutes a bank PE are different than for tax, but similar. The key factors are the method used to make the transaction known to the lender and what, if any, operations the lender has in Canada.
Summary of Expected Changes
The matters above should be discussed with Canadian counsel to ensure that any lender does not inadvertently become subject to Canadian tax or regulatory laws, and that the documentation used in funding these transactions is appropriate under Canadian law.