Canadian Tax Aspects of Creating Leverage in Subsidiary Operations

01 June 2006

Source of Canco Financing : Related party financing 

Cross-border financing provided to Canco from within the group will attract Canadian interest withholding tax. The Income Tax Act (Canada) (the ITA) has no exemption for interest paid to non-arm’s length persons. The 25 per cent statutory rate is typically reduced to 10 per cent for payments made to a person resident in a country with which Canada has entered into a tax treaty (a treaty resident). Unless the group lender can absorb the cost through foreign tax credits, there will be a net tax cost to using group financing in the leverage transaction. 

The thin capitalisation rules in subsection 18(4) of the ITA can apply to disallow a portion of Canco’s interest deduction on outstanding debt to ‘specified non-residents’, where the amount of debt exceeds two times Canco’s shareholder equity as determined for relevant purposes. The rule can apply to interest payable to a group member. A specified non-resident is defined to include a non-resident shareholder of a Canadian corporation that at any time, either alone or together with non-arm’s length persons, owns a 25 per cent votes or value equity interest in the corporation, or a non-resident who is not dealing at arm’s length with a shareholder. A specified non-resident would therefore include a group member.

Third-party financing 

The issues noted above can be avoided if Canco obtains financing from a third party. The thin capitalisation rules do not apply to debt guaranteed by a specified non-resident. Interest paid on Canco debt guaranteed by a group member would therefore not be subject to thin capitalisation limitations. If the financing is obtained from a nonresident, the terms of the debt could be structured to exempt interest payable from Canadian withholding tax. The only relevant exemption would be for interest on mediumterm debt that qualifies under subparagraph 212(1)(b)(vii) of the ITA. 

Use of Funds: Interest Deductibility 

The Canadian tax consequences of the leverage transaction will be determined with regard to the use made by Canco of the financing proceeds. Paragraph 20(1)(c) of the ITA provides that interest will only be deductible to Canco if it is paid or payable pursuant to a legal obligation to pay interest on funds borrowed (or on an amount payable for property acquired) for purposes of gaining or producing non-exempt income from a business or property (an ‘eligible use’). The leverage transaction can introduce special challenges in this regard, because it is typically not driven by Canco’s need to obtain financing for use in its business. It is more likely to be the case that the financing proceeds either replace outstanding Canco equity capital, or are ultimately invested in the group outside of Canada. 

If the financing proceeds are repatriated by way of a dividend payment, it will typically be subject to a 5 per cent Canadian dividend withholding tax if made to a treaty resident parent (the ITA statutory rate is 25 per cent). The proceeds can also be repatriated by a way of a reduction and distribution of Canco’s legal share capital. The distribution can be paid free of Canadian withholding tax to the extent that it is not in excess of the paid-up capital of the shares for purposes of the ITA. Lending the proceeds to a non-Canadian group member is not likely to be effective. If the loan remains outstanding over two Canco taxation yearends, it is treated under subsection 15(2) of the ITA as a deemed dividend paid by Canco, and is subject to dividend withholding tax. 

The dividend payment or return of corporate capital will cause Canco to distribute the value of the leverage transaction proceeds. Can the financing then have an eligible use? In Transprairie Pipelines Ltd [1970] CTC 537 (ex ct), the taxpayer used borrowed money to redeem shares. The court held that, in light of the relevant facts, the borrowed money replaced shareholder capital that was used in the taxpayer’s business for purposes of earning income. The money was therefore considered to be used for the same eligible purpose. A similar argument was endorsed in Chase manhattan Bank of Canada, 2000 DTC 6018 (FCA), where borrowed funds were used for purposes of paying a dividend. 

In light of this judicial authority, the Canada Revenue Agency’s (CRA) administrative practice, as set out in Interpretation Bulletin IT-533, confirms that a return capital or payment of a dividend can be an eligible use. A borrowing to return capital will qualify provided that (i) the amount returned does not exceed the ‘contributed capital’ of the borrower, and (ii) such capital has an eligible use. Contributed capital is defined as funds provided by shareholders to the corporation, the measure of which is normally the corporation’s legal stated capital. Funds borrowed to pay a dividend will have an eligible use provided that (i) the dividend does not exceed the borrower’s ‘accumulated profits’, and (ii) such profits have an eligible use. Accumulated profits are defined as retained earnings computed on an unconsolidated basis with investments accounted for at cost. 

