The Canada Revenue Agency (CRA) has issued a series of favourable tax rulings in which it concluded that Canadian domestic anti-avoidance legislation would not apply to certain proposed transactions involving back-to-back cross-border loans. In particular, these rulings consider situations in which Canadian trusts and partnerships use such structures to obtain foreign financing, and in so doing, avail themselves of a withholding tax exemption that is ordinarily only available to Canadian corporations. The favourable outcome of these rulings is good news for both non-resident investors and Canadian non-corporate entities alike.
Generally speaking, interest payments made by Canadian borrowers to non-resident lenders are subject to Canadian withholding tax. An exemption from such tax is generally available where a Canadian corporation borrows funds from an arm's length person and is not obliged to repay more than 25% of the principal amount of the loan within five years. Since this exemption applies only to corporate borrowers (and, by CRA administrative extension, partnerships of which all the partners are corporations), withholding tax will still apply to otherwise qualifying loans that are made to Canadian trusts and partnerships with non-corporate partners.
In theory, a non-corporate entity could circumvent the imposition of withholding tax by participating in what is commonly referred to as a back-to-back loan financing. A Canadian partnership could, for example, incorporate a Canadian corporate subsidiary which would borrow funds directly from the non-resident. The corporation would then, in turn, lend the borrowed funds to the partnership on normal commercial terms. The CRA has historically frowned upon such arrangements and has indicated on a number of occasions that a loan to a newly-incorporated subsidiary, the primary purpose of which was to obtain the exemption from withholding tax, would be subject to the application of Canada's domestic general anti-avoidance rule. Consequently, there was a great deal of uncertainty amongst Canadian taxpayers and tax practitioners as to when, if ever, a back-to-back loan structure would not run afoul of the CRA's administrative position.
This uncertainty has now been resolved, to some extent, by four recent CRA tax rulings. In each case, the CRA indicated that the withholding tax exemption would be available and that it would not apply the general anti-avoidance rule to the particular transactions being proposed. In three of these rulings the CRA concluded that the exemption was available to a corporate general partner that borrowed funds from non-residents and in turn lent such funds, on substantially the same terms (but with a higher interest rate), to the limited partnership. In the fourth tax ruling, the CRA took the view that the exemption would be available where a newly-incorporated subsidiary of a trust borrowed funds from a non-resident and then lent such funds to the trust (also on substantially the same terms and with a higher interest rate).
CRA tax rulings do not generally provide detailed reasons or analysis to support their conclusions. Consequently, it is still not entirely clear under what circumstances the CRA will consider back-to-back loan transactions to be offensive. That being said, in the three rulings relating to partnership structures, the CRA's favourable conclusion appears to have been largely driven by the fact that the taxpayers in question had significant reasons for borrowing the funds indirectly through the corporate general partner (other than to obtain the benefit of the withholding tax exemption). Two of these rulings specifically refer to the fact that the corporate entity provided better security to lenders, while one notes that the general partner was able to borrow money at a lower rate of interest than the limited partnership. The CRA also appears to have been influenced, in one case, by the fact that the structure under consideration had been in existence for some time.
The CRA's recent rulings relating to back-to-back cross-border loan transactions are therefore helpful in that they have confirmed that, in certain situations, Canadian non-corporate taxpayers may obtain the benefit of a withholding tax exemption where they have structured their borrowings through a related corporate entity. Although the CRA has not, as of yet, provided any detailed guidelines as to when it will accept such arrangements, it would appear that the CRA will be less likely to challenge transactions that are motivated by significant business concerns. As noted above, these developments are encouraging not only for non-corporate Canadian taxpayers seeking medium- to long-term debt financing, but also for non-resident investors looking for investment opportunities in Canada.
Mario Abrioux (mabrioux@mccarthy.ca), Toronto
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