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Research tax-efficient structures to facilitate real estate investing.
Using the Income Tax Act to avoid tax.
Utilizing the butterlfy.
Navigating through the delicate nature of non-arms length transactions.
Preventing Unwanted Canada – U.S Cross-Border Tax Issues – Due Diligence Concerns – Part 2
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It is common for businesses to consider international expansion as a means to achieve growth. Given the geographic proximity of Canada and the U.S., it is logical that many Canadian businesses would consider expanding into the U.S. and vice-versa.
Below are discussed a few tax and compliance issues that must be considered when Canadian corporations expand into the U.S
- Repatriation of Funds
- Withholding taxes
- Foreign Affiliate Dumping (FAD) Rules
- Loans to and from foreign affiliates
- Thin capitalization rules
- Back-to-Back Rules
- Earnings Stripping Rules
- Reporting obligations
In part 1 of this series, numbers 1 to 3 were addressed. This article will discuss Numbers 4 and 5 above. Issues 6 to 8 will be discussed in Part 3 of this series.
4. Loans to and from foreign affiliates
Regardless of whether expansion into the U.S. or Canada is as a result of organic growth or an acquisition, a decision must be made as to how to fund the expansion - debt or equity. This section will provide an overview of the financing considerations when expanding into the U.S. and Canada.
It may also be desirable to maximize cross-border debt financing from a repatriation perspective, as the Treaty generally reduces the interest withholding tax rate between Canada and the U.S. to 0%, whereas the dividend withholding tax rate is generally 5%. From a U.S. perspective, any distributions to the Canadian parent will be subject to withholding tax until all E&P has been exhausted. In contrast, a Canadian subsidiary is able to return capital to its U.S. parent free of withholding tax; however, for U.S. tax purposes, the return of capital will still be treated as a dividend.
Cross-border expansion often creates opportunities to implement tax-efficient financing structures that can drive additional benefits above and beyond plain vanilla intercompany debt financing. Two examples of common tax-efficient financing structures between Canada and the U.S. are shown below.
Example 1 - Hybrid Instrument Financing Structure
In a Hybrid Instrument Financing Structure, a hybrid instrument, such as a preferred share, is used to achieve tax-efficiency. For example (see graphic 1 below), a Canadian parent ("CanCo") invests in preferred shares of its U.S. subsidiary ("USCo"). From a U.S. tax perspective, the preferred shares are viewed as debt, such that the preferred share dividend payments are considered interest, which is deductible against the income of the USCo. From a Canadian tax perspective, the legal form of the preferred shares is respected, such that preferred share dividend payments are considered dividends, which are deductible to CanCo under ITA subsection 113(1) to the extent sufficient surplus and/or underlying foreign tax balances are available. As such, the end result is an interest deduction in USCo with no corresponding income inclusion in CanCo.
Example 2 - Hybrid Entity Financing Structure
In contrast to graphic 1, which relies on the use of a hybrid instrument to achieve tax-efficiency, graphic 2 below relies on the use of a hybrid entity to achieve tax-efficiency. In the Hybrid Entity Financing Structure, two Canadian corporations ("CanCo" and "CanSub") form U.S. limited partnership ("US LP"). US LP forms a U.S. limited liability company ("US LLC"). US LP borrows funds from a third party and capitalizes US LLC. US LLC uses the funds to make an intercompany loan to a U.S. subsidiary in a separate consolidated group ("USCo"). USCo uses the funds to either acquire a new U.S. investment or in its existing business.
From a Canadian tax perspective, US LP is viewed as a Canadian partnership because it has Canadian partners. As such, US LP files a Canadian partnership return and allocates its income or loss (in this case, a loss driven by the interest on its third party debt) to its partners, which can generally use the lost against their taxable income.
From a U.S. perspective, US LP elects to be treated as a U.S. corporation. U.S. LLC is considered disregarded for U.S. tax purposes, such that it is part of US LP's U.S. tax return. As such, the interest income in US LLC from the intercompany loan to USCo is offset by the interest expense in US LP on the third party debt, such that there should be no U.S. tax liability. USCo deducts the intercompany interest expense to US LLC against its taxable income.
