Example illustrating key difference between the existing and amended rules in a situation Canco and 4 related non-residents (NR1, NR2, NR3 and NR4) (pp. 6-7)
Facts
Loans (it is assumed that each loan satisfies the connection test in the back-to-back rules):
- Canco receives a $1,500 loan from NR1
- NR1 receives a $2,000 loan from NR2 and a $1,000 loan from NR3
- NR3 receives a $1,000 loan from NR4
Other facts:
- Canco pays $150 interest to NR1, which is subject to 10% withholding tax or ($15) due to a tax treaty
- Interest paid to NR4 is also eligible for a 10% treaty rule
- Interest paid to NR2 and NR3 is not eligible for treaty benefits (and is therefore subject to a 25% withholding tax rule)
Existing Rules
Under the existing rules, Canco is deemed to pay interest to both NR2 and NR3, because they both provide funding to NR1, and interest paid to each funder would be subject to a higher withholding tax rate than interest paid to NR1 (notwithstanding that NR3 is itself funded by NR4, which is not subject to a higher tax rate). ...Amended Rules
Under the amended rules, NR2 and NR4 are both ultimate funders. ...Because NR1 receives $1,500 excess funding (see above), the amounts of funding received from NR2 and NR3 are reduced pro-rata ) to $1000 from NR2 and $500 from NR3) to eliminate the excess. Accordingly, the deemed interest paid to each ultimate funder is computed on the basis that Canco receives indirect funding of $1,000 from NR2 and $500 from NR4. ...
Canco is not deemed to pay any interest to NR4, because NR4 is eligible for the same 10% treaty rate as NR1.
Canco is deemed to pay $60 interest to NR2, which is subject to $15 tax.
Difficulty for the taxpayer in determining ultimate licensing structure (pp. 3-4)
The new back-to-back royalty rules...apply in certain circumstances when one or more "ultimate licensors" indirectly lease or license property to a Canadian taxpayer by way of a chain of "relevant royalty arrangements" involving one or more intermediaries. ...
When the licensor under an incoming royalty arrangement deals at arm's length with the taxpayer, the connection test will be satisfied only if one of the main purposes of this arrangement is to reduce or avoid withholding tax, or to avoid the back-to-back royalty rules.
This additional condition was added in the October proposals, and is intended to prevent the rules from applying to ordinary, arm's length commercial transactions that are structured without any main tax purposes. However, it may be difficult to rely on this condition in practice because a Canadian taxpayer is not likely to have sufficient information to determine an arm's length licensor's tax motivations.
Potentially punitive effect of CRA not accepting allocation (p.4)
If the Minister does not accept that the taxpayer's allocation is reasonable, the amount paid to each ultimate licensor is equal to the actual amount paid by the taxpayer, adjusted to reflect:
- an equal allocation of the actual payment between all ultimate licensors, and
- the difference between the highest withholding tax rate imposed on a payment to any ultimate licensor and on the actual payment
The effect of the allocation formula, when the Minister does not accept the taxpayer's allocation as being reasonable, will be additional withholding taxes (due to the use of the highest withholding tax imposed on a payment to any ultimate licensor). This can be exacerbated by the fact that the formula does not recognize any spread between the royalties paid and received by an intermediary, which may reflect value added by the intermediary.
Email this Content