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A non-resident planning to expand its business into Canada must decide whether to carry on the business directly (i.e., through a branch, partnership or joint venture) or to incorporate a Canadian subsidiary. There are a number of tax and non-tax factors that inform the decision, including the benefits of consolidating Canadian and foreign businesses for foreign tax purposes, limitation of liability concerns, exposure to Canadian branch tax and the availability of foreign tax credits.

One factor that can easily be overlooked is the potential application of the withholding tax under Part XIII of the Income Tax Act (Canada)[1] to the non-resident on payments made to other non-residents of Canada. Ordinarily, Canadian withholding tax applies to amounts paid or credited by a resident of Canada to a non-resident on account of payments described in Part XIII, such as interest, dividends, rents and royalties. However, subsection 212(13.2) can expand the scope of the withholding tax by deeming a non-resident that carries on business in Canada to be resident in Canada in respect of payments described in Part XIII that are made to another non-resident. Because these payments do not originate from Canada, a non-resident (or its foreign advisors) can be caught off guard by the imposition of Canadian withholding tax. These rules would not be a concern if the non-resident had chosen to operate through a Canadian subsidiary. Although Part XIII tax would apply to the subsidiary on certain payments to non-residents, both payer and recipient would likely have expected a withholding tax in that situation or might have undertaken appropriate planning.

The application of subsection 212(13.2) can be a particularly delicate problem where a non-resident lender makes a loan to a non-resident borrower that has a branch in Canada. Without Canadian tax advice, the parties may be unaware that Canadian withholding tax could apply to a portion of the interest payable on the loan. This article reviews the current and proposed versions of subsection 212(13.2) in the context of a lender and borrower relationship and highlights some of the practical difficulties that can arise.

CURRENT LEGISLATION

The version of subsection 212(13.2) currently in force provides as follows:

For the purposes of [Part XIII], where in a taxation year

1. a non-resident person whose business was carried on principally in Canada, or
2. a non-resident person who
1. manufactures or processes goods in Canada,
2. operates an oil or gas well in Canada or extracts petroleum or natural gas from a natural accumulation thereof in Canada, or
3. extracts minerals from a mineral resource in Canada

pays or credits an amount (other than an amount to which subsection 212(13) applies) to another non-resident person, the first-mentioned non-resident person shall be deemed, in respect of the portion of that amount that was deductible in computing that person's taxable income earned in Canada for any taxation year, to be a person resident in Canada.

In the lender/borrower context, two questions must be answered to determine whether withholding tax will apply to payments of interest (as well as to amounts that are deemed to be interest for purposes of Part XIII). First, does the non-resident borrower carry on its business "principally" in Canada, and if not, does it engage in the activities described in paragraph (b)? Second, what portion of the interest was deductible in computing the borrower's taxable income earned in Canada? The subsection will apply for a particular taxation year of the non-resident borrower if the relevant criteria are met in that year. Therefore, the inquiry must be made for each taxation year in which the borrowing was outstanding.

Carried on Principally in Canada

In other contexts, the Canada Revenue Agency ("CRA") has interpreted the word "principally" to have the same meaning as "primarily" or "chiefly" and generally equates it numerically with 50% or more.[2] However, the question of whether a particular non-resident carries on its business principally in Canada is a question of fact which can only be determined based on the circumstances of that non-resident. Accordingly, a 50% test may or may not be appropriate for the particular non-resident. Furthermore, there is no guidance in the Act or CRA administrative policy to assist in determining which measures to use to answer this question. Appropriate measures could include gross revenues, net income, salaries and wages, location of assets or a combination of any of them. For example, a non-resident borrower may earn more than 50% of its gross revenues from its Canadian business, but less than 50% of its net income may be realized in Canada. A second non-resident may spend more than 50% of its salary and wage expense in Canada, earn less than 50% of its gross revenues in Canada, but, because of fixed costs in the home jurisdiction, realize more than 50% of its net income from its Canadian operations. Do either of these non-residents carry on their business principally in Canada? Because the factual nature of the test often necessitates making a judgment call, it can be difficult for the borrower and the lender to reach a consensus on whether the "principally" test is satisfied.

