Canadian withholding taxes on interest paid by a Canadian resident borrower to a non-resident of Canada that deals at arm’s length with the Canadian borrower was eliminated for most interest payments on or after January 1, 2008. However, the Canadian withholding tax exemption on interest on arm’s length debt does not apply to “participating debt interest”. “Participating debt interest” generally means interest, any portion of which is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of share of the capital stock of a corporation.
There is a concern that the convertible feature of a debt obligation may give rise to participating debt interest under subsection 214(7) of the ITA which could be subject to Canadian withholding taxes. Subsection 214(7) of the ITA provides that, where a debt obligation held by a non-resident of Canada is assigned or otherwise transferred to a Canadian resident person, the difference between the price for which the debt obligation was assigned or otherwise transferred and the price for which the obligation was issued is deemed to be a payment of interest on the debt obligation paid by a Canadian resident person to a non-resident of Canada. Subsection 214(14) of the ITA brings convertible debt obligations within the scope of subsection 214(7) as the redemption in whole or in part or the cancellation of an obligation held by a non-resident of Canada is deemed to be an assignment of the debt obligation for the purposes of section 214 of the ITA.
Certain debt obligations referred to as “excluded obligations” in subsection 214(8) of the ITA are not subject to the application of subsection 214(7) of the ITA. A debt obligation that would have been exempt under the former exemption for Canadian withholding taxes on interest on arm’s length debt in subparagraph 212(1)(b)(vii) of the ITA is an “excluded obligation”. Due to the uncertainty surrounding the treatment of any deemed interest arising under subsection 214(7) on the conversion of debt obligations, most convertible debt obligations continue to comply with the requirements of former subparagraph 212(1)(b)(vii) and have, among other things, a term of at least five years.
At both the 2008 Canadian Tax Foundation Conference and the 2009 International Fiscal Association Conference, the CRA was asked to provide guidance on the issues related to convertible debt obligations with reference to subsection 214(7) and the definition of “excluded obligation” in subsection 214(8). Despite the apparent need for a general framework, the CRA, citing the difficulty posed by the variety of convertible securities available in the market, has limited its comments to what it describes as “traditional convertible debentures,” in so far as:
- The debentures are unsecured subordinated debts.
- The issuer is a public corporation.
- The debentures are issued for a fixed amount of money in Canadian dollars that represents the face value of the debenture with no original discount.
- The debentures bear interest at a commercial fixed rate per year calculated on their face value that is to be paid by the issuer at least annually.
- The debentures are convertible at any time at the holders’ option into the common shares of the issuer prior to maturity, although an initial non-conversion period is acceptable.
- The terms of the debentures specifically provide either a fixed conversion price or a fixed conversion ratio, although certain changes in the conversion price or conversion ratio over time may be acceptable.
- The conversion price exceeds the price at which the common shares of the issuer could have been purchased on the market at the time the debentures are issued.
- The debentures have a specified maturity date.
- At maturity, the debentures are redeemable by the issuer at a redemption price of 100% of the face value, plus accrued and unpaid interest.
On the conversion of a debt obligation satisfying the foregoing terms and conditions, the CRA considers that there will not be any excess amount for the purposes of subsection 214(7) and, therefore, no deemed interest that could attract Canadian withholding tax. It is not clear why CRA decided to limit its comments to “traditional debt obligations”.
In November 2007, the Department of Finance indicated in the Explanatory Notes to subsection 214(8), which subsection was amended to preserve the exclusion for debt obligations that comply with former paragraph 212(1)(b)(vii), that these amendments were being made so as not to unduly complicate matters, pending a more comprehensive examination of the rules in section 214 in light of the changes made to the Canadian withholding tax regime for interest on arm’s length debt. It is hoped that Finance will complete its comprehensive review in the near future and will provide needed guidance on so-called “non-traditional convertible debt obligations”. Without this guidance, there will continue to be uncertainty as to whether interest on “non-traditional convertible debt obligations” will be subject to Canadian withholding taxes. This uncertainty will in turn generally result in less flexibility in fixing the terms and conditions of “non-traditional convertible debt debentures”.