Canadian Federal Revised Anti-Avoidance Back-to-Back Loan Arrangement Proposals Provide Some Relief for Certain Financing Transactions Involving Multinational Groups

Lyne M. Gaulin, CPA, CA (Ontario, Canada), CPA (State of Illinois, USA), Tax Partner
Miller Thomson LLP, Toronto
[email protected]
416-595-8590

In Budget 2014, the Federal Government introduced new anti-avoidance rules for back-to-back loan arrangements aimed at financing transactions where a third party (e.g., a bank) is interposed between a Canadian borrower and a Specified Non-Resident[1] of the Canadian borrower to circumvent either or both the Canadian thin cap rules (including the existing anti-avoidance back-to-back loan rules in subsection 18(6) of the Income Tax Act (Canada) (the “Act”)) and Canadian withholding taxes under Part XIII of the Act.[2]

The proposed anti-avoidance back-to-back loan arrangement rules in new subsections 18(6), 18(6.1), 212(3.1), 212(3.2) and 212(3.3) of the Act included in Budget 2014 were overly broad.  One significant concern was that these proposed rules would catch typical arm’s length financing transactions entered into with a Canadian or foreign bank where any entity in the multinational group that is a Specified Non-Resident of a Canadian borrower provides security for the debt or obligation of the Canadian borrower.  According to the 2014 Federal Budget Supplementary Information, a guarantee, in and of itself, should not be caught. However, it would appear that a secured guarantee could be caught under the proposed rules in Budget 2014.

Revised Back-to-Back Loan Arrangement Proposals Released on August 29, 2014

On August 29, 2014, the Department of Finance (“Finance”) released revised anti-avoidance back-to-back loan arrangement proposals (“August 2014 Draft Proposals”) which should provide some relief for certain typical arm’s length financing transactions involving multinational groups. The purpose of these proposed rules, as expressed by Finance in the Explanatory Notes to the August 2014 Draft Proposals, is to “ensure that variations of “back-to-back” debts, and certain economic equivalents, cannot be used to circumvent” the Canadian thin cap regime.

Conditions for Application of Proposed Anti-Avoidance Back-to-Back Loan Arrangement Rules

The conditions for the application of proposed subsection 18(6.1), which is the anti-avoidance operative rule for back-to-back loan arrangements, are set forth in proposed subsection 18(6).  Subsection 18(6.1) will be applicable to a particular back-to-back loan arrangement if all of the following conditions in subsection 18(6) are met:

First Condition

The taxpayer (e.g., a Canadian resident corporation) has a particular amount outstanding as or on account of a particular debt or other obligation to pay an amount to a person (e.g., a bank) or partnership (referred to in the August 2014 Draft Proposals as the “Intermediary”).  The Explanatory Notes clarify that an Intermediary may be either a resident of Canada or a non-resident.

Second Condition

The Intermediary is neither (i) a person resident in Canada with whom the taxpayer does not deal at arm’s length for purposes of the Act nor (ii) a person that is a Specified Non-Resident of the taxpayer.  The purpose of this condition is to carve-out the following particular situations: (a) the Intermediary is a Canadian resident that is not dealing at arm’s length with the taxpayer and is itself subject to the Canadian thin cap rules on an amount directly owing to the Specified Non-Resident, or (b) an amount owed by the taxpayer to the Intermediary is already subject to the Canadian thin cap rules because the Intermediary is a Specified Non-Resident of the taxpayer.

Third Condition

The third condition may be satisfied in one of two ways:

1. Intermediary Debt Rule

First, this third condition will be satisfied if the Intermediary or a person or partnership not dealing at arm’s length with the Intermediary for the purposes of the Act has an amount outstanding as or on account of a debt or other obligation to pay an amount to a Specified Non-Resident of the taxpayer that meets any of the following conditions (referred to in the August 2014 Draft Proposals as the “Intermediary Debt”):

(a)  recourse in respect of the Intermediary Debt is limited in whole or in part, either immediately or in the future and either absolutely or contingently, to the Taxpayer Debt[3],

(b)   the Intermediary Debt was entered into on condition that the Taxpayer Debt be entered into,

(c)    the Taxpayer Debt was entered into on condition that the Intermediary Debt be entered into, or

(d) it can reasonably be concluded that if the Intermediary Debt did not exist (i) all or a portion of the Taxpayer Debt would not be outstanding at that time, or (ii) the terms or conditions of the Taxpayer Debt would be different.

