The modified back-to-back loan measures proposed in the 2014 Budget were enacted on Dec. 17, 2014.1 These measures are intended to address situations where certain non-residents try to avoid the application of the thin capitalization2 and interest-withholding tax3 rules by making back-to-back loans to Canadian corporations and trusts through third-party intermediaries rather than making those loans directly to the Canadian taxpayer.
The enacted back-to-back loan rules are substantially different than those originally proposed in the 2014 Budget, with the result that the rules should not apply to most commercial lending transactions.4 Nevertheless, the reduced scope has come at the cost of increased complexity, requiring the application of the rules to be reviewed whenever multinational groups establish back-to-back loans, cross-collateralized loans or notional cash pooling arrangements.
The thin capitalization rules limit the deduction by a Canadian taxpayer that is a corporation or a trust of the interest expense on debts that are outstanding to connected non-residents – to be understood broadly as non-residents holding, directly or indirectly, a significant interest in the taxpayer – to the extent that the taxpayer has exceeded its thin capitalization ratio. The thin capitalization rules apply to loans entered into by a corporation or trust that is either resident in Canada or non-resident but carrying on business in Canada and to that corporation or trust’s share of any debt owing by a partnership in which it is a member.
The interest withholding tax rules apply to interest payments made by Canadian residents (corporations, trusts or individuals) to non-residents.
This article describes both types of back-to-back rules in terms of debt incurred by a corporation resident in Canada (a “Canadian corporation”).
Where the debt owing by a Canadian corporation to connected non-residents5 exceeds 1.5 times its equity amount,6 the interest on the excess debt is not deductible and is deemed to be a dividend subject to dividend withholding tax. Therefore, while one of the functions of the thin capitalization rules is to ensure that Canadian taxpayers do not unduly erode the Canadian tax base by using interest deductions to reduce their Canadian taxable income, the other is to ensure that the non-resident investor does not avoid Canadian dividend withholding tax on its return on investment by making its investments through debt instead of equity.
Dividends paid by a Canadian corporation to a non-resident of Canada are subject to a withholding tax of 25%, reduced under most Canadian tax treaties to 15% and in some tax treaties further reduced to 5%, if the non-resident is a company that owns at least 10% of the voting stock in the payor.
In contrast, interest paid by a Canadian resident to a non-resident is only subject to withholding tax if the non-resident does not deal at arm’s length with the payor (or if it is participating debt interest).7 Under most Canadian tax treaties the withholding rate on interest is reduced to 10%, and under the Canada-US tax convention (“Canada-US Treaty”), non-participating interest is exempt from withholding tax.
Absent the anti-avoidance back-to-back loan rules, real tax savings could be achieved both from a domestic tax and withholding tax perspective by the connected non-resident making the loan to the Canadian corporation through an unrelated third party (namely, through a back-to-back loan) instead of making the loan directly. In the case of the thin capitalization regime, a back-to-back loan could permit the Canadian corporation to deduct interest on the unrelated party loan that it would not have been able to deduct had the connected non-resident made the loan directly. In the case of the withholding tax regime, a back-to-back loan could permit the connected non-resident to eliminate the withholding tax that would otherwise have applied to the non arm’s length interest on the loan, had it made the loan directly. In this sense, the withholding tax back-to-back loan rules are both an anti-avoidance rule and an anti-treaty shopping rule, because they prevent connected non-residents from benefiting from the unique interest withholding tax exemption in the Canada-US Treaty on non-arm’s length interest.
In both cases the new back-to-back rules thwart the avoidance transactions by deeming all or a part of the loan from the third party intermediaries to the Canadian corporation to have been made directly by the connected non-resident.
The adverse application of the back-to-back loans rules is dependent on all of the following conditions being met:
- The corporation owes an amount that bears interest to an “intermediary creditor”.
Both resident and non-resident lenders can be an intermediary creditor vis-à-vis the corporation.
However, an exemption provides that a Canadian resident lender that does not deal at arm’s length with the Canadian corporation cannot be an “intermediary creditor”. This exemption allows a non-resident investor to make a back-to-back loan to the Canadian corporation through another Canadian corporation that is related to the first (for example, a Canadian holding corporation).8
Under a second exemption, a non-resident creditor that is a connected non-resident with respect to the Canadian corporation cannot be an “intermediary creditor” for purpose of the thin capitalization back-to-back rules. The thin capitalization rules already apply to the amount owing by the Canadian corporation to such a creditor. This exemption allows, for example, a non-resident parent to make a loan to the Canadian corporation through another non-resident corporation that serves as the financing arm of the group.
The latter exemption does not apply in the case of the withholding tax back-to-back rules. The deductible interest (under the thin capitalization rules) paid on the loan from the connected non-resident creditor may still be subject to a lower withholding tax than would have applied had the connected non-resident made the loan to the Canadian corporation directly. For example, if the financing intermediary were resident in the US but the non-resident parent was not, the back-to-back loan structure would permit the parent company to avoid interest withholding tax. Consequently this structure is not exempt from the withholding tax back-to-back rules.
- A “secondary transaction” exists between the intermediary creditor and connected non-residents
A “secondary transaction” is a form of financial assistance provided by the connected non-resident to the intermediary creditor (or a non-arm’s length person with respect to the connected intermediary creditor) either in the form of an “intermediary debt” or a “specified right” in particular property.
