Debt financing is commonly used in cross-border transactions due to the relative ease of implementation and the concurrent tax efficiencies. However, certain Canadian tax rules could easily be overlooked, which may result in unintended adverse tax consequences.
This article is the first of a series on cross-border debt financing arrangements and focuses on shareholder loans in the Canadian inbound investment context.
General rule - Shareholder loans
In a cross-border setting, the shareholder loan rules very broadly apply when a Canadian-resident corporation provides debt financing to its non-resident shareholders or any other non-resident persons who do not deal at arm’s length with the non-resident shareholders. There are certain exceptions to the rules, which we will explain below.
When the shareholder loan rules apply, the debt financing provided to the non-residents will be deemed to be a dividend paid to the non-residents. The deemed dividend can be subject to Canadian withholding tax at 25 per cent or reduced pursuant to applicable tax treaties. As such, a non-resident shareholder who received debt financing from its Canadian subsidiary will be taxed in the same manner as if it had received a dividend from the subsidiary.
The non-resident shareholder will be eligible to apply for a refund for the withholding tax paid on the deemed dividend when the shareholder loan is repaid. The shareholder loan will not be considered to have been repaid if the repayment is part of a series of loans or other transactions and repayments. The application for a refund must be submitted to the CRA within two years after the end of the year in which the shareholder loan is repaid.
Exception - Repayment within one year
If the shareholder loan is repaid within one year after the end of the taxation year of the lender in which the loan was made, and the repayment is not considered to be part of a series of loans or other transactions and repayments, the loan will not be subject to the shareholder loan rules. Nonetheless, the non-resident shareholder will be deemed to have received a benefit from the Canadian subsidiary if the loan is non-interest bearing or the interest rate is less than the interest rate prescribed by the CRA. The CRA announces the prescribed interest rate on a quarterly basis. The prescribed interest rate is currently at 2 per cent.
The benefit conferred on the non-resident shareholder is equal to the interest on the loan computed at the prescribed interest rate in excess of the amount of interest received in the year and within 30 days after the end of the year. The benefit will also be treated as a deemed dividend paid to the non-resident shareholder and therefore is subject to Canadian withholding tax. The withholding tax remitted on the benefit is not refundable in any event.
Trap - Series of loans or other transactions and repayments
It is a question of fact whether a repayment of a shareholder loan is considered to be part of a series of loans or other transactions and repayments. The CRA takes a view that a repayment would generally be considered to be part of series of loans or other transactions and repayments where a non-resident shareholder makes a repayment shortly before the year-end and borrows the same amount, or substantially the same amount shortly thereafter in the immediately following year.
Many Canadian taxpayers maintain a running loan account that contains all shareholder loan transactions arising from intercompany cash transfers, intercompany reimbursements for the expenses paid on behalf of each other, intercompany charges for goods and services, declaration of dividends and etc. In this situation, the underlying transactions that give rise to the fluctuation of the running loan balance play a key role in determining whether a series of loans or other transactions and repayments exists. Bona fide repayments should not be considered to be part of a series of loans or other transactions and repayments. A decrease of the running loan balance will generally be treated as a bona fide repayment if the decrease arises from the provision of goods and services by, or from the payments of dividends, salaries or bonuses to, the non-resident shareholder.
Exception - Pertinent Loan Or Indebtedness (PLOI) Regime
Under the PLOI Regime, a shareholder loan that would otherwise be subject to the shareholder loan rules can be exempted if the loan meets the following general criteria:
- The loan is payable by a non-resident corporation (the ‘subject corporation’) to a corporation resident in Canada ( the ‘CRIC’)
- The CRIC is controlled by the subject corporation when the loan was received by the subject corporation
- The CRIC and the subject corporation jointly file a tax election with the CRA to treat the loan as a PLOI
Further, to be valid, PLOI elections are subject to various compliance requirements. For example, the PLOI loan should carry an interest rate that is not less than the interest rate prescribed by the CRA. Otherwise, the CRIC is required to include deemed interest income in its taxable income. The deemed interest income is equal to the interest income computed on the loan at the prescribed interest rate in excess of the actual interest income receivable by the CRIC. The prescribed interest rate for PLOI loans is also announced by the CRA on a quarterly basis, and is 4 per cent higher than the prescribed interest rate for the computation of shareholder benefits. Other compliance obligations relating to, for example the timing and form of elections, also apply to PLOI loans.
By filing a PLOI election, instead of paying a one-time withholding tax on a deemed dividend under the shareholder loan rules, the CRIC will pay annual income tax on the imputed PLOI interest. A taxpayer should consider not only the tax consequences but also the administrative efforts required to comply with the relevant tax rules when deciding whether to file a PLOI election.
Variation of shareholder loans
Non-resident shareholders may find debt financing directly from Canadian subsidiaries to be tax inefficient due to the application of the shareholder loan rules. As such, a Canadian subsidiary of a multinational group may instead decide to directly fund a foreign affiliate operation, rather than indirectly provide funding through the non-resident parent. Or, a foreign affiliate of a Canadian subsidiary may directly advance amounts to other foreign sister entities, thereby completely bypassing Canada. While the shareholder loan rules should not apply in these circumstances, such arrangement may be subject to other limitations such as the upstream loan rules or the foreign affiliate dumping rules, both of which will be explored in subsequent articles.