Paragraph (a) covers limited recourse debt included in Budget 2014. Paragraph (b) addresses situations similar to those targeted by the existing anti-avoidance back-to-back loan rules also included in Budget 2014 while paragraph (c) is focused on vice versa situations. Paragraph (d) is broadly drafted and could catch an Intermediary Debt that has some “reasonable” linkage with the Taxpayer Debt and is not covered under paragraphs (a) to (c) above.

2. Specified Right Rule

Second, this third condition will also be satisfied if the Intermediary or a person or partnership not dealing at arm’s length with the Intermediary for purposes of the Act has a specified right in respect of a particular property granted directly or indirectly by a Specified Non-Resident of the taxpayer and (a) the existence of the specified right is required under the terms and conditions of the Taxpayer Debt, or (b) it can reasonably be concluded that if the Intermediary or the person or partnership not dealing at arm’s length with the Intermediary was not granted any specified right (i) all or a portion of the Taxpayer Debt would not be outstanding at that time, or (ii) the terms or conditions of the Taxpayer Debt would be different.  A specified right, at any time in respect of property, means “a right to, at that time, use, mortgage, hypothecate, assign, pledge or in any way encumber, invest, sell or otherwise dispose of, or in any way alienate, the property.”

Finance has indicated in the Explanatory Notes that “an Intermediary will not be considered to have a specified right in respect of a property solely by virtue of having been granted a security interest in the property.” It would appear based on the Explanatory Notes that this new rule targets those situations where the taxpayer grants rights in respect of a property to the Intermediary (or a person or partnership not dealing at arm’s length with the Intermediary) that would be the economic equivalent of making a loan to the Intermediary (or any such person or partnership) including, for example, the right to assign or pledge the property in order to raise capital for the Intermediary (or any such person or partnership) or to dispose of the property.  In light of these comments, the third condition should generally not catch “security interests” in respect of property (defined in the August 2014 Draft Proposals as “an interest in, or for civil law a right in, the property that secures payment of an obligation”) granted to an Intermediary (or any such person or partnership) by one or more Specified Non-Residents of a taxpayer in typical arm’s length financing transactions entered into by multinational groups. However, this new rule could potentially apply in a situation, for example, where a Canadian borrower defaults on its obligations thereby giving the lender the right to realize on a security interest in property by disposing of the property.

Fourth Condition

The fourth condition consists of a de mininis test that will be satisfied if at least 25% of the Taxpayer Debt is funded by the Intermediary through Intermediary Debt or property subject to a specified right granted to the Intermediary (or a person or partnership that does not deal at arm’s length with the Intermediary) by one or more Specified Non-Residents of the taxpayer. According to the Explanatory Notes, this rule ensures that subsection 18(6.1) should not apply where the Taxpayer Debt is funded mainly from sources other than a Specified Non-Resident of the taxpayer.

This condition also includes a rule intended to provide some relief where a multinational group including a Canadian borrower enters into cross-collateralized loans and notional cash pooling arrangements with an Intermediary that is granted a security interest in property consisting of the Intermediary Debt or subject to a specified right in order to secure all of the obligations under the particular arrangement. If this relieving rule is applicable, the borrowing base for purposes of determining whether the de minimis test has been satisfied is broader and includes the Taxpayer Debt plus any borrowing under the group facility by other entities in the group.

Examples in Explanatory Notes

The Explanatory Notes include three examples that provide some insights into Finance’s views on when the conditions in subsection 18(6) will be satisfied in situations where a person not dealing at arm’s length with the Intermediary is granted a specified right in property by a Specified Non-Resident of a Canadian borrower, a multinational group (including a Canadian borrower) enters into cross-collateralized loans or a notional cash pooling arrangement with an Intermediary.

