If a Canadian Corporation “CanCo” has a loan outstanding to NR Shareholder, it’s important to know the tax consequences, if any, of this loan, and what options are available to minimize any Canadian tax costs.
The Income Tax Act (the Act) contains a number of rules intended to discourage the repatriation of profits by a Canadian subsidiary to a non-resident shareholder (or a corporation that does not deal at arm’s length with the shareholder) in the form of a loan (the rule also applies to loans made to Canadian resident shareholders, but this portion of the rules is not applicable to this situation). The Canadian Government is concerned, for example, that a Canadian subsidiary could avoid paying Part XIII withholding taxes on a dividend distribution to NR Shareholder making a low-interest loan to the non-resident shareholder instead of paying a dividend. In the course of an audit, it is common for the CRA to scrutinize intercompany non-resident loan activity to determine whether any tax liability exists.
Generally, when a NR Shareholder of a Canadian subsidiary (or a person connected to that shareholder) receives a loan from the Canadian subsidiary, the amount of the loan or indebtedness is deemed to be a dividend paid by the Canadian subsidiary unless the loan is repaid within one year after the end of the non-resident’s taxation year in which the loan was made or indebtedness arose (sections 15 and 214 of the Act). For this purpose, a series of loans and repayments will not count as a bona fide repayment of the loan. Where a deemed dividend is triggered, the dividend is subject to Part XIII withholding tax at a rate of 25%, unless the rate is reduced under the provisions of a tax treaty between “CanCo” and NR Shareholder.
If withholding tax is remitted to the CRA in respect of a deemed dividend, but the loan or indebtedness is subsequently repaid (other than as part of a series of loans and repayments), the non-resident person may apply for a refund of the Part XIII withholding tax under section 227 of the Act (i.e. since no profits were repatriated in this instance). The refund is limited to the lesser of:
the tax originally paid in respect of the amount of the loan repaid, and
the Part XIII tax that would be payable at the time of the repayment if a dividend equal to that amount were paid to the non-resident at that time (i.e. the withholding tax rate under the relevant tax treaty at the time of the repayment is relevant).
To recoup the withholding tax, an application must be made to the CRA within 2 years after the end of the calendar year in which the repayment is made using Form NR7R: Application for Refund of Part XIII Tax Withheld.
If the application is not made within the two-year time limit, it may be possible for the NR Shareholder to re-appropriate the Part XIII tax withheld to another Canadian tax liability of the non-resident in accordance under section 221.2 of the Act. (see VD 2013-0482991E5 the CRA has taken the position that it will generally not refund the taxes, and that it also will not allow the non-resident debtor to re-appropriate the outstanding refund to another Canadian tax debt (if any) of the debtor (i.e. under section 221.2).
Despite the two-year limitation period in the Act referred to above, the Canada-US Tax Treaty provides that the competent authorities may grant relief in the case of excess Part XIII withholdings provided they are notified within six-years from the end of the taxation year to which the case relates.
If the deemed dividend rule were to apply to a debt that was assigned to another creditor, if the debt were subsequently repaid, the Part XIII tax could still be refunded.
Imputed Interest Benefit to NR Shareholder
A separate provision of the Act (section 80.4) provides a rule in respect of certain low-interest or non-interest bearing indebtedness extended by a corporation to a shareholder of the corporation, a connected person or partnership or a member of a partnership or a beneficiary of a trust that is a shareholder of the corporation. Where the loan or indebtedness was extended by virtue of such shareholding, a benefit is deemed to be received by the debtor. The interest benefit is equal to the difference between interest paid on the loan (during the year or not later than 30 days after the end of the year) and interest computed at a prescribed rate on the outstanding loan balance. Thus, in respect of the loan owing by “CanCo” to NR Shareholder, if the rate of interest charged is less that the prescribed rate, “CanCo” may be deemed to have paid a dividend to NR Shareholder (see paragraph 214(3)(a) of the Act) equal to the amount calculated under the provision at the prescribed rate, less actual interest paid (see Regulation 4301(c) and canada.ca/en/revenue-agency/services/tax/prescribed-interest-rates.html). Part XIII withholding tax would apply in respect of the deemed dividend at the applicable treaty rate.
The interest imputation rule in section 80.4 does not apply if the loan is deemed to be a dividend.