As such, the end result is two interest deductions (a Canadian deduction in CanCo/CanSub and a U.S. deduction in USCo) in respect of one third party interest payment (by US LP to the third party lenders).
Both of the examples above illustrate financing structures into the U.S. Similar structures using hybrid instruments and hybrid entities are available for investments into Canada as well. However, the benefit of the inbound Canadian structures is generally limited to a deferral opportunity, as opposed to the permanent savings that often result from the inbound U.S. structures. This is because of the additional layer of U.S. tax required as a result of the CFC rules discussed above.
Please note that both hybrid instrument and hybrid entity structures are addressed in the Organization for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project that is discussed in the "Emerging Issues" section below.
Although not illustrated above for the sake of simplicity, tax-efficient financing structures often include Canadian unlimited liability corporations, which are disregarded for U.S. tax purposes, but regarded as corporations for Canadian tax purposes.
From a compliance perspective, additional requirements not previously noted above that may be triggered by tax-efficient financing structures typically include the following:
- Form 8858 - Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
- Form 8832 - Entity Classification Election
- Dual Consolidated Loss Election and Certification
- Form W-8BEN-E - Certificate of Status of Beneficial Owner for United States Withholding and Reporting (Entities)
- Form W-9 - Request for Taxpayer Identification Number and Certification
- FinCen114 - Report of Foreign Bank and Financial Accounts (FBAR)
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- Form T1135 - Foreign Income Verification Statement
Loans to and from foreign affiliates
Where the FA may have excess cash or the ability to secure financing at a more favourable rate than its Canadian parent it could lend such cash or the proceeds of the financing to its parent. Even if the loan was made in the commercial course of the business, there is no purpose test for the application of the upstream loan rules. The amount of the loan is included in OMB's income if outstanding for more than two years, with a full or partial deduction depending on OMB's surplus balances. Accordingly, surplus computations need to be maintained to determine the extent of the deduction or if distributions may made to the extent of any surplus that is not being relied upon for such deduction. Where it is more advantageous to borrow outside Canada, the back-to-back loan rules may operate to deem the loan from the third party lender to be made directly to the Canco, where it has been made from the FA because it borrowed from the third party.
a. Taxation of Interest Income
For various reasons, including some reasons discussed below, loans to foreign affiliates will often be interest-bearing. If the lender corporation is a CCPC, the interest income earned by the CCPC should be aggregate investment income of the CCPC; even though the foreign affiliate and the CCPC may be related or associated, the interest income should not be recharacterized as income from an active business unless the foreign affiliate is carrying on an active business in Canada.
The absence of recharacterization creates a material disincentive to charge interest on loans to foreign affiliates when the foreign affiliate is carrying on an active business and is subject to tax in its country of residence at a rate that is less than the applicable CCPC investment income rate. For example, if the foreign affiliate is resident in the US and carries on an active business, its earnings will be subject to tax at the 21% US federal rate plus any applicable state taxes, while interest income paid to a CCPC could be taxed at a combined federal-provincial rate of up to 53.67%. However, it may be nevertheless be advisable to charge interest on loans to foreign affiliates even with the rate differential in order to avoid, among other things, the potential recharacterization of the loans as equity for US tax purposes or US dividend withholding taxes on returns of capital.
For Canadian corporations that are not CCPCs, it generally makes sense to charge interest on loans to US-resident foreign affiliates. The effective federal-provincial corporate tax rate in Canada will likely be close the effective federal-state corporate tax rate in the US; thus, absent losses in the foreign affiliate or the application of US interest deduction limitations, any inefficiencies created by the interest payment should be minor. Further, since interest payments from a US affiliate to a Canadian lender should generally not be subject to US withholding taxes, the overall result of a cross-border interest payment may be more efficient than generating taxable income in the US and causing the affiliate to pay an exempt surplus dividend.
b. Deemed Interest Income and Transfer Pricing
Corporations resident in Canada that make loans to non-resident persons or to whom amounts are owed by non-resident persons may be required to include a deemed interest benefit in their income if three conditions are met:
- The debt is owed by a non-resident person;
- The debt has been or remains outstanding for more than one year; and
- The amount included in the corporation’s income as interest on the debt is less than the interest that would have been included in income had interest been charged at a reasonable rate.
