Historically, Canadian multinationals have generally been entitled to deduct interest incurred in respect of borrowed funds used to invest, directly or indirectly, in foreign affiliates. The deductibility of interest related to the financing of foreign affiliates combined with the favourable dividend tax regime applicable to foreign affiliates located in treaty countries that derive their income from an active business generally results in lower financing costs for Canadian multinationals that invest abroad.
In its March 2007 Budget, the Federal Government proposed to deny the deduction of interest and other financing costs incurred by Canadian multinationals on borrowed funds that could be traced to an investment in a foreign affiliate. These proposals were not well received by the tax and business communities and were seen by many as being detrimental to Canadian multinationals that compete abroad. The scope of these proposals was initially very broad. However, the scope of the final set of denial rules that ensued from these proposals was scaled down in response to concerns raised by the public.
These denial rules were included in section 18.2 of the Income Tax Act (Canada) (the “ITA”) which was enacted on December 14, 2007. The main purpose of section 18.2 was to attack double-dip outbound financing structures, including structures commonly referred to as “tower structures”, which allow Canadian corporations and their foreign affiliates to claim an interest deduction in two jurisdictions and repatriate the interest income received on a loan between two foreign affiliates on a tax efficient basis. The effect of these rules was to limit the deduction of interest or other financing costs paid or payable by a Canadian corporation for periods that begin after 2011 in circumstances involving a double-dip outbound financing structure such as the “tower structure” described below.
In a typical “tower structure”, two Canadian corporations form a US limited partnership (“US LP”) that borrows funds from a third party lender usually US based. US LP then uses the borrowed funds to invest in shares of a Canadian unlimited liability company (“Canadian ULC”) which in turn uses the funds contributed by US LP to invest in shares of a US limited liability company (“US LLC”). US LLC then loans these funds to a US corporation (“US Borrower”) which carries on an active business in the US. Outbound financing through a “tower structure” is generally tax effective for the following reasons: (i) the Canadian corporate partners of US LP are entitled to an interest deduction in Canada on interest paid or payable by US LP on the third party loan, (ii) interest paid by US LP on the third party loan is not subject to Canadian or US withholding taxes, (iii) dividends received by US LP from Canadian ULC that are allocated to the Canadian corporate partners are not subject to Canadian taxation, (iv) the US Borrower is entitled to a deduction in the US on interest paid to US LLC, (v) for Canadian tax purposes, the interest paid by US Borrower to US LLC is considered to be active business income and is included in the exempt surplus of US LLC, (vi) dividends from exempt surplus paid by US LLC to Canadian ULC are not subject to Canadian taxation, (vii) interest paid by US Borrower is exempt from US withholding taxes because from a US perspective both US LLC and Canadian ULC are disregarded and the dividend is considered to have been paid by the US Borrower to a US corporation (i.e., the US LP elects to be treated as a US corporation), and (viii) for US tax purposes, the interest paid by US Borrower is included in US LP’s income but is offset by the interest paid by US LP on the third party loan.
In November 2007, the Minister of Finance (Canada) established the Advisory Panel on Canada’s System of International Taxation (the “Panel”) with the mandate to recommend ways to improve the competitiveness, efficiency and fairness of Canada’s system of international taxation, minimize compliance costs, and facilitate administration and enforcement by the Canada Revenue Agency. In its report released in December 2008, the Panel recommended, among other things, that Canada impose no additional rules to restrict the deductibility of interest expense incurred by Canadian companies where the borrowed funds are used to invest in foreign affiliates and that section 18.2 of the ITA be repealed.
In the 2009 Federal Budget tabled on January 27, 2009, the federal government announced its intention to implement the Panel’s recommendation to repeal section 18.2. On February 2, 2009, the Minister of Finance released a Notice of Ways and Means Motion to implement certain proposals included in the 2009 Federal Budget including the repeal of Section 18.2. This Notice of Ways and Means Motion, as amended on February 4, 2009, was included in Bill C-10 which received royal assent on March 12, 2009. The repeal of section 18.2 should be welcome news for Canadian multinationals doing business abroad especially in these uncertain economic times.
We note that some of the inbound double-dip cross-border financing structures will be significantly impacted by the new anti-hybrid rules included in the Fifth Protocol to the Canada-US Treaty which will apply on or after January 1, 2010. However, the outbound double-dip cross-border financing “tower structure” described above should still be tax efficient under these new anti-hybrid rules. Although any profits distributed by US LP to its Canadian partners would be treated as a dividend for US tax purposes and would be subject to US withholding taxes at a rate of 30% under these new rules, the tax implications should not be material because the profits realized by US LP are generally nominal under the “tower structure” described above.