Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Whether Part XIII withholding tax under paragraph 212(1)(b) arises when a debt obligation and accrued interest that are owing by a Canadian partnership to a foreign affiliate of one of its Canadian partners is assumed by another foreign affiliate.
Position: Yes, where the assumption of the debt obligation and accrued interest liability constitutes a novation.
Reasons: Based on the facts reviewed, in this particular instance the novation of the debt and accrued interest results in a payment or credit of the accrued interest for purposes of paragraph 212(1)(b).
July 13, 2018
National Advisor Tax Avoidance Income Tax Rulings
XXXXXXXXXX Tax Services Office Ina Eroff
Withholding Tax on Assumption of a Liability to Pay Accrued Interest
This is in reply to your email of June 29, 2017, as clarified and expanded by subsequent correspondence, regarding the application of paragraph 212(1)(b) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended, (the “Act”) to accrued interest, when the obligation to pay such interest is assumed by a foreign affiliate of a taxpayer.
Unless otherwise stated, all statutory references herein are to the Act, and all terms used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.
In XXXXXXXXXX, a corporation resident in Canada (“Canco”) held a XXXXXXXXXX% partnership interest in a general partnership formed under the laws of the state of XXXXXXXXXX (the “Partnership”). The other XXXXXXXXXX% interest in the Partnership was held by a Canadian subsidiary of Canco. The Partnership was a Canadian partnership within the meaning of section 102, and the Partnership elected to be treated as a corporation for United States (“U.S.”) tax purposes.
In XXXXXXXXXX, the Partnership held all of the issued and outstanding shares of a limited liability corporation incorporated in the U.S. (the “Creditor Affiliate”). The Creditor Affiliate was a disregarded entity for U.S. tax purposes. The Creditor Affiliate was a foreign affiliate and a controlled foreign affiliate of Canco.
In XXXXXXXXXX, the Creditor Affiliate made an interest bearing loan to the Partnership (the “Loan”). The Loan was not recognized for U.S. tax purposes because it was made by a disregarded entity. The Partnership made payments to the Creditor Affiliate for interest that accrued through to XXXXXXXXXX. The Partnership withheld Part XIII tax on these interest payments at a rate of 25% on the basis that the Creditor Affiliate did not qualify for treaty benefits under the Convention between Canada and the United States of America with respect to Taxes on Income and on Capital (the “Treaty”) because it was not liable to tax in the U.S. within the meaning of paragraph 1 of Article IV of the Treaty and therefore, was not a resident of the U.S. for Treaty purposes.
Interest on the Loan continued to accrue, but was not paid, from XXXXXXXXXX (the “Accrued Interest”). The Partnership deducted the interest on the Loan, including the Accrued Interest, in computing its income from Canadian sources pursuant to subsection 96(1).
On XXXXXXXXXX, the Partnership transferred all of its assets, including the shares of the Creditor Affiliate, to a newly formed corporation incorporated in the U.S. (the “Debtor Affiliate”), all of the shares of which were held by the Partnership. The Debtor Affiliate was a corporation for U.S. tax purposes. In partial consideration for the assets of the Partnership, the Debtor Affiliate assumed the Partnership’s liability to repay the Loan and to pay the Accrued Interest to the Creditor Affiliate. We understand that as a result of this assumption by the Debtor Affiliate, the Partnership was released of its obligations to the Creditor Affiliate, and the Creditor Affiliate consented to the assumption of the obligations by the Debtor Affiliate and to the release of the Partnership.
Subsequently, on XXXXXXXXXX, the Partnership transferred the shares of the Debtor Affiliate to a newly incorporated XXXXXXXXXX unlimited liability company that was wholly-owned by the Partnership. The Partnership then wound up on XXXXXXXXXX.
On XXXXXXXXXX, the Debtor Affiliate repaid the Loan, together with the Accrued Interest and additional interest that had accrued after XXXXXXXXXX, to the Creditor Affiliate. The Creditor Affiliate was wound up shortly after the end of the XXXXXXXXXX.
Whether Part XIII withholding tax applies to the Accrued Interest pursuant to paragraph 212(1)(b).
