CANADIAN AND CANADA/U.S.
CROSS-BORDER TAX UPDATE
6th Annual Dallas TEI Canadian Tax Luncheon
February 24, 2015 – The City Club
Bryan Bailey, Partner
Chris Van Loan, Partner
Back-to-Back Loan Rules
• First proposed in 2014 federal budget;
revised proposals in August and October
2014
• Now law (no grandfathering)
• Anti-avoidance rules designed to prevent
taxpayers from circumventing Canada’s
withholding tax and thin capitalization rules
2
Cross-Border Debt: Withholding Tax
• Generally, no Canadian withholding tax on interest paid
by Canadian borrower to “arm’s length” (e.g. unrelated)
foreign lender
• Generally, there will be Canadian withholding tax on
interest paid to “non-arm’s length” (e.g. related) foreign
lenders (25% domestic rate; generally reduced to 10%
by treaty)
– complete exemption may be available for qualifying persons
under Canada-U.S. treaty and Canada-U.K. treaty
• Take away: related party lender, generally withholding
tax
3
Cross-Border Debt: Thin Cap
• Canadian thin capitalization rules limit deductions for
interest where Canadian borrower is too thinly
capitalized by “specified non-residents”
– non-residents who hold, or do not deal at arm’s length with
entities that hold, 25% of votes or value of borrower
– 1.5:1 debt/equity ratio
• Deduction for interest on excessive debt is denied and is
deemed to be a dividend subject to withholding tax (so
this matters to US lenders)
• Take away: related party lender, thin cap concerns
4
Back-to-Back Loan Rules – Objective
• Prevent taxpayers from interposing an intermediary (e.g.
arm’s length bank) between Canadian borrower and
foreign parent lender to circumvent withholding tax and
thin cap rules
5
Example
•
Franceco
– 10% withholding tax on interest
– “bad” debt for thin cap
•
loan
Netherlands
Bank
100%
loan
Canco
6
direct loan:
indirect loan:
– 0% withholding tax on interest
– Existing thin cap “indirect loan”
rule; concerns that it is not broad
enough
Specific Requirements
• One set of rules for thin cap; one set for
withholding tax; broader than expected
• Basic requirements (thin cap)
1. Canadian borrower owes amount to
intermediary – “primary debt”
2. (a) intermediary owes amount to specified
non-resident (e.g. borrower parent) –
“secondary debt”
– secondary debt is “limited recourse” or there is “link” between
primary debt and secondary debt
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OR
Specific Requirements (cont’d)
(b) “specified right” in a property is granted
by specified non-resident to intermediary
– specified right means a right to mortgage, assign, pledge or
encumber property to secure payment of a debt (other than
primary debt) or to use, invest or sell property (unless all
proceeds first used to repay primary debt)
• If rules apply, primary debt (to the extent of
the amount of secondary debt or FMV of
specified right) will be deemed “bad debt”
for thin cap
8
Specific Requirements (cont’d)
• Similar requirements for withholding tax
purposes, with an additional requirement
that withholding tax on interest would be
greater if interest paid by Canadian
borrower directly to non-resident (instead
of intermediary)
• If rules apply, deemed payment of interest
by Canadian borrower to non-resident
9
Example – Specified Right – Caught by Rules
Forco
(US parent)
Bank
Bank Sub/
Securities Dealer
Canco
•
•
•
10
$50 m
marketable securities
securities dealer has right to pledge or assign securities and full discretion over use of proceeds
$50 m is “bad debt” for thin cap; maybe no withholding tax issue unless LOB
provision of lien on Forco property to secure $50 m loan/provision of secured guarantee by Forco
not caught
Example – Indirect Treaty Shopping Rule
Caymanco
$50 m
loan
USco
$50 m
loan
Canco
•
•
•
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rules apply because “link” between loans
for withholding tax purposes, non-arm’s length non-residents not
excluded as intermediaries
deemed interest payment by Canco to Caymanco (25% withholding)
Example – Cash Pooling and De Minimus Rule
Forco
$80 m deposit
Bank
$40 m loan
Canco
•
•
–
12
•
Forco1
total borrowings cannot exceed
20M + cash deposit amounts
all amounts placed on deposit with
bank by net lenders secure
payment of all amounts lent by the
bank to net borrowers
back-to-back loan rules apply
safe harbour available if amount provided to intermediary (secondary debt/FMV of
specified right) < 25% of primary debt
–
•
•
in addition to primary debt, include debt owing by related borrowers under same or
connected agreement, where security provided secures all debt obligations
intended to provide relief where multiple cross-collateralized debts owing to intermediary
by multiple group entities
safe harbour not available in this example
Cash Pooling – Other Possible
Canadian Tax Issues
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
13
NRSub
Loan 3
• Additional tax considerations are involved where the
pooling arrangements involve foreign subsidiaries of a
Canadian taxpayer (i.e., downstream ) or transactions
between such foreign subsidiaries and foreign sister
corporations of the Canadian taxpayer