Manufactures or Processes Goods, etc.

As with the "principally" test above, it is a question of fact whether a non-resident borrower satisfies the criteria in paragraph 212(13.2)(b). As there are no relevant definitions of the key phrases "manufactures and processes", "operates" and "extracts", those words will have their ordinary and everyday meaning, which can be open to differing interpretations. As a result, consensus between borrower and lender may also be difficult to reach under this paragraph.

It should be noted that CRA takes the view that the definition of "manufacturing or processing" in subsection 125.1(3) is not relevant in interpreting the meaning of "manufactures and processes" in subsection 212(13.2).[3] The former definition contains several exclusions from the ordinary meaning of "manufacturing or processing" for purposes of the credit in section 125.1, including farming, fishing, construction and processing various minerals, natural gas and oil. Accordingly, the scope of the phrase in subsection 212(13.2) is much wider than in subsection 125.1(3).

Deductible in Computing Taxable Income in Canada

If it is established that a non-resident borrower meets the criteria set out in paragraphs (a) or (b) of subsection 212(13.2), the next task is to determine the extent to which payments of interest or deemed interest are deductible in computing the borrower's taxable income in Canada.[4] This requires tracing the interest expense to specific uses of the borrowed money within and outside Canada. If the borrowing is only used to finance the Canadian business, all of the interest will be deductible in computing the borrower's taxable income in Canada and, consequently, withholding tax will apply to all of the interest. However, the borrowing will often be used to finance both the Canadian and non-Canadian branches of the business. This renders the tracing exercise difficult or impossible unless the borrower has adequate systems in place to precisely track the use of borrowed funds between jurisdictions.

If the borrower's preference for income tax purposes is to aggressively claim interest deductions in Canada (e.g., because it has losses in its home jurisdiction and is profitable in Canada), the withholding tax exposure of the lender may be increased. The lender will therefore require information and possibly a say in the methods used to compute the interest expense allocable to Canada to confirm that the allocation is reasonable and does not result in unnecessary or unexpected exposure to Canadian withholding tax. The lender will also want to monitor the interest deductions claimed in the borrower's annual Canadian income tax returns to confirm that the correct amount of tax has been withheld.

It should be noted that paragraph 212(13.2)(c) applies to amounts that are deductible, whether or not they are actually deducted. Thus, it is not necessarily sufficient for a non-resident borrower to compute its withholding tax obligations under subsection 212(13.2) based on interest expense claimed in its Canadian income tax returns. The withholding tax technically applies even if the borrower declines to take a deduction for interest expense allocable to Canada. Thus, the lender should inquire as to the deductibility of interest expense and not rely solely on the borrower's Canadian income tax returns to ascertain its Part XIII exposure. The problem is that while the lender may have access to certain relevant financial information and can employ measures to approximate deductibility, it cannot achieve absolute certainty on this point without conducting an ongoing audit of the use of the loan proceeds, which is not practical. One way for the lender to get some comfort is to incorporate into the loan agreement a reserve for Canadian withholding taxes (in addition to standard gross-up and indemnity provisions). The reserve would have to be recalculated on an annual basis to account for fluctuations in the measures used by the lender to approximate deductibility of the interest expense. The lender may also want security for some period after the loan is repaid to protect against a future assessment by CRA, because there is no limitation period on Part XIII taxes owed by the lender.

In many cases, the terms of a loan will require interest payments to be made free of withholding tax. In those cases, alternative structures must be considered. The preferred solution from the lender's perspective is often to have the borrower transfer its Canadian business to a Canadian subsidiary. This can generally be accomplished on a tax-deferred basis. Because the borrower would cease to carry on business in Canada, subsection 212(13.2) would not apply and payments of interest would no longer be subject to Canadian withholding tax. The borrower could then use the borrowed funds to finance its Canadian subsidiary with debt and/or equity, shifting all of the Canadian withholding tax exposure away from the lender. However, from the borrower's perspective, it may not be advantageous for tax purposes to do away with its Canadian branch if it is important to consolidate profits and losses from the two jurisdictions (although this can sometimes be managed by using an unlimited liability company formed under the laws of either Nova Scotia or Alberta to hold its Canadian business). In addition, depending on the size and type of business, it can be complex, time-consuming and expensive to convert a Canadian branch into a subsidiary.