If these conditions are satisfied, the deemed interest benefit will be equal to the difference between interest at the prescribed rate (currently 1%) for the portion of the year in which the debt is outstanding and the actual interest income inclusion in respect of the debt.
A deemed interest inclusion can also arise in less straightforward instances, including back-to-back loans, loans to or through partnerships, and loans through trusts. As a result, all lending arrangement involving a Canadian parent corporation and non-arm’s length entities must be reviewed to determine whether a deemed interest benefit can arise.
An income inclusion will not arise if the debt is owed by a controlled foreign affiliate of the corporation and:
- Throughout the period that the debt was outstanding, it was used to:
o Earn income from an active business of the affiliate or to earn income that was deemed to be income from an active business of the affiliate; or
o Make a loan to another controlled foreign affiliate of the corporation, if interest on the loan would not be included in FAPI (e.g. because the interest is deemed to be income from an active business of the lender affiliate); or
- The debt arose in the course of an active business carried on by the affiliate throughout the period that the debt was outstanding (e.g. an amount owed to the corporation as a result of inventory purchased by the affiliate, etc.).
 Justin Heisler and Darlene Shaw, "Cross-Border Tax Issues with a Business Focus," in 2017 Atlantic Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2017), 3:1-25.
 Taylor Cao and Annika Wang, "Introduction to Inbound Investments in Canada," in 2021 YP Focus Virtual Conference (Toronto: Canadian Tax Foundation, 2021), 2: 1-59.
 Andrew Morreale and Andrew Somerville, "Structuring Outbound Foreign Expansion for Owner Managed Businesses," in 2017 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2017) 10:1-37.
For these purposes, a slightly different definition of controlled foreign affiliate is used. This amended definition does not deem the corporation to own shares of the foreign affiliate that are owned by non-arm’s length non-residents or by non-residents who do not deal at arm’s length with a relevant Canadian shareholder. This more restrictive definition means that a foreign affiliate that is a controlled foreign affiliate for FAPI purposes may not be a controlled foreign affiliate for the purpose of avoiding an interest income inclusion on outbound loans. Again, an anti-avoidance rule may cause a foreign affiliate to not be a controlled foreign affiliate where options or similar rights exist or where shares have been acquired or disposed of to defer or avoid tax.
If the exception for loans to controlled foreign affiliates does not apply, then it is also possible that Canada’s transfer pricing rules could apply to adjust the interest rate charged on any loan by a Canadian-resident person to a non-arm’s length person. Transfer pricing adjustments can arise where the terms of a transaction (e.g. the interest payable on a loan) do not reflect the terms that would have been selected by arm’s length persons. If, for example, a Canadian-resident taxpayer made an interest free loan to a non-arm’s length foreign affiliate that is not a controlled foreign affiliate, the CRA could use a transfer pricing adjustment to include in the taxpayer’s income an amount equivalent to interest at an arm’s length rate.
Determining whether a reasonable, arm’s length interest rate is being charged by the Canadian corporation is an art rather than a science and there will almost always be a range of potentially reasonable rates. Nevertheless, taxpayers must ensure that there is some rationale for the interest rate chosen and that the rationale is appropriately documented, as a failure to make reasonable efforts to select the interest rate or to maintain contemporaneous documentation can result in penalties in the event of a transfer pricing adjustment. As a practical matter, resisting CRA attempts to make transfer pricing adjustments in the event of an audit will be far more difficult and expensive where the taxpayer lacks contemporaneous documentation.
Taken together, interest-free loans to non-arm’s length non-resident persons by a corporation resident in Canada are likely to result in unanticipated adverse income tax consequences unless the borrower is a controlled foreign affiliate carrying on an active business. Even then, the timing of the borrowing and use of the borrowed money may result in a deemed interest income inclusion. As it will often not be possible to avoid an interest income inclusion and as there are often good US tax reasons to charge interest on loans to US affiliates (typically at the applicable federal rate (AFR)), charging arm’s length interest on outbound loans is a reasonable best practice.