Example 1 – Specified Right

The first example is based on the following assumptions:

• ForeignCo, a non-resident corporation, owns all of the shares of Canco, a Canadian resident corporation. Canco requires $50 million for the expansion of its business.
• Instead of loaning $50 million to Canco, ForeignCo arranges with a third party bank (the “Intermediary”) to loan $50 million to Canco (the “Taxpayer Debt”).  This is the only amount owing by Canco (or a person or partnership not dealing at arm’s length with Canco) to the Intermediary.
• Under the arrangement, ForeignCo agrees to acquire $50 million of marketable securities which ForeignCo is required to hold through an account with a securities dealer, a subsidiary of the Intermediary.
• ForeignCo grants to the securities dealer the right to pledge or assign the securities for the purpose of raising capital for the Intermediary or the securities dealer.

See Diagram 1 for an example.

The first and second conditions are considered satisfied in this example because there is a Taxpayer Debt and the Intermediary is neither a Canadian resident person not dealing at arm’s length with Canco nor a Specified Non-Resident of Canco.

For purposes of the third condition, the securities dealer, a person not dealing at arm’s length with the Intermediary, is considered to have a specified right in respect of the marketable securities granted by ForeignCo, a Specified Non-Resident of Canco. The third condition should be satisfied if the existence of this specified right is required under the terms and conditions of the Taxpayer Debt, or if it can reasonably be concluded that if the securities dealer was not granted this specified right all or a portion of the Taxpayer Debt would not be outstanding at that time or the terms and conditions of the Taxpayer Debt would be different.

The de minimis test should also be satisfied in this example if the fair market value of the marketable securities is equal to at least 25% of the Taxpayer Debt in the amount of $50 million. Assuming that the fair market value of the marketable securities is $50 million, the fourth condition should be met because 100% of the Taxpayer Debt in the amount of $50 million would be considered funded by the Intermediary through the property subject to the specified right granted to the securities dealer.

Example 2 – Cross-Collateralized Loans

Finance assumes in this second example that:

• ForeignCo, a non-resident corporation, owns all of the shares of Canco, a Canadian resident corporation, and all of the shares of ForeignSubCo 1 and ForeignSubCo 2, two non-resident corporations.
• This multinational group enters into a credit facility with a third party bank (the “Intermediary”). Under this facility, any member of this group can borrow from the Intermediary, subject to an overall agreed upon group borrowing limit.
• Each group member provides the Intermediary with a cross-guarantee and a general security interest against all property held by that member, which secures payment of all the interest and principal owed by all group members.
• ForeignSubCo 1 and ForeignSubCo 2 collectively borrow $450 million, while Canco borrows $50 million under this group facility (the “Taxpayer Debt”).
• Under the terms of this facility, the group is required to maintain with the Intermediary a cash balance representing 5% of the aggregate amount on loan to the group.  ForeignCo maintains a $25 million cash deposit in a segregated account with the Intermediary at all times to satisfy this condition.

See Diagram 2 for an example.

The first and second conditions are considered satisfied in respect of this example for the same reasons set forth above in Example 1.  Finance considers that the third condition could be satisfied in two ways.  Depending on the facts and circumstances, the $25 million cash deposit with the Intermediary would likely represent an Intermediary Debt or property in respect of which the Intermediary was granted a specified right by ForeignCo, a Specified Non-Resident of Canco.

However, Finance considers that the fourth condition would not be satisfied in this example if the Intermediary is granted a security interest in the $25 million cash deposit that secures all amounts owing under the group facility. In these circumstances, the borrowing base would include the Taxpayer Debt in the amount of $50 million plus the total debt of ForeignSubCo 1 and ForeignSubCo 2 in the amount of $450 million under the group facility.  As a result, the de minimus test would not be satisfied because the $25 million cash deposit would only represent 5% of this borrowing base.

