Canadian taxpayers, including Canadian-based multinationals, with arm’s-length commercial lending arrangements could be unexpectedly impacted by the 2014 federal budget’s new thin capitalization and withholding tax proposed anti-avoidance measures targeting certain back-to-back loan arrangements. Although the Department of Finance Canada has indicated that the proposed anti-avoidance measures are aimed at certain abusive transactions, the broad wording of the proposals could apply to catch many Canadian taxpayers’ current commercial financing arrangements.
The 2014 budget continues the focus on Canada’s thin capitalization regime, following significant amendments presented in the 2012 and 2013 federal budgets. Canada’s thin capitalization rules, like those of many other countries, are aimed at preventing excessive interest deductions on loans received from related non-residents. If the Canadian taxpayer is too thinly capitalized, the rules could limit the deduction of some or all of the interest paid on such loans.
The thin capitalization rules generally limit the deductibility of interest paid to a non-resident who is a “specified shareholder” of a Canadian corporation (called a “specified non-resident shareholder”) or to a non-resident who does not deal at arm’s length with a specified shareholder. A specified shareholder is defined as a person who, either alone or together with non-arm’s-length persons, owns shares of the corporation having at least 25% of the voting rights in the corporation or having a fair market value of at least 25% of the fair market value of all issued and outstanding shares. Loans made by such a non-resident to a Canadian taxpayer are subject to a 1.5:1 debt-to-equity ratio and, if this ratio is exceeded, some or all of the interest paid on the loan would be denied as a deduction, and would instead be treated as a dividend paid to the non-resident.
Canada’s withholding tax regime generally provides an exemption for interest paid to arm’s-length persons, other than interest paid on certain participating debt interests. Interest paid to non-arm’s-length persons is subject to a 25% domestic withholding tax rate, which can be reduced under the terms of a tax treaty, if applicable. Canada’s tax treaties generally allow a 10% withholding tax rate to apply to interest paid to non-arm’s-length persons. In the case of the Canada-U.S. tax treaty, however, this rate can be reduced to 0% if the terms of the limitation on benefits provisions or the anti-hybrid rules do not apply.
The budget papers indicate that some taxpayers have sought to avoid either or both the thin capitalization rules and the application of withholding tax through the use of certain back-to-back loan arrangements. These arrangements typically involve interposing a third-party intermediary (e.g., a foreign bank), between two related taxpayers (e.g., a foreign parent and its Canadian subsidiary) to avoid rules that would have applied if a loan were made directly between the two related taxpayers.
The first part of the budget proposals involve changes to Canada’s thin capitalization rules. The proposed rules will apply where a taxpayer owes an interest-bearing obligation to an intermediary, and the intermediary (or any person not dealing at arm’s length with the intermediary) either:
- Has an interest in property that secures payment of the obligation where the interest is provided by a specified non-resident shareholder or by a non-resident person that does not deal at arm’s length with a specified shareholder (collectively called a “Specified Non-Resident”)
- Is indebted to a Specified Non-Resident under a limited recourse debt, or
- Is indebted to a Specified Non-Resident where the debt or obligation was entered into on the condition that the original obligation is entered into by the taxpayer.
Where one of these conditions is met, the proposals will deem all or a portion of the obligation to be owing by the Canadian taxpayer to a specified non-resident shareholder rather than the intermediary. Even in structures where the shares of the Canadian group are not owned by a non-resident, the thin capitalization provisions could still apply to potentially limit the deductibility of interest on the obligation. The proposed rules will not apply if the intermediary is a Specified Non-Resident, but they could apply if the intermediary is a Canadian or foreign arm’s-length lender.
Example #1 — Thin Cap Avoidance Transaction
Based on the budget documents, it would appear that these rules are designed to target structures where a foreign parent (Foreign Parent) of a Canadian subsidiary (Canco) pledges a property (e.g., a bond), to a third-party lender (Intermediary) as security for a loan made by Intermediary to Canco.
This scenario is a fairly straight-forward example of the avoidance of the thin capitalization rules. Had Foreign Parent used its own cash or borrowed from the Intermediary to make a loan to Canco, interest paid on the loan would have been limited under the thin capitalization measures, since Foreign Parent is a specified non-resident shareholder of Canco. By routing the loan through an arm’s-length intermediary, these provisions are not applicable under currently enacted rules.