If a foreign affiliate makes an interest-bearing loan to a Canadian corporation, the interest income will be included in the affiliate’s FAPI. Nevertheless, where the affiliate is a US affiliate, charging interest on the loan is good practice to avoid the upstream loan being characterized as a distribution (potentially subject to US dividend withholding tax) or to prevent a US transfer pricing reassessment. Foreign exchange gains and losses on loans from a foreign affiliate to a Canadian parent could result in capital gains and losses for the Canadian parent and FAPI for the foreign affiliate (with the use of a USD functional currency election by the Canadian parent again serving as a potential solution).
More significantly, a loan from a foreign affiliate to its Canadian shareholder or a person not at arm’s length with the Canadian shareholder may result in the Canadian shareholder (and not the debtor, if the shareholder and debtor are not the same person) having to include the principal amount of the loan in computing its income. This can include back-to-back loans, whereby the foreign affiliate makes a loan to an arm’s length person who thereafter makes a loan to the Canadian shareholder or a person not at arm’s length with the Canadian shareholder. Further, income inclusions can arise where either the debtor or creditor is a partnership.
In the owner-manager context, there are three principal exceptions that may apply to prevent the inclusion of an upstream loan in the income of the Canadian shareholder, or alternatively provide an offsetting deduction for the income inclusion:
- The loan is repaid within two years of the date that it arose (unless the repayment is part of a series of loans and repayments);
- The debt or loan arose in the ordinary course of the affiliate’s business and, at the time the debt or loan arose, there were bona fidearrangements to repay the debt within a reasonable time; or
- The affiliate had enough exempt surplus, hybrid surplus, hybrid underlying tax, taxable surplus, underlying foreign tax and pre-acquisition surplus (as represented in the ACB of the shares of the affiliate) to allow for some or all of the upstream loan to have been paid to the Canadian shareholder as a tax-deductible dividend. This exception is only relevant to Canadian shareholders that are corporations).
In contrast to the domestic shareholder loan rules, the deadline for repayment of an upstream loan is tied to the date that the debt arose and not the end of the taxation year in which the debt arose. As in the domestic shareholder loan context, a series of loans and repayments should exist where a repayment is temporary but should not exist where repayment is made through a taxable transaction or where there is a mere succession of loans. Whether or not bona fide arrangements exist for the repayment of a debt within a reasonable time should be a question of fact; the CRA’s administrative position is that the reasonableness of repayment obligations will be determined by reference to normal commercial practice for similar debts.
Whether an affiliate has enough surplus in respect of a Canadian shareholder to shelter an income inclusion in respect of an upstream loan is determined on an annual basis because the relevant provisions are structured as an annual deduction and add-back. If the affiliate’s surplus pools are reduced because of losses or dividends paid by the affiliate or are used by the Canadian shareholder to determine the taxability of other distributions, it is possible that the affiliate will have a net income inclusion in a following taxation year. If the upstream loan is denominated in Canadian dollars but the affiliate’s calculating currency is not the Canadian dollar, then foreign exchange fluctuations may also result in income inclusions in later taxation years.
Should a Canadian shareholder be required to include an upstream loan in income, any subsequent repayment should entitle the shareholder to a deduction; forgiving the debt will not be a repayment and will eliminate the Canadian shareholder’s ability to claim a deduction. Repayments may also give rise to foreign exchange surprises: if the debt is not CAD-denominated, the CAD-denominated income inclusion should be determined using the relevant exchange rate at the time the debt arose, while the CAD-denominated deduction should be determined based on the proportion of the CAD-denominated debt included in income that has been repaid.
Reorganizations of corporate groups with upstream loans can also lead to unexpected, adverse income tax consequences. For example, a sale of the shares of a foreign affiliate together with the assumption of an upstream loan by the share purchaser may not constitute a repayment of the loan by the former debtor. Non-specialists should either cause upstream loans to be repaid or should seek specialist advice prior to any reorganization.