Example 3 – Notional Cash Pooling Arrangement

The assumptions in this example are as follows:

• ForeignCo, a non-resident corporation, owns all the shares of Canco, a corporation resident in Canada, and all of the shares of ForeignSubCo, a non-resident corporation.
• This multinational group enters into a notional cash pooling arrangement with a third party bank (the “Intermediary”).  Pursuant to this arrangement, the total group borrowing cannot exceed the aggregate group limit of $20 million plus the total of all amounts placed on deposit by members of the group.
• All amounts placed on deposit with the Intermediary by group members secure payment of all amounts loaned by Intermediary to net borrowers under this arrangement.
• ForeignSubCo borrows $40 million, while Canco borrows $60 million under this arrangement (the “Taxpayer Debt”). ForeignCo maintains $80 million on deposit with the Intermediary in support of these borrowings.

See Diagram 3 for an example.

The first and second conditions in this example are satisfied for the same reasons set forth above in Example 1. The third condition could be considered satisfied based on the reasons discussed above in Example 2.

The de minimus test would also be considered satisfied in this example because the $80 million cash deposit that secures all amounts borrowed under the arrangement would represent 80% of the aggregate of the Taxpayer Debt in the amount of $60 million and the debt to ForeignSubCo in the amount of $40 million under the arrangement.

Canadian Tax Consequences if Conditions for Application of Anti-Avoidance Back-to-Back Loan Arrangement Rules are Satisfied

If the four conditions discussed above are satisfied in respect of a particular back-to-back loan arrangement, the operative rule under subsection 18(6.1) will be applicable. Under this operative rule, all or a portion of the Taxpayer Debt may be deemed to be an amount owing by the taxpayer to one or more Specified Non-Residents of the taxpayer (i.e., one or more Specified Non-Residents of the taxpayer that are creditors in respect of an Intermediary Debt or grantors of specified rights in property to the Intermediary or a person or partnership not dealing at arm’s length with the Intermediary) rather than to the Intermediary for purposes of the Canadian thin cap rules.

According to the Explanatory Notes, subsection 18(6.1) should not deem more than the Taxpayer Debt to be owed by the taxpayer to such Specified Non-Residents. Subsection 18(6.1) also includes a rule to provide for apportionment of the Taxpayer Debt among two or more Specified Non-Residents of the taxpayer based on the Intermediary Debt and/or fair market value of property subject to a specified right where the total of any Intermediary Debt and/or the fair market value of such property exceeds the Taxpayer Debt.

In addition, all or a portion of the interest on any portion of the Taxpayer Debt that is deemed under this operative rule to be an amount owing to Specified Non-Residents of the taxpayer rather than to the Intermediary may be deemed to be interest paid or payable by the taxpayer to one or more such Specified Non-Residents rather than to the Intermediary for purposes of the Canadian thin cap rules.

A taxpayer will have to take into account any deemed amount owing by it to Specified Non-Residents of the taxpayer pursuant to this operative rule in computing its debt-to-equity ratio under the Canadian thin cap rules. This could give rise to the denial of an interest deduction for a taxpayer (including any interest deemed paid or payable by a taxpayer to Specified Non-Residents of the taxpayer under this operative rule) on any excess debt.

For purposes of Canadian withholding taxes under Part XIII and subject to existing subsections 214(16) and 214(17) of the Act (i.e., existing rules that treat denied interest on excess debt under Canadian thin cap rules as dividends subject to Canadian withholding taxes), any denied interest that is interest deemed paid or payable by the taxpayer to Specified Non-Residents of the taxpayer under this operative rule will also be interest deemed paid or payable by the taxpayer to Specified Non-Residents and not to the Intermediary. This will result in any such denied deemed interest being treated as a dividend for Canadian withholding tax purposes. According to comments made by Finance in the Explanatory Notes, the intended effect is to coordinate the existing Canadian withholding tax rules in subsections 214(16) and 214(17) with the proposed Canadian withholding tax rules discussed below such that these existing rules would apply in priority to those new rules.

These new proposed measures apply to taxation years beginning after 2014.