KPMG observations — Example 1
Although Finance indicated in the budget documents that these new anti-avoidance measures are targeted at certain abusive transactions, the draft wording of the proposals appears to be significantly broader and may capture many ordinary commercial lending arrangements.
Example #2 — Guarantee by foreign affiliate group
The proposed rules may inadvertently apply where a borrower is a subsidiary (CanSub) of a Canadian public company (Can Pubco), and the loan is guaranteed by CanSub’s foreign holding company (Foreign Holdco) in the form of a pledge of all its property to the lender (Intermediary).
In this example, Foreign Holdco, a non-resident, has provided property as security for the loan, and is related to a specified shareholder of CanSub (i.e., Can Pubco). As such, even though the Canadian group does not have a non-resident shareholder, the proposals could apply to deem CanSub to have received the loan from a specified non-resident shareholder rather than from Intermediary, and therefore to be subject to the thin capitalization rules.
KPMG observations — Example 2
Although Finance has indicated that a guarantee will not, in and of itself, be considered a pledge of property, lenders often require security for guarantees in the form of a pledge of all or some of the guarantor’s assets. As such, it would be difficult to argue that there is not an interest in property that secures the payment of the loan in situations where a non-resident guarantor makes such a pledge.
It is unclear how this typical Canadian financing arrangement could be seen as avoiding the thin capitalization rules. There is no ultimate non-resident shareholder in the structure that could have made a loan to CanSub, thus triggering the application of the rules. The lender in this case is often a Canadian financial institution that has been the banker of the Canadian group for a long period of time. If commercial lending arrangements need to be changed to accommodate the proposed rules, there could be a potential disruption to this relationship.
Example #3 — Group credit facilities
Canadian companies are often co-borrowers under a group credit facility. Assume that a foreign parent (Foreign Parent), its Canadian subsidiary (Canco), and Canco’s foreign subsidiary (Foreign Holdco) are all co-borrowers under a credit facility with a lender (Intermediary). All three entities provide cross guarantees of all borrowings, with security provided over specific property such as Canco’s shares and assets and the assets of Foreign Holdco and its subsidiaries. Canco uses the credit facility for its own Canadian operating activities, and Foreign Holdco also uses the credit facility to make loans to Foreign Opcos for use in their businesses.
Lenders often require more than one form of security for their loans, especially for large borrowings, resulting in pledges of property by more than one entity in a group. In this case, the application of the proposed rules would require the determination of the fair market value (FMV) of property pledged directly or indirectly by a non-resident in order to calculate the amount of debt that would be deemed to be owed by Canco to a specified non-resident shareholder.
KPMG observations — Example 3
This example raises a number of questions. Would only the value of Canco’s shares and the value of the foreign assets be included in this FMV determination, and not the value of the Canadian assets based on the argument that the related pledge is not provided by a non-resident? Or would the value of all pledged property be taken into consideration, and then allocated proportionately to the two loan balances to determine the total value attributable to Canco’s loan? Additionally, how would property such as a cash sweep account, which is often required by lenders to support their security arrangements, be valued for this purpose given that the balance of such an account fluctuates daily?
The more complex the group lending arrangement, the more complex the application of the proposed rules could become.
The second part of the budget proposals involve changes to Canada’s withholding tax rules. In some respects, the proposed withholding tax changes are even broader than the thin capitalization proposals.
In general, the proposals will apply where a taxpayer pays interest on a debt or other obligation to a person or partnership (the Intermediary) and the Intermediary (or any person not dealing at arm’s length with the Intermediary) either:
- Has an interest in property that secures payment of the debt or obligation where the interest is provided by a non-resident
- Is indebted to a non-resident under a limited recourse debt, or
- Is indebted to a non-resident where the debt or obligation was entered into on the condition that the original obligation is entered into by the taxpayer.
Additionally, for these rules to apply, the withholding tax that would have applied had the taxpayer instead paid the interest directly to the non-resident must be greater than the withholding tax that otherwise applies on the payment to the Intermediary.
If these conditions are met, the taxpayer is deemed to pay interest to the non-resident person rather than to the intermediary, subject to the application of an applicable income tax treaty.
The withholding tax proposals differ from the thin capitalization proposals in a number of ways. The interest in property that is provided as security for a particular debt can be provided by any arm’s-length or non-arm’s length non-resident. There is no stipulation that the non-resident has to be a Specified Non-Resident. As well, the intermediary in this case can be any arm’s-length or non-arm’s length Canadian or foreign person or partnership. Because there is such a broad group of persons to whom the rules could apply, the proposals seem to be very wide-reaching.
