Introduction – Non-Resident Withholding Tax
For individuals or corporations that are not tax residents in Canada, certain payments that they receive from Canadian sources are subject to withholding taxes. A withholding tax applies in a somewhat different manner than normal income tax: a withholding tax is calculated at the time of the payment to the non-resident of Canada and usually applies to the gross payment; normal income taxes are calculated at the end of the tax year and are based on the taxpayer's net income (profits). Withholding taxes apply to various payments such as pensions, interest, dividends, rents, and royalties to non-residents unless otherwise specified by a tax treaty between Canada and the country in which the individual or corporation resides. The standard withholding rate is 25% of the gross payment for most types of payments; however, this amount is typically reduced to 10% or 15% for interest payments to a tax resident in a country that has a tax treaty with Canada, with the rates for other types of payments varying greatly depending on the particular tax treaty. For rental income, non-residents can elect under s.216 of the Income Tax Act and pay withholding tax on the net rental income rather than the gross rental income as discussed in more detail in our article on non-resident real estate taxation found here. While international tax planning can be complicated, our top Toronto tax firm is well equipped to advise you and meet your needs.
Tax planning by Treaty Shopping
Since the withholding tax rates vary from jurisdiction to jurisdiction, non-Canadian residents can carry out tax planning to operate in a jurisdiction with a favourable tax treaty with Canada so as to minimize the withholding tax rates. This in itself is not a problem, and, in fact, the reduced tax rates are an intentional benefit aimed at promoting international investment and business. However, what concerns the Canada Revenue Agency ("CRA") is the practice usually called treaty shopping.
Treaty shopping typically occurs where an individual wants to invest into Canada but resides in a jurisdiction that has either no tax treaty with Canada or a tax treaty with unfavourable terms. In order to minimize his tax burden, that individual may incorporate an entity in an intermediate jurisdiction—in particular, a jurisdiction whose tax treaty with Canada offers favorable terms. The individual can then invest into Canada through the entity and benefit from the intermediate jurisdiction's tax treaty. In effect, that individual would be able to access the beneficial treatment without residing in that intermediate jurisdiction and often with minimal actual presence in the intermediate jurisdiction.
Back-to-Back Loan Provisions: Canada's Response to Treaty Shopping
The treaty-shopping issue is an international problem, and countries have enacted various ways to discourage this behaviour. The back-to-back loan provisions in ss. 212(3.1) - (3.81) of the Income Tax Act for interest and ss. 212(3.9) - (3.94) for rents and royalties are in essence types of anti-conduit rules somewhat similar to what is utilized by the U.S. These provisions are aimed at preventing the use of a conduit in an intermediary jurisdiction where that conduit exists primarily to facilitate a loan to a Canadian borrower from the true lender, who is resident in a less favourable tax jurisdiction.
Technically speaking, pure conduit arrangements are already ignored—i.e., "looked through"—with the interest being treated as paid to the beneficial owner of the interest payment. Although the Canadian Courts imposed a fairly high standard to acknowledge that this type of pure conduit arrangement existed, taxpayers could often sidestep this problem with a properly set up structure. In response, the Department of Finance enacted the back-to-back loan provisions with regards to withholding tax on interest in 2014 and then amended them in 2016, further strengthening these provisions.
The result of these provisions is a horrendously complex set of definitions, rules and various applicability tests, which in some cases are unclear as to how broadly they apply.
The back-to-back loan provisions function by first identifying 'relevant funding arrangements' and then following the chain of 'relevant funders' until reaching an 'ultimate funder' of a particular loan arrangement.
The withholding tax on interest paid from Canada to the immediate foreign entity is then compared to what the withholding tax would have been had the interest been paid directly to the 'ultimate funder.' If paying the interest to the 'ultimate funder' would have incurred a higher withholding tax, then interest is deemed to have been paid to the 'ultimate funder' through a formula that results in the withholding rate on the interest essentially increasing to what it would have been if the entire interest payment had been paid to the 'ultimate funder'. Basically, the withholding tax on the interest paid to the immediate funder remains unchanged, but the 'ultimate funder' is deemed to have received a payment such that the withholding tax on that payment eliminates the tax advantage gained from the impugned funding arrangement.