• This slide illustrates the types of indebtedness that may
result from a cash pooling arrangement involving a
foreign affiliate of the Canadian taxpayer
• These loans could have a number of Canadian tax
implications including the following:
• the application of the upstream loan rules
• foreign accrual property income (“FAPI”
considerations)
• deemed interest inclusion under section 17
• Application of the foreign affiliate dumping rules
Cash Pooling – Upstream
Loans
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
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NRSub
Loan 3
• The upstream loan rules were intended to
prevent foreign affiliates of Canadian taxpayers
from making loans of taxable or hybrid surplus
to a Canadian taxpayer
• The rules, however, have broader application
• Generally, the rules are potentially applicable
where a “specified debtor” becomes indebted to
a foreign affiliate of the taxpayer (a “creditor
affiliate”)
• A “specified debtor” is generally the Canadian
taxpayer, a person that does not deal at arm’s
length with the taxpayer other than a “controlled
foreign affiliate” for purposes of section 17
Cash Pooling – Upstream
Loans
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
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NRSub
Loan 3
• If applicable, the upstream loan rules could
result in an income inclusion based on the
amount of the loan
• Each of Loans 1, 2 and 3 could give rise
to an upstream loan concern
• A cash pooling arrangement where a
“creditor affiliate” deposits an amount with
a bank that also makes a loan to a
“specified debtor” could be caught by these
rules as well pursuant to a “back-to-back
loan” provision included in subsection
90(7)
Cash Pooling – Upstream
Loans
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
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NRSub
Loan 3
• There are exceptions available including
• loans or indebtedness repaid within two years
from the day the loan was made or indebtedness
arose, provided repayment is not part of a series
of loans or other transactions and repayments
(paragraph 90(8)(a))
• Indebtedness that arose in the ordinary course of
business of creditor or loan made in ordinary
course of creditor’s ordinary course of business of
lending money, provided bona fide arrangements
made for repayment within a reasonable time
(paragraph 90(8)(b))
•
There is also an annual deduction/reserve which
generally may be claimed each year during which
loan is outstanding to the extent that at the time the
loan was made, the creditor affiliate could have paid
up an amount as a dividend that would have been
eligible for a deduction under certain provisions of
subsection 113(1) or under subsection 91(5)
Cash Pooling – Foreign Accrual
Property Income
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
17
NRSub
Loan 3
• Any interest earned by FA1 from Loans 1,
2 or 3 would likely be considered to be
“foreign accrual property income” (“FAPI”)
• Any such FAPI would be subject to tax in
Canco’s hands in the year in which it was
earned regardless of whether the income
was distributed to Canco
• Interest on these loans would not be
eligible to be recharacterized as “income
from an active business” pursuant to subparagraph 95(2)(a)(ii)
Cash Pooling – Deemed
Interest Inclusion
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
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NRSub
Loan 3
• Each of Loans could result in a
deemed interest inclusion to Canco
pursuant to section 17
• The amount of each such inclusion is
reduced by the amount that would
otherwise have been included in FA1’s
FAPI
• If NRSub had been another controlled
foreign affiliate of Canco, an exception
to this rule would have been available
under paragraph 17(3)(a) with respect
to Loan 3
Cash Pooling – Foreign Affiliate
Dumping
NR Co
Loan
1
Loan
2
Canco
Loan 4
FA1
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NRSub
Loan 3
• Loan 4 could result in the application of the “foreign
affiliate dumping” rules under section 212.3
• An exception may be available if
• the loan was a “pertinent loan or indebtedness”
(“PLOI”)
• The loan was made in Canco’s “ordinary course of
business”
• A CRA administrative position suggests that a loan
made under a cash pooling arrangement may be
considered to be made in a taxpayer’s ordinary course
of business (see CRA document 2013-0483751C6)
• If the foreign affiliate dumping provisions are
applicable, the “paid-up capital” of Canco would either
be reduced by the amount of the loan or Canco could
be deemed to have paid a dividend subject to
withholding tax to NR Co (or a combination of both)
Income Tax Issues Relating to Foreign
Currency-Denominated Debt
• Fluctuations in the value of currencies relative to the
Canadian dollar can have significant income tax
implications
• With the strengthening of the Canadian dollar against the
U.S. dollar, the issue of foreign exchange-related gains
and losses will be a significant Canadian income tax
issue
• In the spring of 2012, CDN$1was worth US$1.02 while it
is worth just over US$0.80 today