5. Thin capitalization rules
Both Canada and the U.S. have rules in place that limit interest deductions on debt owing to related non-residents, so as to prevent inbound companies from eroding the domestic tax base by stripping all of the taxable income out of the country in the form of interest deductions. From a Canadian perspective, the thin capitalization rules (discussed below) may apply to limit the interest deduction available to a Canadian subsidiary of a non-resident to the extent that the debt-to-equity ratio of the Canadian subsidiary exceeds 1.5:1. Any interest expense that is considered to relate to debt in excess of the 1.5:1 debt-to-equity ratio is deemed to be a dividend paid by the Canadian subsidiary to the non-resident parent and such dividend is subject to Part XIII withholding tax, which would generally be 5% in the context of a Canadian subsidiary of a U.S. parent.
As mentioned above, interest payments made by a Canadian subsidiary are generally deductible for the Canadian subsidiary, while dividend payments must be made out of after-tax income. Heavy reliance on debt capitalization from non-resident investors gives rise to concerns about the “erosion” of the Canadian tax base, because it creates interest deductions in the Canadian entity while interest income is earned by a non-resident, thus reducing the amount of Canadian taxes paid by the group as a whole. 22 Thus, countries are often motivated to limit the amount of debt capitalization by non-resident investors. The 1997 Report of the Technical Committee on Business Taxation (the Mintz Report), a comprehensive study of business taxation in Canada, stated the following regarding the policy rationale of limiting debt capitalization by non-residents:
In the absence of legislative restrictions, foreign investors seeking to minimize taxes associated with an investment in Canada would tend to invest a disproportionate amount of debt (as opposed to equity) in Canada. The interest expense reduces income otherwise subject to tax in Canada. By thinly capitalizing a Canadian business enterprise, a foreign investor can receive a greater proportion of its return in the form of deductible interest payments […], rather than dividend payments out of after-tax income. The purpose of thin capitalization rules is to prevent this type of erosion of the domestic tax base in the country in which the business enterprise is being carried on.
Canada has a number of rules that are aimed at restricting the amount of interest deductions a Canadian subsidiary can take as a result of debt capitalization, particularly in a related party context, including the thin capitalization rules, foreign affiliate dumping rules, and transfer pricing rules. The 2021 federal budget also proposed to introduce a new “earnings-stripping” rule.
Canada’s thin capitalization rules are found in section 18 . Subsection 18(4) generally denies a deduction for interest expense by a Canadian corporation (or trust) if the interest expense is paid or payable on “outstanding debts to “specified non-residents,” to the extent that the amount of the debt
exceeds 1.5 times the applicable “equity amount.” This formula for the percentage of the interest expense that is disallowed can be expressed as follows:
“Equity amount” is defined, generally, as the Canadian corporation’s retained earnings, contributed surplus and paid-up capital on investments made by a specified non-resident shareholder. This is broadly intended to capture the amount of equity invested by specified non-residents in the Canadian corporation.
A “specified non-resident shareholder” is, generally, a non-resident person that owns, either alone or together with non-arm’s length persons, shares of the Canadian corporation with 25% or more of the votes or 25% or more of the FMV. This is intended to ensure that the thin capitalization rules only apply to non-residents that have some measure of influence over the Canadian corporation.
Where a partnership with non-resident partners has loaned money to a Canadian corporation, for purposes of the thin capitalization rules, the CRA has stated that the determination of whether there are any “specified shareholders” should be made at the level of the partners (which are deemed to proportionately own any shares held by the partnership), rather than the partnership, and any loans made by the partnership should be attributed to its partners based on the relative FMV of their respective interests. As a result, if the interests in a partnership are widely held by non-resident persons and all members of the partnership deal with each other at arm’s length and are not otherwise specified non-resident shareholders of a Canadian corporation, the thin capitalization rules may not apply to loans made by the partnership to the Canadian corporation even where the partnership owns all of the outstanding shares of that Canadian corporation.
Further, any amount of interest that is not deductible under the thin capitalization rules is also deemed to be a payment of a dividend for purposes of withholding tax. Therefore, in the above example, the $20 interest payment from CanCo to NRCo would be deemed, for withholding tax purposes, to be a $15 interest payment and a $5 dividend.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com.