Canadian Withholding Taxes for Deemed Interest on Back-To-Back Loan Arrangements

All of the four conditions set forth in proposed subsection 212(3.1) must be satisfied in order for the Canadian withholding tax operative rule in proposed subsection 212(3.2) to apply to a particular back-to-back loan arrangement. Two of these four conditions are similar to the third and fourth conditions in subsection 18(6) discussed above, except for certain differences discussed below.  The two following conditions must also be met:

• The Taxpayer must pay or credit a particular amount on account or in lieu of payment of, or in satisfaction of, interest (referred to in this article as “Interest on Taxpayer Debt”) in respect of a Taxpayer Debt.
• The amount of Canadian withholding taxes under Part XIII of the Act would have been greater if the Interest on Taxpayer Debt had been paid or credited to the non-resident person (i.e., the non-resident person that is the creditor in respect of the Intermediary Debt or grantor of a specified right in respect of property to the Intermediary or a person or partnership that does not deal with the Intermediary) rather than to the Intermediary.

For purposes of determining whether the first condition described above has been satisfied, the Interest on Taxpayer Debt must be determined without taking into account any denied interest under the Canadian thin cap rules in relation to the Taxpayer Debt that is deemed to be a dividend under existing subsection 214(16). However, there is a carve-out in proposed subsection 212(3.2) in computing the interest deemed paid or payable by the taxpayer to a non-resident person for any such denied interest.

The second condition described above should generally not be satisfied where the non-resident person is dealing at arm’s length with the taxpayer because interest on arm’s length debt (other than “participating debt interest” as defined in the Act) should be exempt from Canadian withholding taxes under Part XIII. However, this condition could be met where a non-resident person is not dealing at arm’s length with the taxpayer since there is no Canadian exemption from Part XIII tax for interest on such debt. The only tax treaty that currently includes an exemption from Canadian withholding taxes for interest on non-arm’s length debt is the Canada-US Tax Treaty.

One difference between the conditions set forth in subsection 18(6) and those in subsection 212(3.1) is that the former require that the creditor in respect of the Intermediary Debt or the grantor of a specified right be a Specified Non-Resident of the taxpayer while the latter require that such creditor or grantor be a “non-resident person”. The meaning of “non-resident person” for purposes of the Act is much broader than the meaning of Specified Non-Resident. Another difference is that there is no carve-out in subsection 212(3.1) like the one in subsection 18(6) for a Canadian resident Intermediary that does not deal at arm’s length with the taxpayer or is a Specified Non-Resident of the taxpayer. Therefore, it would appear that the scope of these proposed Canadian withholding tax provisions for back-to-back loan arrangements is broader. The Explanatory Notes do not shed any light on why these proposed Canadian withholding tax provisions should catch situations that would not otherwise be caught under the proposed anti-avoidance back-to-back arrangement rules in subsections 18(6) and 18(6.1).

If the four conditions discussed above are met, all or a portion of the Interest on Taxpayer Debt may be deemed to be paid or payable by the taxpayer to one or more non-resident persons (i.e., one or more non-resident persons that are creditors in respect of the Intermediary Debt or grantors of a specified right in respect of property to the Intermediary or a person or partnership that does not deal at arm’s length with the Intermediary). This deemed interest amount is computed based on a formula that, among other things, takes into account any denied interest in relation to the Taxpayer Debt under the Canadian thin cap rules that is deemed to be a dividend subject to Canadian withholding taxes in accordance with existing subsection 214(16) and any Canadian withholding tax imposed on the Intermediary in respect of interest paid or credited to it by the Taxpayer on the Taxpayer Debt in order to avoid double taxation.

Subsection 212(3.3) includes a rule to ensure that any interest deemed paid or payable by a taxpayer to two or more non-resident persons under subsection 212(3.2) does not exceed the amount of interest actually paid or payable by the taxpayer on the Taxpayer Debt.

These new Canadian withholding tax measures apply to amounts paid or credited after 2014.

Conclusion

The August 2014 Draft Proposals should provide some welcome relief for certain typical arm’s length financing transactions entered into by multinational groups involving the granting of security interests. However, as discussed herein, certain typical arm’s length financing transactions may still be caught by these proposals depending on the circumstances. Since there is no transitional relief for existing arrangements, it will be important for taxpayers to carefully review all of their financing arrangements to determine whether they are caught by these rules. The terms and conditions of existing agreements may need to be renegotiated and amended to address any significant issues identified in the course of this review.