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.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues:
Where the foreign branch of a Canadian financial institution enters into repurchase transactions and reverse repurchase transactions with a foreign counterparty, will clause 212(1)(b)(iii)(E) apply to exempt certain amounts paid under the arrangement such as the repo spread, lending fee and compensation payments from non-resident withholding tax?
Position:
For the exemption in clause 212(1)(b)(iii)(E) to apply, certain requirements must be met. One such requirement is that the amount must be interest payable in a foreign currency on any obligation entered into in the course of carrying on a business in a foreign country. The word “obligation” as used in clause 212(1)(b)(iii)(E) has a broad meaning. It appears that the requirement to repurchase the securities at the end of a repurchase transaction or the requirement to return the securities at the end of a reverse repurchase transaction can be considered to be an obligation for the purposes of the exemption in clause 212(1)(b)(iii)(E). Accordingly, if the amounts in question constitute interest, the exemption in clause 212(1)(b)(iii)(E) would be available provided that the other requirements in the provision are met. It is a question of fact whether the other requirements in clause 212(1)(b)(iii)(E) are met.
Reasons:
The broad meaning of “obligation” in clause 212(1)(b)(iii)(E) and tax policy.
5-972840
XXXXXXXXXX J. Leigh
Attention: XXXXXXXXXX
March 25, 1998
Dear Sirs:
Re: Cross-border Repurchase Transactions
This is in reply to your letter of October 24, 1997 in which you requested our views concerning the availability of the withholding tax exemption under clause 212(1)(b)(iii)(E) of the Income Tax Act (the "Act") in circumstances where the foreign branch of a Canadian financial institution enters into repurchase ("repo") transactions and reverse repo transactions with a foreign counterparty. In the situations described, the terms of the repo transactions are governed by a master repo agreement. You advise that the master repo agreement does not provide for a lending fee. You further advise that the repo transactions and the reverse repo transactions meet the definition of a securities lending arrangement ("SLA") in subsection 260(1) of the Act.
The situations described in your letter appear to relate to either proposed or completed transactions involving specific taxpayers and we are unable to consider specific situations in a general letter of opinion. Should you wish the views of the Department with regard to a completed transaction, you should contact the appropriate local tax services office and provide them with the full particulars of your client's situation (including copies of the relevant agreements). Alternatively, if the situations presented are proposed transactions, you may request an advance income tax ruling in accordance with the guidelines set out in Information Circular 70-6R3. We can, however, provide you with the following general comments.
Repo Agreements
In a typical repo transaction, one party (the "seller") sells securities at fair market value to another party (the "purchaser") for cash consideration ("cash proceeds") and at the same time agrees to repurchase identical securities at a specified future time or on demand. The repurchase price paid by the seller will exceed the initial sale price by an amount generally referred to as the "repo spread". This amount is calculated with reference to a pricing rate agreed to by the parties for the term of the repo arrangement. Essentially, under a repo, the seller has full use of the cash proceeds until the time of repurchase and any income from those amounts is income of the seller. In addition, the seller will usually earn a lending fee for the use of securities (which may be in the form of cash or a reduction in the repo spread). The purchaser, on the other hand, will receive any dividends or interest from the issuer of the securities and will compensate the seller for any such dividends or interest that the seller would have received on the disposed securities. Depending on which party is motivating the transaction, repos are used as a method of short-term financing or to cover obligations under short sales.
1.It is our view that the repo spread paid by the foreign branch (seller) to the foreign counterparty (purchaser) will usually constitute interest. Accordingly, non-resident withholding tax will apply to such amount subject to the exemptions in the Act or tax treaty provisions. Since Part XIII applies to the gross amount, the repo spread must be broken down into its component parts if the repo spread paid is net of a lending fee. Notwithstanding that a repo agreement may not expressly provide for a lending fee, it is a question of fact whether or not there is a lending fee for the use of the underlying securities. If the underlying securities have a lending value, it would be reasonable to conclude that a lending fee has been factored into the repo spread.
2.With regard to the question of whether the requirement to repurchase the underlying securities at the end of a repo transaction or the requirement to return the underlying securities at the end of a reverse repo transaction can be considered an obligation for the purposes of clause 212(1)(b)(iii)(E) of the Act, it is our view that the word “obligation” as used in that clause has a broad meaning. Accordingly, it appears that the requirement to repurchase or the requirement to return the underlying securities under a repo or a reverse repo transaction, as the case may be, can be considered to be an obligation for the purposes of the exemption in clause 212(1)(b)(iii)(E) of the Act.
