Requirements for Part XIII Withholding Tax on Canadian Interest to Non-Residents – A Toronto Tax Lawyer Guide
Introduction – What is Withholding Tax on Interest Paid to Non Residents
Under the Income Tax Act, a Canadian tax resident must pay tax on his or her worldwide income, while non-residents of Canada are only liable to pay tax on his or her Canadian source income. Part XIII of the Income Tax Act sets out rules for determining when payments from Canadian residents (for tax purposes) to non-residents become taxable. The general rules for withholding tax on interest payments to non-residents is discussed in our articles here:
This article will discuss the requirements for Part XIII withholding tax on interest paid to non-residents. The current regime of the requirements for withholding tax on interest paid to non-residents was enacted in 2008.
Requirements for Withholding Tax on Interest Paid to Non-Residents – the Legislation
The requirements are laid out in paragraph 212(1)(b) of the Income Tax Act as the following:
212 (1) Every non-resident person shall pay an income tax of 25% on every amount that a person resident in Canada pays or credits, or is deemed by Part I to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of,
(b) interest that
- (i)is not fully exempt interest and is paid or payable
- (A)to a person with whom the payer is not dealing at arm’s length, or
- (B)in respect of a debt or other obligation to pay an amount to a person with whom the payer is not dealing at arm’s length, or
- (ii)is participating debt interest;
The Income Tax Act sets out three scenarios when withholding tax applies to interest payment to non-residents. The first two scenarios are when the interest or the principal amount of debt is payable to a non-resident to whom the payer is not dealing at arm’s length, and the interest is not considered fully exempt interest under the Income Tax Act. The third scenario is when the interest is considered a participating debt interest. Both “fully exempt interest” and “participating debt interest” are further defined in subsection 212(3), whereas “non-arm’s length persons” are defined in section 251(1). We will go through each of these concepts below
Fully Exempt Interest
Fully exempt interest is defined in subsection 212(3). This definition sets out a list of borrower-lender relationships where the interest arising from such debt obligation would be considered fully exempt interest. The list includes:
- interest payments on debt obligations owed to a Canadian governmental entity, including the federal government, provincial governments, or municipal governments;
- interest payments on a secured debt obligation owed to a quasi-governmental entity such as educational institutions or hospital;
- mortgages in respect of real property located outside of Canada, except where the interest on the mortgage is deductible in computing income in Canada;
- debt obligations owed to a prescribed international organization or agency; and
- Securities arrangement between a non-resident lender and a Canadian public corporation borrower, where the Canadian public corporation is carrying out business outside of Canada
Non-Arm’s Length Lender
Under the Income Tax Act, non-arm’s length can describe a relationship between two natural persons, a natural person and a corporation or two corporations. The idea behind non-arm’s length is that two persons are said to be dealing at arm’s length with each other if they are independent, and one person does not have undue influence over the other.
The starting point for understanding non-arm’s length relationship under the Income Tax Act is subsection 251(2)’s definition of related persons. The definition provided here provides the conditions where the Income Tax Act deems related persons to be dealing at non-arm’s length regardless of the actual level of independence one has from the other.
Under paragraph 251(1)(c) of the Income Tax Act, two unrelated persons can also be dealing at non-arm’s length as a matter of fact. The Supreme Court of Canada has set out a test for factual non-arm’s length in MNR v Sheldon’s Engineering Ltd. The test looks for three factors:
- the existence of a common mind, which directs the bargaining of both parties to a transaction
- whether parties to a transaction were acting in concert without separate interest; and
- the existence of de facto control of one party over the other.
Factual non-arm’s length between unrelated persons has been subject to considerable jurisprudential treatment and will be discussed in detail in a separate article.
Participating Debt Interest
Participating debt interest, or participating interest, is an interest payment with a participating feature in the commercial activity of the borrower. Specifically, a participating interest is interest that is determined with reference to receipts, sales, income, profit, or any other cash flow of the debtor or a related person to the debtor. Interest payments that are determined in relation to the change in the debtor’s property value are also considered as participating interest.
The determination of whether an interest payment scheme falls under participating interest can be particularly complex, given the complexities of international commercial loan arrangements. However, as a general rule, a periodic interest payment determined at a fixed rate, and determined only in relation to the amount owing, would not generally be considered to be participating interest unless other features of the loan agreement affect the nature of how the interest is determined. It is best to consult a professional Canadian tax lawyer if you have questions about whether a particular international loan arrangement would be subject to the interest withholding tax by virtue of the participating interest requirement.
Pro Tax Tips – Conduct Due Diligence When Drafting Loan Agreements
While there are only three general conditions for withholding tax on interest payment to non-residents, the determination of whether your international loan agreement would be subject to the Part XIII withholding tax can be very complex. Failure to remit the withholding tax could subject a taxpayer to hefty penalty and interest payments on top of the 25% Part XIII tax.
It is important to retain knowledgeable Canadian tax professionals who are experienced in dealing with tax consequences of international loan agreements if you are contemplating entering into a loan agreement with a non-resident lender. Contact our top Toronto Tax Lawyers for assistance with your loan drafting needs.