The repatriation of the borrowed funds out of Canada can also be effected by causing Canco to purchase the shares of another group member. Both the case law and CRA administrative practice confirm that interest payable in respect of borrowed funds to acquire common shares would generally be deductible in computing income. This conclusion is based, among other things, on the presumption that the purchaser would have a reasonable expectation that dividends would be received on the shares. In the case of preferred shares, the eligible use analysis is more complicated. Is Canco required to have a positive spread based on expected dividend income net of interest expense? In Ludco Enterprises et al, 2001 DTC 5505 (SCC), the court held that ‘income’ for purposes of the eligible use test meant gross income. On the other hand, the Department of Finance has proposed introducing legislation to overturn this result. Prudence would suggest that a fixed dividend rate on the preferred shares generate a positive spread for Canco. 

It is important to note that the tax motivation of the leveraged transaction, ie, the desire to introduce interest expense in Canco, should not be relevant to the question of eligible use. The court in Ludco held that the eligible use test does not require a determination of the taxpayer’s ‘true’ purpose when establishing the use of borrowed funds under paragraph 20(1)(c), unless the transaction is a sham designed to create a deduction. Thus, even though a borrower may have only an ancillary purpose to earn income, this is a sufficient requisite purpose. This conclusion is subject, however, to the possible legislative change referred to above. 

Section 17 – imputed interest 

If the leverage transaction proceeds are to be repatriated from Canada, the transaction must be assessed in light of section 17 of the ITA. This rule can impute a prescribed rate of interest income to Canco if it makes certain interest-free or low-interest bearing loans to a non-resident. Subsection 17(2) is an indirect loan rule that can apply where an amount is owing between non-residents, and this amount is funded by Canco. Subsection 17(2) operates to deem the amount as owing directly to Canco, such that the interest imputation rule can apply to the amount. 

Very generally, subsection 17(2) can apply to an amount owing between non-resident group members if it is reasonable to conclude that the amount is outstanding because Canco made, directly or indirectly, a loan or transfer of property (other than an ‘exempt loan or transfer’). A causal connection is required between the loan or transfer of property out of Canada, and the amount owing by the non-resident debtor. The limits of this causal connection remain largely undefined. It is not likely to be sufficient that the loan or transfer merely provides the opportunity for the transaction under which the amount became owing. On the other hand, the immediate flow of leverage transaction proceeds out of Canco to fund the transaction are likely to be caught. 

There are relevant exceptions to subsection 17(2). It does not apply to an amount owing where both the non-resident debtor and the creditor is a controlled foreign affiliate (a CFA) of Canco. In order to qualify as a CFA of Canco, Canadian group members must generally have majority ownership of the affiliate’s shares (ie, are underneath Canco). Subsection 17(2) also does not apply where the loan or transfer of property out of Canada was an exempt loan or transfer. This includes a dividend or return of capital paid by Canco, and also payment of an arm’s length purchase price for property, other than shares of a foreign affiliate of Canco or of a Canadian corporation with whom Canco does not deal at arm’s length. 

The rules in section 17 are complex. They can lead to unexpected results. If the leverage financing proceeds are invested by Canco in non-Canadian group members, including the purchase of group member shares, regard must be had as to whether the proceeds are ultimately, directly or indirectly, obtained as a form of funding by a group member other than a CFA. 

Other avoidance rules 

Certain anti-avoidance rules of the ITA could also be relevant to the leverage transaction if Canco acquires shares of a non-resident group member. Subsection 258(3) can apply if Canco is a ‘specified financial institution’ for purposes of the ITA. This rule can apply to recharacterise tax-free dividends received by Canco on the shares as taxable interest. To avoid the application of the rule, it would generally be necessary to conclude that the shares were not acquired in the ordinary course of Canco’s business. In addition, subsection 95(6) is a broadly worded anti-avoidance rule that can apply in qualifying circumstances to deny foreign affiliate status to Canco’s acquired interest in the non-resident group member. Very generally, the rule can apply where the purpose of the acquisition of shares is to permit a person to avoid payment of tax under the ITA. The rule could cause Canco to receive otherwise tax-free dividends on the shares as taxable dividends. The application of these rules is beyond the scope of this discussion. It should be expected, however, that an isolated long-term investment by Canco in common shares of an operating company would not fall within their purview. Anything outside of this scenario would have to be considered more fully. 