Paragraph 212(1)(b) requires every non-resident person to 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, interest that is either participating debt interest or is not fully exempt interest that is paid or payable to a person with whom the payer is not dealing at arm’s length or that is 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. Pursuant to paragraph 212(13.1)(a), a partnership is deemed to be a person resident in Canada for purposes of Part XIII in connection with the portion of an amount that it pays or credits to a non-resident person that is deductible in computing the partnership’s income or loss from a Canadian source.
In our view, where the assumption by the Debtor Affiliate of the Partnership’s liability to repay the Loan and to pay the Accrued Interest resulted in a novation of those obligations, the delivery by the Partnership to the Creditor Affiliate of the Debtor Affiliate’s covenant to assume those obligations would constitute a payment or credit of the Loan and the Accrued Interest by the Partnership to the Creditor Affiliate at the time of the assumption for purposes of paragraph 212(1)(b).
Whether or not the assumption of the principal and Accrued Interest obligations resulted in their novation is a question of fact which can only be determined following a review of all of the terms and conditions pertaining to the particular transactions. We can, however, provide you with our general comments with respect to the doctrine of novation, as well as our views on whether withholding tax would apply based on an assumption there was a novation of the principal and Accrued Interest obligations at the time the Debtor Affiliate assumed those obligations.
The Supreme Court of Canada in National Trust Co. v Mead,  2 S.C.R. 410, defined a legal novation of a debt as follows:
A novation is a trilateral agreement by which an existing contract is extinguished and a new contract brought into being in its place. Indeed, for an agreement to effect a valid novation the appropriate consideration is the discharge of the original debt in return for a promise to perform some obligation. The assent of the beneficiary (the creditor or mortgagee) of those obligations to the discharge and substitution is crucial. This is because the effect of novation is that the creditor may no longer look to the original party if the obligations under the substituted contract are not subsequently met as promised.
The courts have established a three part test for determining whether novation has occurred. It was first set out in Polson v Wulffsohn (1890), 2 B.C.R. 39 (S.C.):
- first, the new debtor must assume the complete liability;
- second, the creditor must accept the new debtor as a principal debtor, and not merely as an agent or guarantor; and
- third, the creditor must accept the new contract in full satisfaction and substitution for the old contract.
Based on our review of select transaction documents relating to the assumption of the Loan, we understand that the Debtor Affiliate assumed the Partnership’s obligation to pay the Loan and the Accrued Interest. We also understand that the Creditor Affiliate accepted the obligation of the Debtor Affiliate to pay the Loan and the Accrued Interest in complete satisfaction of the obligations of the Partnership under the Loan agreement and consented to the full release of the Partnership from its obligations to pay the Loan principal and the Accrued Interest. Based on this understanding of the facts, our preliminary conclusion, and therefore assumption for purposes of the discussion below, is that there was a novation of the Partnership’s Loan and Accrued Interest obligations at the time the Debtor Affiliate assumed these obligations.
In our view, at the time of this novation, the Partnership would be considered to have made a payment or credit in kind of the Accrued Interest to the Creditor Affiliate by delivering the Debtor Affiliate’s covenant to make the payments under the Loan agreement to the Creditor Affiliate.
Based on the facts presented, paragraph 212(13.1)(a) would deem the Partnership to be a person resident in Canada in respect of this in kind payment of the Accrued Interest for purposes of paragraph 212(1)(b). Consequently, it is our view that pursuant to paragraph 212(1)(b), the Creditor Affiliate would have an obligation to pay a tax of 25% on the amount of the Accrued Interest that was paid or credited to it in kind by the Partnership at the time the obligation to pay the Accrued Interest was assumed by the Debtor Affiliate as a result of the novation.
However, as a novation is ultimately a question of fact, you should review all the facts regarding the assumption by the Debtor Affiliate of the Partnership’s liability to repay the Loan and to pay the Accrued Interest to determine if the assumption resulted in a novation of those obligations. In the event you determine that there was not a novation of the Accrued Interest, we suggest that you contact us for additional analysis on the application of paragraph 212(1)(b) to the Accrued Interest.
Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.
Ann Kippen, CPA, CA
For Division Director
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
International and Large Business Directorate
International Advisory Services, XXXXXXXXXX
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