Canada: Participating interest: No loophole under the Canada-US Tax Convention

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Canada: Participating interest: No loophole under the Canada-US Tax Convention

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Jean Marc Gagnon


Emmanuel Sala

Effective 2010, the Canada-US Income Tax Convention (treaty) eliminated withholding tax imposed by a source country on cross-border interest payments, unless exceptions apply. Under Canadian tax law, only arm's-length interest payments are exempt from withholding tax, subject to exceptions. One exception common to some extent both to the treaty and the Canadian law relates to interest payments that under US law are affected by a contingency and under Canadian law measured somehow with reference to the value of other property. Under subparagraph XI(6)(b) of the treaty, interest payments "determined with reference […] to any change in the value of any property of the debtor […]" (emphasis added) remain subject to a 15% withholding tax. Under the Canadian law, "participating debt interest" is " … contingent or dependent on the use of or production from property in Canada or … computed by reference to […] commodity price […] or any other similar criterion" is subject to a 25% withholding tax, subject to reduction under a tax treaty.

Despite their apparent resemblance, one can see distinctions between the treaty notion of participation and contingency and even, in the Canadian test, a distinction between these two notions. Notably, contingency and measurement indices affecting the payment of interest are not the same notions. Moreover, the treaty relies upon a connection between the participating amount and the debtor's receipts or property, whereas the Canadian law requires no such nexus.

There is quite a long history on the part of taxpayers, tax advisers and the Canada Revenue Agency considering whether interest payments computed with reference to a public benchmark commodity index and not with reference to the value of any specific property of the debtor are subject to withholding under Canadian law, but eligible for treaty exemption. In many cases, such a computational reference would not result in a loss of an exemption from withholding tax.

In a recent interpretation, the Canadian tax authorities have considered whether there would be a strong enough link between the value of the debtor's property and the value of a commodity on a stock exchange, as they thought in the case considered, that interest linked to the index price of the commodity would be considered to fall within subparagraph (6)(b) of Article XI of the treaty, that is to be referable to a debtor's property. From the authorities' point of view, the commodity index from which an interest is computed creates a sufficient link to the change in value of the debtor's property when the debtor's principal assets consist of resource property rights which are being held for the purpose of extracting the commodities making up the index. The statements made by the Canadian tax authorities do not make clear as to what constitutes a sufficient linkage between interest paid by the debtor and its property for such interest to be considered to fall within subparagraph (6)(b) of Article XI. Although the circumstances that were considered by the Canadian tax authorities involved a debtor, the principal assets of which were resource properties (that is the commodities to which interest was linked) they stated that subparagraph 6(b) of Article XI was to be read broadly so as to capture interest computed by reference to a commodity "where there is a link or connection between the commodity price and the value of any property of the debtor". It is not clear that Canadian tax authorities would have taken such a position in a situation where the relevant commodity was not so central to the debtor's business operations. As may be inferred from the earlier references concerning how the Canadian law and the treaty measure participation in relation to Canadian interest, this conclusion may be less clear than the Canadian tax authorities' recent conclusion otherwise might suggest.

Jean Marc Gagnon (jean.gagnon@blakes.com)

Tel: +1 514 982 5025 and
Emmanuel Sala (emmanuel.sala@blakes.com)

Tel: +1 514 982 5081

Blake, Cassels & Graydon

Website: www.blakes.com

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