Withholding Tax on Interest
The Act contains certain exemptions to the normal withholding tax requirements for interest imposed under Part XIII. The most common exemption from withholding tax relates to long-term arm’s-length debt (subparagraph 212(1)(b)(vii)).
The General Electric Capital Equipment Finance Inc. case 7 has created some uncertainty as to the continuing application of the subparagraph 212(1)(b)(vii) exemption to debts whose terms have been modified.
Question 1
Can the CCRA provide guidance as to its administration of the Act on this point?
Response 1
In the GE Capital case, the Federal Court of Appeal stated that the issue was whether or not a new obligation was created by reason of the modifications made to the debts. The debts were found to have four fundamental terms, being:
1. the identity of the debtor;
2. the principal amount of the debt;
3. the interest rate on the debt; and
4. the maturity date of the debt.
The facts were that the last three items (i.e. the principal amount, the interest rate and the maturity date) were all changed. The Federal Court of Appeal found that these constituted substantial changes that materially altered the terms of the obligation and consequently created a new debt for purposes of subparagraph 212(1)(b)(vii). Further, the court expressly stated that, in common law, a novation is not required before there can be a new debt for the purposes of subparagraph 212(1)(b)(vii).
We believe the GE Capital case is consistent with our views expressed in Income Tax Technical News No. 14 – that is, in common law, a rescission of a debt obligation will be implied when the parties have effected such an alteration of its terms as to substitute a new obligation in its place, which is entirely inconsistent with the old, or, if not entirely inconsistent with it, inconsistent with it to an extent that goes to the very root of it.
If a debt obligation is subject to contract law in Quebec and if the changes in the terms of the original debt obligation have resulted in a novation under the Civil Code of Québec (where the original debt obligation is discharged and substituted by a new obligation), it is appropriate to view that a new obligation comes into existence for income tax purposes.
Question 2
Have you dealt with this issue on a rulings basis since the GE Capital case?
Response 2
Yes, we have considered this issue in the context of a ruling request subsequent to the release of the GE Capital case. In that situation the main facts involved a change from paying interest currently to deferring interest payments until maturity, to amend the security interests of the debt holders, to change the conversion ratio of the debt as well as some other changes. In that situation, we considered that the existing obligation continued and that a new obligation did not come into existence for purposes of subparagraph 212(1)(b)(vii).
Question 3
The post-amble to paragraph 212(1)(b) refers to interest computed by reference to “revenue, profit, cash flow, commodity price or any other similar criterion” and deems such interest not to be interest eligible for the withholding tax exemption. This legislation causes concerns to tax practitioners with regard to debts where the terms of loan agreements may contain a provision for upward or downward adjustments to the interest rate from time to time over the term of the loan, that are based on the ratio of certain debt balances to earnings before interest, tax, depreciation, and amortization (EBITDA), to the borrower. Can the CCRA comment on the application of this provision in this context?
Response 3
The wording of the post-amble to paragraph 212(1)(b) is very broad. Our initial reaction is that a term such as that described above could well fall within the ambit of the post-amble to paragraph 212(1)(b) such that the withholding tax exemption would be unavailable.
Question 4
Have you dealt with this issue on a rulings basis?
Response 4
Although we have had numerous requests for technical interpretations on this issue, we have not had any formal ruling requests. We would be pleased to consider this issue in the context of a ruling where we would have the opportunity to examine the draft loan agreements and the details relating to the particular circumstances of the borrower.