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Income Tax Issues Relating to Foreign
Currency-Denominated Debt (Cont’d)
• Because of the significant income tax
consequences these changes in exchange rate
can have on a taxpayer’s income tax liability, we
have seen a number of changes to the
Canadian income tax provisions
– functional currency election
– a number of changes to the foreign affiliate rules
generally designed to minimize the impact of foreign
exchange fluctuations
21
Income Tax Issues Relating to Foreign
Currency-Denominated Debt (Cont’d)
• Subject to the functional currency rules,
taxpayers in Canada are required to determine
their income tax results in Canadian dollars
• Where gains and losses relate to foreign
exchange fluctuations are ordinary business
items, such gains and losses will be fully
included in (deducted from) income
22
Income Tax Issues Relating to Foreign
Currency-Denominated Debt (Cont’d)
• Where the foreign exchange gains and losses
relate to a capital gains asset or capital liability,
only one-half of the gain or loss is included (or
deducted from) income
• Where a borrowing is part of the taxpayer’s fixed
or permanent capital rather than circulating
capital, then such debt will generally be
considered to be on capital account
23
Income Tax Issues Relating to Foreign
Currency-Denominated Debt (Cont’d)
• Subsection 39(2) provides that an issuer of a debt obligation
denominated in a foreign currency will realize a gain or loss based
on foreign exchange fluctuations from the time the debt was issued
until it was repaid or settled
• Subsection 111(12) [provides that] where there has been a loss
restriction event of certain taxpayers (e.g., an acquisition of control
of a corporation), unrealized foreign exchange losses on a debt
issued by the taxpayer would have to be recognized while the
taxpayer could elect whether or not to recognize a foreign
exchange-related gain
24
Agnico-Eagle Mines v. The Queen
• Canadian corporation issued U.S. dollar
convertible debentures in 2002
• Holders had a right to convert the debentures
into a fixed number of common shares of the
issuer. The conversion price of US$14 per
share represented a premium over the
US$12.68 trading price at the time the
debentures were issued
25
Agnico-Eagle Mines v. The Queen
(Cont’d)
• When the issuer announced it would redeem the
debentures in February 2006, the overwhelming
majority of debenture holders opted to convert
into common shares which were trading in a
range from US$14.63 to US$24.15
• All debenture holders would receive shares with
a U.S. dollar amount exceeding the U.S. dollar
principal amount of the convertible debentures
26
Agnico-Eagle Mines v. The Queen
(Cont’d)
• At the time the debentures were issued, the exchange
rate was CDN$1.5881 per U.S. dollar. The Canadian
dollar strengthened during this time and the exchange
rate was between CDN$1.1443 to CDN$1.1726 per U.S.
dollar when holders converted
• The strengthening of the Canadian dollar over the term
of the debentures meant that the U.S. dollar principal
amount of the debentures could have been satisfied with
fewer Canadian dollar than would have been the case at
issuance
27
Agnico-Eagle Mines v. The Queen
(Cont’d)
• These were convertible debentures, however, and the
fair market value of the shares issued on conversion
measured in Canadian dollars exceeded the Canadian
dollar amount of the U.S. dollar debentures at the time
they were issued
• The Canada Revenue Agency (the “CRA”) assessed the
taxpayer with CDN$62 million capital gain pursuant to
subsection 39(2) of the Income Tax Act (Canada)
28
Example
US$
US$:CDN$
CDN$
Issue amount of debentures
US$1,000
1:1.5881
CDN$1,588
Principal amount at time of conversion
US$1,000
1:1.1443
CDN$1,144
Fair market value of 71 fixed number of common
shares issued on conversion (assuming US$24.15
trading value)
US$1,714.65
CDN$1,962

Canadian dollar equivalent of principal amount at conversion is less than at issuance: CDN$1,588 – CDN$1,144 = CDN$444

Canadian dollar equivalent of shares used to repay is more than at issuance: CDN$1,588 – CDN$1,962 = (CDN$374)
29
Tax Court of Canada Decision
• The Court confirmed the amount to be repaid on
repayment of a debt is translated into Canadian dollars
computed at the date of repayment
• The Court stated that it was less clear what the
appropriate translation date should be for determining
the amount paid on a conversion of a debt obligation
• Case law relating to what the cost of property to a
corporation should be where the consideration was in
the form of shares
30
Tax Court of Canada Decision (Cont’d)
• Generally, the “true consideration” is generally determined by the
amount added to the corporation’s stated capital account. It may
also be reflected in what was added to the stated capital account
monitored for the shares
• The Court concluded that the “true consideration” for the issuance of
the common shares issued on the conversion of the debentures was
based on the exchange rate at the time that the debentures were
issued
• Thus, the convertible debentures were considered to have been