For example, an individual is a non-resident of Canada and resides in Country A, which has no tax treaty with Canada but has a tax treaty with Country B with no withholding tax on interest. Country B has a tax treaty with Canada with a reduced interest rate of 10%. The individual creates a corporation in Country B and lends that corporation $1,000,000, and that corporation then lends $1,000,000 to a Canadian entity. If in a particular year the Canadian entity pays $10,000 in interest to the corporation in Country B, and that payment is subject to the 10% withholding rate. So, $1,000 is paid to the Canada Revenue Agency, and the corporation then pays the $9,000 to the individual in Country A.
If the back-to-back provisions apply, then the CRA would compare the $1,000 that it in fact received to the amount that it would have received if the entire $10,000 were paid to the individual in Country A. In this case, since Country A has no tax treaty with Canada, if the Canadian entity had paid the entire $10,000 to the individual residing in Country A, Canada's 25% withholding tax rate would apply and the amount owing to the CRA would equal $2,500. So, if the Canadian entity had paid the full interest directly to the individual in Country A, the CRA would have garnered an additional $1,500 in withholding tax.
As a result, the back-to-back loan provisions deem the Canadian entity to have paid the 'ultimate funder' in Country A an amount of interest that permits the CRA to collect the $1,500 difference from the Canadian entity (on top of the initial $1,000 of withholding tax that the Canada Revenue Agency already received). The back-to-back loan provisions therefore allow the Canada Revenue Agency to collect the full $2,500 of withholding tax that it would have received had the payment been made directly to the 'ultimate funder'.
Character Substitutions Rules
These provisions also include character substitution rules which were added to inhibit the use of equity to avoid being caught by the back-to-back loan rules. These rules require that a share issuer has an obligation to pay an amount or a dividend and that one of two connection tests are met.
The first connection test is met where the amount of the dividend or payment is determined in whole or in part by reference to an amount of interest to be paid under a relevant funding arrangement.
Alternatively, the second connection test is met where it can reasonably be concluded that the particular relevant funding arrangement was entered into or permitted to remain in effect because of the shares.
If either connection test applies, the shareholdings are deemed by subsection 212(3.7) to be part of the relevant funding arrangement and the shareholder to be a relevant funder. In other words, if the character substitution rule applies, the Income Tax Act treats the foreign shareholder as if it were a lender and imposes on the Canadian payor the withholding obligations for interest rather than those for dividends.
The broad language these rules contain causes significant uncertainty—even for relatively standard situations such as international cash-pooling arrangements often used by multi-national businesses where treaty shopping is not a motivator of the arrangement. For example, the character substitution rules only apply where there is an obligation to pay a dividend. The rules are presumably targeted at situations where the issued shares require regular dividend payments of amounts equal to the interest that a corporation receives, essentially creating shares that function like debt. But any payment of a dividend—even on common shares or where there is no obligation to pay dividends—arguably creates an obligation on the corporation 'to pay an amount' (the dividend that was issued) which could then engage the character substitution rules. This may still apply even if the dividend is paid immediately upon declaration as it is likely that the obligation to pay exists, if only for an instant. When asked for clarification, the Department of Justice indicated that these provisions could apply to common shares if the connection tests are met and to view the provisions as anti-avoidance rules. Specifically, they warned that the quantum and timing of dividend payments on the common shares would be relevant in determining whether the connection tests were met. The provisions are further criticized because the similar, US equivalents of these provisions include express exceptions for obligations that arise solely due to a dividend declaration and for "significant financing activities" which provide a degree of flexibility for financing arrangements within a corporate group.
Tax Tip – Multi-Jurisdictional Tax Planning Requires Professional Advice
Tax planning and corporate structures spanning multiple jurisdictions are definitely not examples of DIY endeavours. Beyond the fact that a mistake could effectively lead to much higher withholding tax rates on interest, rents, and royalties due to the back-to-back loan provisions, it is entirely possible that the 'ultimate funder's' resident tax authority will allow claims for foreign tax credits on the withholding tax on the deemed interest payments. This means that not only is the withholding rate increased, but you may be double taxed on that increased amount as well. With these kinds of stakes involved, it would be foolhardy to proceed without professional advice—our experienced Toronto tax lawyers can help you ensure your tax plan is done right.