If the loan is outstanding for more than one year but is repaid before the end of the taxation year following the year in which the loan was made such that a deemed dividend is avoided, the interest imputation rule applies from the time that the loan was made.
As a general rule, it is normally beneficial for a non-resident parent corporation to pay interest on a loan from a Canadian subsidiary at a reasonable arm’s length rate to avoid the application of interest imputation rules under the Act and to allow an interest deduction to be claimed by the non-resident corporation in its taxing jurisdiction.
Imputed Interest Benefit to “CanCo”
Under a separate provision of the Act (section 17 of the Act), income may, in certain circumstances, be imputed to a corporation resident in Canada in respect of an amount owing to it by a non-resident person computed based on a prescribed rate (see Regulation 4301(c) and canada.ca/en/revenue-agency/services/tax/prescribed-interest-rates.html). Any imputed benefit is reduced by interest paid on the loan to the debtor in respect of the year (technically, a rate of interest below the prescribed rate could be charged without the imputed interest rule applying if “CanCo” were able to demonstrate that the rate was reasonable in the circumstances).
Section 17 does not apply if the loan is deemed to be a dividend as described above under “Deemed Dividend”. However, if the loan is repaid and the withholding tax paid on the deemed dividend is recouped, section 17 will apply retroactively (note that the CRA does not consider withholding tax paid under the imputed interest rule in section 80.4 to negate the application of section 17).
The CRA takes the position, which is debatable, that the deemed interest benefit begins to accrue from the time the loan is made (i.e. as opposed to one year after the loan has been outstanding).
It should also be noted that rather than applying section 17, in recent years, the CRA has stated it may instead assess a Canadian resident corporation to include an amount in income in respect of a low-interest loan made to a non-arm’s length non-resident by applying the transfer pricing rules. Proposed amendments to the Act will give the transfer pricing rules precedence over section 17, which would support the CRA’s alternative assessment position.
A Canadian corporation (CanSubCo) whose taxation year ends on December 31st makes an interest-free loan to its foreign parent corporation (Foreign ParentCo) for a period of 13 months from June 2020 to July 2021. The loan is repaid before the end of CanSubCo’s second taxation year after the time that the loan was made and the repayment was not part of a series of loans and repayments. Consequently, the loan is not deemed to be a dividend. However, since the loan to Foreign ParentCo is an interest-free loan and the amount was not deemed to be a dividend under section 15, the interest imputation rule in section 80.4 applies (see under “Imputed Interest Benefit to NR Shareholder”).
Consequently, CanSubCo is deemed to have paid a dividend to Foreign ParentCo equal to the amount of interest on the loan computed at the prescribed rate, and Part XIII tax must be remitted in respect of the deemed payment. Furthermore, given that the loan was made for a period exceeding one year, a deemed interest benefit must also be included in CanSubCo’s income computed in the manner described above under “Imputed Interest Benefit to CanCo” (alternatively, the CRA may reassess CanSubCo to include a higher amount in income applying the transfer pricing rules on the basis that an arm’s-length interest rate on the loan would have exceeded the prescribed rate).
Pertinent Loan or Indebtedness (PLOI) Exception
An elective exception is available to avoid the above rules (other than section 80.4). The election is generally available where a Canadian subsidiary makes a loan to a non-resident parent corporation in a situation in which the indebtedness would otherwise be deemed to be a dividend in accordance with the rules discussed under “Deemed Dividend”. If the Canadian subsidiary and its parent file this joint election, the deemed dividend rule and the interest imputation rule discussed under “Imputed Interest Benefit to CanCo” will not apply. Instead, the loan will be considered a PLOI under the Act, and a different set of interest imputation rules, at a higher prescribed rate, will apply. In particular, the Canadian subsidiary will be deemed to pay interest at the prescribed rate applicable to PLOIs to the non-resident parent corporation, less the amount of any interest actually paid on the PLOI (see Regulation 4301(b.1) and canada.ca/en/revenue-agency/services/tax/prescribed-interest-rates.html).
The PLOI exception is sometimes utilized as a short-term resolution to avoid paying withholding tax on a deemed dividend or is used to facilitate cash pooling and other intercompany debt arrangements employed by multinationals with Canadian subsidiaries.
We would be happy to examine the NR Shareholder loans “CanCo” has made and to recommend procedures to be taken to minimize any adverse tax consequences related to the loan.
For more information, please contact email@example.com or 1 844-GYTD-CPA