Example #4 — No specified shareholder
In the following scenario, a Canadian public company (Can Pubco) has borrowed from an arm’s-length lender (Intermediary) and used the borrowed funds in its own operations as well as to fund the operations of its foreign subsidiary (Foreign Opco). Both Can Pubco and Foreign Opco guarantee the loan and have pledged all of their property as security for the guarantee.
Because a non-resident has pledged property as security for Can Pubco’s loan from Intermediary, the withholding tax proposals could potentially apply even though there is no specified shareholder in the group. If Foreign Opco is resident in any jurisdiction other than the United States, the withholding tax rate that would apply if Can Pubco paid interest to Foreign Opco would be greater than the rate that applies on Can Pubco’s interest payments to Intermediary (i.e., 0%). The Canada-U.S. tax treaty is the only Canadian tax treaty that provides for a 0% withholding tax rate on interest payments to non-arm’s-length persons, where certain conditions are met.
KPMG observations — Example 4
The application of withholding tax in this example could cause concern for Canadian taxpayers and Canadian financial institutions. In many situations, because the Canadian company has access to lower interest rates and greater borrowing levels than its foreign subsidiaries, the decision to borrow in Canada is a matter of economic and business efficiency. The requirement to pay withholding tax on loans from arm’s-length lenders, whether they are non-residents or Canadian residents, would significantly increase the cost of borrowing.
Example #5 — No arm’s-length intermediary
The withholding tax proposals could also potentially apply to internal back-to-back loan arrangements. For example, a U.K. parent company (UK Parent) could make a loan to its U.S. subsidiary (USCo), which in turn makes a loan to its Canadian subsidiary (Canco).
In this example, Canco pays interest on its loan owing to USCo, the intermediary, who received a loan from a non-resident, UK Parent. For the withholding tax proposals to apply, the loan made by UK Parent to USCo would need to be a limited recourse loan, or would need to be made to USCo on the condition that the second loan is made to Canco (the “loan condition”). Additionally, the withholding tax rate on interest paid by Canco to USCo would need to be less than the withholding tax rate on interest that would be paid by Canco to UK Parent (the “withholding tax condition”).
The withholding tax condition is met in this case, as the withholding tax rate on interest under the Canada-U.S. treaty could be 0%, while the withholding tax rate on interest under the Canada-U.K. treaty is generally 10%. Therefore, if the loan condition is met, the proposals would apply to deem Canco to pay interest to UK Parent rather than to USCo, thereby triggering the higher 10% withholding tax rate.
KPMG observations — Example 5
The application of the withholding tax proposals in this example could be viewed as a form of treaty shopping rule, given that the intermediary in the structure is essentially ignored for withholding tax purposes regardless of whether it is the beneficial owner of the interest received from Canco. As such, the proposed domestic changes would override the application of the treaty between the Canadian company and its direct shareholder.
Clarifications to Come?
These proposals pose potential concerns to Canadian taxpayers with arm’s-length financing arrangements in place that were entered into for business reasons. The potential imposition of withholding tax on loans that are subject to complex debt agreements could, in many cases, add additional financing costs that could have an economic impact. As well, taxpayers’ back-to-back loan arrangements will need to be reviewed in light of the application of the withholding tax proposals to certain non-arm’s-length situations.
The thin capitalization measures will apply to taxation years that begin after 2014, and the withholding tax measures will apply to amounts paid or credited after 2014. There is no indication whether Finance will allow current financing arrangements that could unintentionally be affected by these rules to be grandfathered, or whether taxpayers will have a longer grace period to unwind their current loan agreements, if desired. Since arm’s-length credit agreements can be difficult to restructure, taxpayers may find it costly to amend such agreements if the proposed rules are not changed.
Finance has indicated that it will review the proposals in light of taxpayers’ comments, and it is hoped that the next iteration of the rules will provide relief for commercial lending arrangements that should not be considered abusive in respect of either the thin capitalization or withholding tax provisions.
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We can help
Your KPMG adviser can help you assess the potential impact of the proposed thin capitalization and withholding tax rules on your financing arrangements. We can also keep you abreast of the progress of these proposals and help you bring any concerns you may have to the attention of Finance. For more details, contact your KPMG adviser
Information is current to March 3, 2014. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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