“repaid” for the same Canadian dollar equivalent as they were
issued
31
CRA Position on Foreign Currency Hedging
• Profits and losses from derivative transactions, including foreign
currency swaps and foreign currency forward transactions, are
generally on income account
• The CRA takes the position that, in order to be on capital account,
the hedge must be sufficiently “linked” to “an underlying transaction”
that is on capital account
• In this regard, the CRA generally requires that the notional amounts
inception dates and maturity dates of the derivative transactions
correspond to the underlying transaction
• This position is based on the Supreme Court of Canada decision in
Shell Canada Limited v. The Queen, which concerned a “weak
currency loan” structure
32
George Weston Limited v. The Queen
• Tax Court of Canada decision released on February 19,
2015
• Taxpayer had entered into foreign currency swaps to
“protect its consolidated group equity”
• Taxpayer had a formal derivative policy prohibiting it from
speculating in derivatives
• Evidence in financial statements and corporate records
that taxpayer had entered into the swaps in a careful and
systematic manner to hedge its currency risk associated
with its investment in U.S. operations
33
George Weston Limited v. The Queen
(Cont’d)
• Court looked at the taxpayer’s intention at the time that it
entered the swaps and concluded the taxpayer’s
intention was to hedge currency risk associated with the
effect that Canada/U.S. dollar fluctuations were having
on the taxpayer’s debt to equity ratio as a result of its
investment in U.S. operations
• The swaps were entered into to circumvent currency risk
and protect its consolidated group equity; not for reasons
of speculation
• This decision will be welcomed by many taxpayers
34
Exchangeable Shares: Introduction
• Used in acquisitions of Canadian public or private corporations
where consideration consists (in whole or in part) of shares of nonCanadian acquiror
• Principal purpose is to provide Canadian resident shareholders with
tax-deferred rollover on share exchange
• No rollover is available for Canadian tax purposes where shares of a
Canadian corporation are exchanged for foreign shares
– rollover generally available when Canadian shares are exchanged for
shares of Canadian corporation
– accordingly, instead of issuing shares of foreign acquiror, exchangeable
shares of a Canadian acquisition entity are issued to Canadian sellers
– exchangeable shares are "economically equivalent" to, and
exchangeable for, shares of foreign acquiror
35
Exchangeable Shares - Typical Structure
•
Forco
Canada
Callco
Canadian
resident
sellers
exchangeable
shares
Canada
Target
36
Canada
Exchangeco
•
Canadian sellers sell
Canada Target shares to
Canada Exchangeco for
shares of Canada
Exchangeco; nonCanadian sellers (and
Canadian tax-exempts)
typically sell Canada
Target shares in
exchange for Forco
shares
tax elections required for
rollover under this
structure; can be an
administrative nuisance
for Canadian public co
target
Attributes of Exchangeable Shares
• Share terms contain retraction right which allows holder
to require Canada Exchangeco to redeem exchangeable
shares at any time in exchange for Forco shares
– less favourable "deemed dividend" treatment if exchangeable
shares redeemed (generally higher tax rate for holders; Part VI.1
tax for issuer)
– accordingly, Forco or Canada Callco has overriding call right to
purchase exchangeable shares on receipt of retraction notice
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Exercise of Overriding Call Right
1 Delivery of retraction notice
Forco
2
Canadian
resident
seller
Canada
Callco
3
2 Callco exercises call right; Forco
subscribes for shares of Callco;
subscription price satisfied by
delivery of Forco shares
3 Callco delivers Forco shares to
Canadian seller in consideration
for exchangeable shares
1
exchangeable
shares
Canada
Target
38
Canada
Exchangeco
• capital gains treatment instead of deemed
dividend treatment
• use of Callco to generate cross-border paid-up
capital
Attributes of Exchangeable Shares (cont’d)
• Share terms contain dividend rights which entitle holders
to dividends equal to dividends on Forco shares
– receipt of dividends from Canadian corporation is another
potential advantage for Canadian sellers
– however, can be issues if dividends paid (Part VI.1 tax for issuer)
• Automatic redemption dates: outside “sunset” date (5-12
years); if small percentage of exchangeable shares
outstanding (15%)
• Right to receive Forco shares on liquidation of Canada
Exchangeco
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Ancillary Rights to Provide Equivalence
• Holder granted rights to vote shares of Forco; special
voting share issued to trustee
• Holders granted right to put exchangeable shares to
Forco in event of Forco insolvency event
• Voting and put right contained in “voting and exchange”
agreement; represent "boot" (position taken is that "boot"
has nominal value)
• Support agreement under which Forco covenants to fund
Canada Exchangeco to pay equivalent dividends and to