HybrId arrangements 

The tax effectiveness of the leverage transaction can be enhanced further if it is ‘hybridised’, such that it had a dual character for tax purposes (eg, debt under Canadian tax rules, and equity under non-Canadian tax rules). Interest payments made by Canco to the group member creditor could then be received as a tax-free dividend distribution for local tax purposes. The arrangement could also allow the group to realise a ‘double dip’ of interest deduction on a single financing transaction. 

In the Canada–US context, one variant of a hybrid is a forward share subscription arrangement. A US group member (USCo) forms a subsidiary Nova Scotia unlimited company (Finco). USCo can treat Finco as a branch for US tax purposes under the so-called ‘check the box’ rules. NSULC borrows from a third party, and on-lends the funds (the ‘hybrid loan’) to USCo’s Canadian operating subsidiary (ie, Canco). Finco simultaneously irrevocably commits to subscribing for shares of Canco on the hybrid loan maturity date for a subscription price equal to the principal amount of the loan. The subscription would be for that number of shares having a fair market value on the date of issue of the hybrid loan equal to the principal amount of the loan. Interest payable on the hybrid loan could be paid in common shares. The arrangement contemplates that Finco can surrender the hybrid loan to CanOpco on maturity as consideration for the forward subscription price. 

It is expected that the hybrid arrangement would be characterised under US tax rules on a consolidated basis, and be treated as a subscription by USCo for shares of CanOpco. This is because when the arrangement is ended, Finco (a branch of US parent) is in the position of a person who acquired the shares at the outset of the transactions. Interest paid by CanOpco to Finco (eg, in common shares) would then be treated as a non-taxable stock dividend paid to USCo. The interest payable by Finco on the third-party debt would be deductible in computing USCo’s taxable income (the first ‘dip’ for US tax purposes). On the other hand, the Canadian tax analysis would generally follow the legal form of the parties’ arrangements. The hybrid loan would be respected as a loan for Canadian tax purposes. Interest payable by CanOpco to Finco would therefore create a net deduction in CanOpco (a second ‘dip’ for Canadian tax purposes). 

The hybrid exploits differences between the US and Canadian tax regimes’ respective approaches to evaluating the arrangement. Very generally, the US regime focuses on the commercial or economic substance thereof. The equity treatment for US tax purposes is derived from the virtual certainty that the cash advanced under the hybrid loan will ultimately be applied to subscribe for the Canco shares. The Canadian tax analysis focuses on the legal substance of the arrangements. It is the actual legal rights and obligations created by the parties that determine the character of the transaction. As noted by the Supreme Court of Canada in Shell Canada, 99 DTC 5669 (SCC) at paragraph 39: “This Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer’s bona fide legal relationships”. 

Despite these differences in approach, the analysis under the US and Canadian rules is not wholly opposite. The Canadian courts have held that to confirm the legal substance of a transaction with hybrid features, the substance of the overall arrangement must be determined by weighing its ‘debt-like’ features against its ‘equity-like’ features. (See, for example, Canada Deposit Insurance Corp v Canada Commercial Bank, [1992] 3 SCR 558.) In practice, this is not far removed from the US exercise of determining the commercial substance of the arrangement. The transaction documents must therefore perform a delicate balancing act to create at law an advance of loan principal (the Canadian imperative), which is treated by the parties as non-returnable payment for shares (the US imperative). Favouring one taxing jurisdiction’s imperative may upset the desired outcome in the other jurisdiction. To this end, variations can be introduced to the arrangement. The subscription rights can be held by a USCo disregarded subsidiary NSULC other than Finco. Under the US analysis, the rights continue to be viewed as held by USCo. Under the Canadian analysis, it is then easier to respect the form of the hybrid loan where Finco and CanOpco enter into no other transaction between them. 

We understand that the IRS is reviewing the form hybrid arrangement described above. In addition, the Canadian, US and other tax authorities have been cooperating in these matters by sharing information about, and no doubt possible techniques for, attacking cross-border tax-advantaged financing structures. There is a growing trend towards cooperation and taxpayers must therefore approach these arrangements very carefully, ensuring that they are diligent in implementing the transactions. 

Conclusion 

Despite a number of relevant issues and continuing technical amendments to the ITA, groups can still generally affect a tax advantageous cross-border financing arrangement into Canada. Although the CRA and other tax authorities have persevered in reviewing and attacking such structures, taxpayers have continued to find efficient alternatives.

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