If it is not practical to convert a Canadian branch into a subsidiary, consideration should be given to structuring the borrowing to comply with the exemption from withholding tax on interest in paragraph 212(1)(b)(vii).[5] However, complying with the statutory and administrative restrictions required to satisfy paragraph 212(1)(b)(vii) may affect the economic basis upon which the lender was prepared to lend funds to the borrower, or may simply be unacceptable to the lender, depending, among other reasons, on the borrower's credit risk.

TREATY IMPLICATIONS

Under many of Canada's bilateral income tax treaties, Canada cannot impose a tax on interest paid to a non-resident unless the interest "arises" in Canada. The treaties often contain a rule that deems interest to arise in the state where the payer (i.e., the borrower) is resident, unless the payer has a permanent establishment ("PE") or a fixed base ("FB") in the other state, the indebtedness is incurred in connection with the PE or FB and the interest is borne by the PE or FB.[6] Thus, if the borrower does not have a PE or FB in Canada, Part XIII withholding tax would not apply if the lender is resident in a treaty country and is entitled to enjoy the benefits of a treaty with Canada.[7] If it is not clear whether the borrower has a PE or FB in Canada, the lender may want some protection in the form of a reserve or continuing security, as discussed above.

If the borrower does have a PE or FB in Canada, the issue is whether interest on the loan is "borne by" the PE or FB. In this context, "borne by" is generally understood to mean allowable as a deduction in computing taxable income.[8] Thus, subsection 212(13.2), read together with the treaty, allows Canada to impose a withholding tax on a borrower resident in a treaty country if the borrower has a PE or FB in Canada and interest expense is deductible in computing its Canadian income.

In 1994, Revenue Canada (as it then was) published an "Income Tax Treaty Interpretation Manual"[9] in which it gave the following examples of when withholding taxes might or might not be levied on interest associated with a PE or FB, if subsection 212(13.2) applied:

1. When the management of the PE or FB contracts for a loan for the use of the PE or FB and interest is payable. In these circumstances, withholding tax would be exigible by the Contracting State in which the PE or FB is located.
2. Where the management of the Head Office contracts for a loan and the PE or FB receives those funds which it applies to its operation. In these circumstances, withholding tax would be exigible by the Contracting State in which the PE or FB is located.
3. No withholding tax should be attributable in the jurisdiction of the PE or FB in those circumstances where the Head Office raises funds on behalf of the company as a whole and applies these to several PE or FB in different jurisdictions.[10]

With respect to the third example, if a portion of the borrowed funds raised by a non-resident borrower are applied to a PE in Canada for the purpose of earning income from a Canadian business, interest payable on the borrowing should normally be deductible in computing a non-resident borrower's taxable income earned in Canada and, consequently, withholding tax should be exigible. The statement by Revenue Canada that withholding tax would not apply seems generous as it appears to contradict both subsection 212(13.2) and the meaning of "borne by" in Canada's tax treaties.

PROPOSED LEGISLATION

The December 20, 2002 technical bill introduced an amendment to subsection 212(13.2) which was recently reintroduced in July 18, 2005 draft legislation.[11] The draft legislation reads as follows:

For the purposes of [Part XIII], a particular non-resident person, who in a taxation year pays or credits to another non-resident person an amount other than an amount to which subsection (13) applies, is deemed to be a person resident in Canada in respect of the portion of the amount that is deductible in computing the particular non-resident person's taxable income earned in Canada for any taxation year from a source that is neither a treaty-protected business nor a treaty-protected property.

