Back-to-Back withholding loan rules and their anti-treaty shopping effect in Canada Back-to-Back withholding loan rules and their anti-treaty shopping effect in Canada

Abstract

The Income Tax Act imposes withholding tax typically; article 11 of Canadian tax treaties allow Canada to tax interest arising in Canada and paid to residents of the other treaty country at a reduced rate of 10 or 15 percent from the statutory rate that could otherwise apply. Exclusively, under Canada-United States Treaty, no Canadian withholding tax applies to interest on non-arm’s length debt, for example, when a Canadian subsidiary pays interest on money borrowed from its U.S. parent corporation. Nevertheless, as treaties are intended to provide tax benefits only to residents of the treaty countries, residents of third countries, for example, the parent of a multinational enterprise in a third country, might seek to arrange lending transactions indirectly through the United States or perhaps other countries to qualify for treaty benefits that would not otherwise be available on a direct loan from the ultimate lender or some other member of the corporate family. This is often called “treaty shopping,” structuring loans to reduce the withholding tax to the least possible tax treaty rate. These arrangements generally may and frequently involve interposing a non-resident financial intermediary located in a tax treaty jurisdiction between a Canadian taxpayer and a resident of a nonta treaty jurisdiction to reduce the withholding tax that would apply if a loan were made and interest paid on the loan directly. As a response, subsections 212(3.1) and 212(3.2) of the ITA provide specific objective rules to address back-to-back loan arrangements through treaty shopping schemes, attuned to the common commercial characteristics of commercial lending transactions and the interests of genuine self-interested participants in them.