Canada: Canada introduces draft legislation to broaden back-to-back rules to character substitution transactions
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Canada: Canada introduces draft legislation to broaden back-to-back rules to character substitution transactions

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The 2016 Canadian federal budget proposed to significantly broaden certain rules aimed at preventing the use of back-to-back (BTB) loans to circumvent Canadian tax rules governing the withholding tax treatment of interest payments made in relation to certain transactions involving intermediaries and non-arm's length non-residents.

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Bryan Bailey

Josh Jones

Draft legislation to implement these proposals was not included with the budget and was released later by the Department of Finance on July 29 2016.

In addition to extending the BTB rules to apply to rents, royalties and similar payments and clarifying how the BTB rules apply in the context of multiple intermediary structures, the draft legislation extends the BTB rules to apply to "character substitution" transactions.

If enacted as proposed, the "character substitution" rules will apply where a Canadian taxpayer has paid a particular amount of one character (e.g. rent, royalties or interest), and the BTB rules may otherwise have been avoided by substituting a payment of another character (which for this purpose includes dividends) within a BTB arrangement.

For example, in the loan context (similar rules apply for rents, royalties or other payments), the draft legislation provides that the BTB rules may apply where a non-resident parent corporation in a non-treaty jurisdiction that wishes to make a loan to a related Canadian corporation instead subscribes for shares of an intermediary corporation in a treaty jurisdiction that makes a sufficiently connected loan to the Canadian corporation. In general, a sufficient connection will exist if there is an obligation to pay dividends on the shares and the amount of any such dividend is determined by reference to the interest paid by the Canadian corporation or the loan to the Canadian corporation was entered into because the shares were issued.

If the BTB rules apply to a lending or royalty arrangement, the Canadian corporation would be deemed to make an interest or royalty payment (as applicable) to the parent corporation in the non-treaty jurisdiction. The withholding tax rate on the deemed payment would be equal to the difference between the statutory rate of withholding that would apply to a payment made directly to the parent and the treaty-reduced rate that actually applied to the payment made by the Canadian corporation to the intermediary in the treaty jurisdiction.

Foreign multinational corporations should consider the application of the character substitution rules to any rents, royalties or interest paid by a Canadian subsidiary to determine whether upstream payments of another character could give rise to a deemed withholding tax obligation.

If enacted as proposed, these character substitution rules will apply to amounts paid or credited after 2016.

Bryan Bailey (bryan.bailey@blakes.com) and Josh Jones (josh.jones@blakes.com), Toronto

Blake, Cassels & Graydon

Tel: +1 416 863 2297 and +1 416 863 4278

Website: www.blakes.com

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