The amendment, if enacted, will apply retroactively to amounts paid or credited under obligations entered into after December 20, 2002. Its effect will be to significantly expand the scope of subsection 212(13.2). Any non-resident borrower, even one with a proportionately insignificant Canadian branch, will be required to determine whether any part of the interest payable on the loan is deductible in computing its taxable income earned in Canada and to make Part XIII withholdings. Because the amendment will be applied retroactively, prudent borrowers and lenders have governed themselves by the new rules for some time.

The other change to the provision is the exception to the rule for income from a "treaty-protected business" or a "treaty-protected property". These terms are defined in subsection 248(1). A non-resident will have a "treaty-protected business" if, under the terms of a treaty, it is not required to pay tax under Part I. Generally, this will be the case if the non-resident has no PE or FB in Canada. Similarly, a non-resident will have a "treaty-protected property" if, under the terms of a treaty, income or gains on the property are not taxable under Part I. Again, this will generally be the case if the non-resident has no PE or FB in Canada.

In the context of interest payable by one non-resident to another, the new exemptions for a "treaty-protected business" and "treaty-protected property" in subsection 212(13.2) effectively incorporate the withholding tax exemption found in most treaties. As noted above, even if Part XIII applied to a payment of interest (including through the application of current subsection 212(13.2)) Canada would not be permitted, under most tax treaties, to impose withholding tax on the interest unless the interest was deductible by a Canadian PE or FB of the borrower. The revised version of the subsection will provide an exemption from withholding tax where a non-resident borrower pays interest to another non-resident, unless the borrower had a PE or FB in Canada and interest was deductible by the PE or FB. Thus, under either the current version of subsection 212(13.2) (read together with an applicable treaty, if any) or the revised version of the subsection (read on its own), for withholding tax to apply, the borrower must have a PE or FB in Canada in respect of which interest on the borrowing was deductible. As the revised subsection contains the exemption within its terms, it will no longer be necessary in most circumstances to rely on a treaty for relief where the borrower has no PE or FB, or the interest on the borrowing is not deductible by the PE or FB.

This article was previously published in Taxation Law, the Ontario Bar Association's Taxation Law Section Newsletter, Vol. 16, No. 2, April 2006.

[1].   R.S.C. 1985 (5th Supp.), c.1, as amended (the "Act"). All statutory references herein, unless indicated otherwise, are to the Act.

[2].   See for example CRA Document Nos. 2005-0141551E5 dated November 18, 2005, 2005-0142171E5 dated November 2, 2005 and 2003-0051221E5 dated April 13, 2004.

[3].   CRA Document No. 2003-0003841E5 dated February 27, 2004.

[4].   This should be distinguished from an amount that is deductible in computing gross revenues. See Eastern Success Co. Ltd. v. The Queen, 2004 DTC 3521 (TCC).

[5].   The exemption in paragraph 212(1)(b)(vii) generally applies to a loan made between a Canadian corporate borrower and a non-resident lender acting at arm's length, under the terms of which not more than 25% of the loan principal can be required to be repaid within the first five years of the loan, except under certain specific circumstances. The exemption can apply where the borrower is a non-resident corporation if it is deemed to be resident in Canada under subsection 212(13.2). See CRA Document Nos. 2005-0120761R3 dated August 10, 2005 and 2005-0134621E5 dated July 26, 2005.

[6].   See, for example, Article XI, section 6 of the Canada-U.S. Income Tax Convention.

[7].   For instance, a lender that is a U.S. limited liability company (LLC) is not considered to be resident in the United States for purposes of the Canada-United States Income Tax Convention (1980) as amended and would therefore not be entitled to relief from Canadian withholding tax.

[8].   See, for example, the technical notes to Article XI, section 6 of the Canada-United States Income Tax Convention, supra. Interest expense may generally be "borne by" a PE either directly by way of an interest deduction or indirectly through management, administration or other charges.

[9].   Revenue Canada, Income Tax Treaties Reference Manual (Ottawa: Revenue Canada, 1994-1995).

[10]. Ibid.

[11]. Draft Legislation Re: Non-Resident Trusts and Foreign Investment Entities, Reimbursement of Crown Charges, and Technical Amendments dated July 18, 2005.

The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed.

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