Canada confirms withholding tax can apply to the assumption of accrued interest
Canada's Revenue Agency (CRA) confirmed in a recent technical interpretation (2017-071330117) that Canadian withholding tax can apply to the accrued (but unpaid) interest on a debt owed by a Canadian resident to a non-resident when the debt is assumed by another entity and such an assumption constitutes a "novation" of the debt obligation for purposes of the applicable commercial law.
This is because a novation would generally involve the creditor accepting all obligations under the original debt as being satisfied and discharged by the substitution of the new debtor under the assumed debt. Such obligations would include the obligation to pay accrued and unpaid interest under the original debt which could constitute such interest being considered to have been paid or credited by the Canadian resident debtor to the non-resident creditor for purposes of the non-resident withholding tax provisions of the Income Tax Act (Canada).
The CRA commented on a situation involving two Canadian companies that were partners in a partnership (partnership) formed in the US. The partnership was a Canadian partnership under the Act because all of its partners were resident in Canada. The partnership elected to be treated as a corporation for US tax purposes. The partnership owned all the shares of a US company (creditor affiliate), which was a disregarded entity for US tax purposes. The creditor affiliate had made an interest bearing loan (loan) to the partnership. The loan was not recognised for US tax purposes because it was made by a disregarded entity. The partnership (which was deemed to be a person resident in Canada for withholding tax purposes of the Act) withheld on the interest payments at a rate of 25%. There was no reduction of the withholding tax rate under the Canada-US tax convention (1980) (treaty) because the creditor affiliate was not liable for tax in the US and therefore was not a resident of the US for treaty purposes.
The partnership then transferred all of its assets (including the shares of the creditor affiliate) to a newly incorporated US company (debtor affiliate). In partial consideration for the said transfer, the Debtor Affiliate assumed the loan, including the obligation to pay all accrued and unpaid interest (accrued interest), and the creditor affiliate released the partnership from its obligations under the loan.
The CRA was asked whether Canadian withholding tax applied to the accrued interest when the loan was assumed by the debtor affiliate. The CRA looked at whether the delivery by the partnership to the creditor affiliate of the debtor affiliate's covenant to assume the loan constituted a payment or credit of the accrued interest. The CRA stated that this will be the case if the assumption constitutes a novation of the loan, which is a question to be determined after reviewing the terms and conditions of the particular transaction. At Canadian law, a novation is a trilateral agreement by which an existing contract is extinguished and a new contract is brought into being in its place. Canadian case law provides that a novation will generally occur when:
The new debtor assumes the complete liability;
The creditor accepts the new debtor as principal debtor (and not merely as an agent or guarantor); and
The creditor accepts the new contract in full satisfaction and substitution for the old contract.
The CRA determined that these requirements were satisfied at the time the debtor affiliate assumed the loan and the creditor affiliate consented to the assumption, resulting in a novation of the original debt. At this time, the accrued interest was credited (in kind) to the creditor affiliate and the partnership was required to withhold 25% of the amount of the accrued interest.
This technical interpretation is a reminder to consider, in the cross-border context, the legal consequences of any assumption of debt. In addition to other tax considerations for both debtors and creditors (such as the possible realisation of foreign exchange related gains or the application of the debt forgiveness rules), Canadian withholding tax on the underlying accrued and unpaid interest may arise.
This is a particularly undesirable outcome in circumstances where the former debtor does not realise cash proceeds (in the transaction involving the assumption) can be used to fund the withholding obligation.