deliver Forco shares on redemption/retraction events
40
Derivative Forward Agreements
• Character conversion rule treats the gain (or
loss) realized on a purchase or sale of capital
property under a “derivative forward agreement”
as ordinary income (or loss) rather than capital
gain (or loss)
• The new rules were directed at funds that have
used forward contracts or derivative contracts to
convert ordinary income into capital gains
41
Derivative Forward Agreements
(Cont’d)
•
42
A derivative forward agreement is defined to include any agreement to purchase or
sell capital property where:
(a) the term of the agreement or a series of agreement exceeds 180 days, and
(b) in the case of a purchase agreement, the difference between the fair market
value of property to be delivered on settlement, including partial settlement, of
the agreement and the amount paid is attributable, in whole or in part, to an
underlying interest (including a value, price, rate, variable, index, event,
probability or thing) other than:
(i) revenue, income or cash flow in respect of the property over the term of the
agreement, changes in the fair market value of the property over the term
of the agreement, or any similar criteria in respect of the property, or
(ii) where the purchase price is denominated in the currency of a country other
than Canada, changes in the value of the Canadian currency relative to
that currency,
Derivative Forward Agreements
(Cont’d)
(c)
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in the case of a sale agreement,
(i) the difference between the sale price of the property and the fair market value of the
property at the time the agreement is entered into by the taxpayer is attributable, in
whole or in part, to an underlying interest (including a value, price, rate, variable,
index, event, probability or thing) other than
(A) revenue, income or cash flow in respect of the property over the term of the
agreement, changes in the fair market value of the property over the term of the
agreement, or any similar criteria in respect of the property, or
(B) where the sale price is denominated in the currency other than Canada, changes
in the value of the Canadian currency relative to that other currency,
and
(ii) the agreement is part of an arrangement that has the effect – or would have the effect
if the agreements that are part of the arrangement and that were entered into by
persons or partnerships not dealing at arm’s length with the taxpayer were entered
into by the taxpayer instead of non-arm’s length persons or partnerships – of
eliminating a majority of the taxpayer’s risk of loss and opportunity for gain or profit in
respect of the property for a period of more than 180 days
Derivative Forward Agreements
(Cont’d)
•
Paragraph 12(1)(z.7) includes amounts in income
– for a purchase, the amount by which the fair market value of the property
exceeds the cost of the property
– for a sale, the amount by which the proceeds of disposition of the property
exceeds the fair market value of the property at the time that the agreement is
entered into
•
Paragraph 20(1)(xx) provides for a deduction (subject to certain restrictions)
equal to
– for a purchase, the amount by which the cost of the property exceeds its fair
market value at the time it is acquired by the taxpayer
– for a sale, the amount by which the fair market value of the property at the time
the agreement is entered into exceeds the proceeds of disposition of the property
•
44
Corresponding adjustments to adjusted cost base prevent double counting
Derivative Forward Agreements
and Exchangeable Shares
• The explanatory notes that accompanied the
introduction of the derivative forward agreement
rules should not be an issue
• The basis seemed to be that the exchange right
was embedded in the terms of the shares
• Recall, however, that there are typically separate
put and call rights
45
Derivative Forward Agreements
and Exchangeable Shares (Cont’d)
•
•
•
•
•
46
The CRA addressed the issue at the Canadian Tax Foundation’s Annual
Conference in November 2014
The CRA was asked to confirm that an example exchangeable share
structure does not give rise to a derivative forward agreement because of
the embedded exchange right
The CRA would not confirm that, but stated instead that the risk of loss or
opportunity for profit was not eliminated and, hence, the example
exchangeable share structure did not meet the requirements of (c)(ii) of the
definition
This means that typical exchangeable share structure should not be a
concern
That being said, care should be taken to ensure that the exchange feature
is part of the terms of the share
Presenters’ Contact Information
•
Chris Van Loan
Tax Partner
email address: chris.vanloan@blakes.com
Direct Tel. No.: (416) 863-2687
Fax No.: (416) 863-2653
•
Bryan Bailey
Tax Partner
email address: bryan.bailey@blakes.com
Direct Tel. No.: (416) 863-2297
Fax No.: (416) 863-2653
Blake, Cassels & Graydon LLP
Barristers & Solicitors
Patent & Trade-mark Agents
199 Bay Street
Suite 4000, Commerce Court West
Toronto, Ontario M5L 1A9
Canada
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