“Intermediary debt” is a debt that is owed by the intermediary creditor to the connected non-resident in circumstances where:
- recourse in respect of the debt is limited to the debt owed by the Canadian corporation to the intermediary creditor (meaning that the intermediary creditor is not bearing the economic risk of the loan it has made), or
- it can reasonably be concluded that the intermediary creditor made the loan to the Canadian corporation or permitted it to remain outstanding because of the loan made by the connected non-resident to the intermediary creditor (meaning that the former loan was a result or consequence of the latter).
A “specified right” in particular property is defined as the right to encumber (e.g. to mortgage) the property to secure payment of an obligation or to dispose of the property (e.g. to sell it or use it), except where the encumbrance secures the payment of the debt owed by the Canadian corporation to the intermediary creditor (and certain other connected debts) or the proceeds from the sale are required to be applied first to reduce the amount of that debt (or those other connected debts).
A specified right in particular property exists whenever:
- The existence of the specified right is required in the loan agreement between the intermediary debtor and the Canadian corporation; and
- it can reasonably be concluded that the intermediary creditor made the loan to the Canadian corporation or permitted it to remain outstanding because of the specified right granted by the non-resident to the intermediary creditor.
What is being targeted are situations where the connected non-resident gives the intermediary creditor a right in property that the intermediary creditor can use to raise capital to finance the loan it has made to the Canadian corporation or for a purpose other than to guarantee the repayment of that loan.
- The de minimis exception does not apply.
At their core, the back-to-back loan rules target situations where the connected non-resident funds, through the secondary transaction, 25% or more of the loan made by the intermediary creditor to the Canadian corporation. The 25% is therefore the de minimis threshold for the rules to apply. Through the application of complex rules and subject to specific conditions, the de minimis criterion also applies to the total debts and secondary transactions in a related group. This permits a multinational group to set out cross-collateralized loans and notional cash pooling arrangements without triggering the back-to-back loan rules, provided that very strict conditions are met.
- In the case of the withholding tax rules only: in order for the rules to apply, the withholding tax rate applicable to the interest paid by the Canadian corporation to the intermediary creditor must be less than the withholding tax rate that would have applied had the corporation paid the interest directly to the connected non-resident.
Where the thin capitalization back-to-back rules apply they deem, for purposes of the thin capitalization rules, all or a portion (depending on the relative value of the secondary transaction to the amount of the debt) of the debt and related interest owed by the Canadian corporation to the intermediary creditor to be owed instead to the connected non-resident. This debt is therefore included in calculating the debt-to-equity ratio of the Canadian corporation and interest on any excess debt is treated as a dividend for withholding tax purposes.
Where the withholding tax back-to-back rule applies, the Canadian corporation is deemed to have paid to the connected non-resident a portion of the deductible interest paid on that part of the loan from the intermediary creditor that was funded by the secondary transaction. The deeming rule only applies for withholding tax purposes. The portion of the interest is determined so as to ensure that it triggers an amount of withholding tax which, together with the amount (if any) already paid by the intermediary creditor, equals the withholding tax that the non-resident would have paid had it received the full amount of the interest on the debt directly.
The thin-capitalization and withholding tax back-to-back loan rules apply to different portions of the interest paid on the debt owing to the intermediary creditor. The thin capitalization rules apply to the interest expense on the excess debt to deny its deduction for Canadian tax purposes and treat it has a dividend for withholding tax purposes while the withholding tax rules apply to the deductible portion of the interest to subject it to a higher withholding tax rate.
Despite their various iterations – the provisions were substantively redrafted twice – the back-to back loan measures continue to be unnecessarily complex and require taxpayers to plan through the various inclusions and exclusions rules in an effort to prevent their unwarranted application. Arguably, a similar anti-avoidance result would have been achieved by simply expanding the previous conditional-loan thin capitalization back-to-back rules to cover the grant of specified rights in property and to include substantially similar provisions in the withholding tax context.
1 These measures are contained at subsections 18(6) and 18(6.1) of the Income Tax Act (Canada) (the “Act”), in the case of the thin capitalization back-to-back loan rules; and at subsections 212(3.1) to (3.3) of the Act, in the case of the withholding tax back-to-back loan rules.
2 Set out at subsections 18(4) to 18(8) of the Act.
3 Set out at paragraph 212(1)(b) of the Act.
4 Prior to the 2014 Budget, the Act contained much more limited back-to-back loan rules that applied only to conditional loans.
5 With respect to a corporation resident in Canada, a “connected non-resident” is a “specified non-resident shareholder” of the corporation or a non-resident person not dealing at arm’s length with the specified shareholder. A “specified shareholder” is a person that holds, either alone or together with other non-arm’s length persons, at least 25 percent of the votes or value of the corporation.
6 For a corporation resident in Canada “equity amount” is calculated in terms of the unconsolidated retained earnings, and the paid-up capital of the shares held by the connected non-residents and contributed surplus attributed to such shareholdings.
7 “Participating debt interest’ is interest that is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of a corporation (i.e., interest that resembles a return on an equity investment).
8 This back-to-back loan structure is necessary as under the thin capitalization rules, the non-resident would not be able to deduct the interest if it made the loan to the corporation directly given that it would not have any “relevant” equity in the corporation.