3.Where the repo transaction is part of a business that is carried on by the foreign branch in a country other than Canada, it appears that the repo spread paid by the foreign branch to an arm's length counterparty would be exempt from non-resident withholding tax pursuant to clause 212(1)(b)(iii)(E) of the Act if the other requirements in the provision are satisfied. It is a question of fact whether the requirements in clause 212(1)(b)(iii)(E) of the Act are satisfied.
4.Where the foreign branch (purchaser) enters into a reverse repo transaction that is a SLA with a foreign counterparty (seller) and the foreign counterparty receives money as consideration for the use of the securities, paragraph 260(8)(b) of the Act will apply to deem a lending fee to have been paid if the arrangement does not provide for a reasonable lending fee. In our view, a SLA which does not provide for a lending fee will also be subject to paragraph 260(8)(b) of the Act. Under that provision, the deemed lending fee is the difference between interest on the money held, calculated at a prescribed rate, and any amount which is paid or credited to the purchaser by the seller other than as a return of the consideration.
5.Regarding your question on whether the Department considers the bid-offer spread to be acceptable as a reasonable amount deemed to be a lending fee for the purpose of paragraph 260(8)(b) of the Act, we note that this matter falls within the purview of our Audit Directorate. Accordingly, we have forwarded your question to that Directorate for reply.
6.Under paragraph 260(8)(b) of the Act, a reasonable lending fee paid or credited under a SLA is deemed to be a payment of interest. In circumstances where a lending fee is deemed to have been paid, the deemed lending fee is also deemed by paragraph 260(8)(b) of the Act to be a payment of interest. However, for the purposes of Part XIII and any tax convention to which Canada is a party, an amount deemed by paragraph 260(8)(b) to be a payment of interest is deemed not to be payable on or in respect of the underlying security. Accordingly, where a payment of interest on the underlying security would be exempt from Part XIII withholding tax, such treatment will not necessarily apply to the deemed payment of interest under paragraph 260(8)(b) of the Act. However, a non-resident withholding tax exemption may nevertheless be available if the requirements of the particular exemption are otherwise met. We note that based on the broad meaning of “obligation” in clause 212(1)(b)(iii)(E) of the Act, it is possible for that provision to have application to the deemed payment of interest under paragraph 260(8)(b) of the Act.
7.With regard to compensation payments made by a Canadian borrower to a non-resident lender under a SLA, the treatment of such payments will depend, in part, on the extent of collateral provided by the borrower. Under paragraph 260(8)(a) of the Act, where a borrower of a security has throughout the term of the arrangement furnished to the lender money or government debt obligations having at least 95% of the value of the borrowed security and the borrower is entitled to enjoy the benefits of substantially all the income from and opportunity for gain with respect to the money or debt obligations, any payment made by the borrower as compensation for any dividends or interest paid in respect of the security will be treated for the purposes of Part XIII as a payment of dividend or interest, as the case may be, on the security by the borrower to the lender. In any other case, the compensation payment will be deemed to be a payment of interest for the purposes of Part XIII and will, by virtue of the concluding words of subsection 260(8) of the Act, be deemed not be payable on or in respect of the underlying security for the purposes of Part XIII.
8.Where a compensation payment is made by the foreign branch (purchaser) to the foreign counterparty (seller) under a reverse repo arrangement that is a SLA and the compensation payment is deemed to be a payment of interest that is not payable on or in respect of the underlying security pursuant to subsection 260(8) of the Act, it is our view that such payment can qualify for the exemption under clause 212(1)(b)(iii)(E) of the Act. As noted in comment 3 above, it is a factual determination whether the requirements of clause 212(1)(b)(iii)(E) of the Act are met.
9.Where the foreign branch and the foreign counterparty do not deal at arm's length, the rules in section 260 of the Act will not apply to the transactions. Whether or not the two parties are dealing at arm's length is a question of fact.
10.A lending fee involving non-arm's length parties would not be subject to the deeming rules in paragraph 260(8)(b) of the Act. While a determination must be made with regard to the particular facts, it would seem likely that these amounts could not properly be classified as interest for the purposes of the Part XIII tax. Where it does not constitute interest, it is our view that a lending fee paid by the foreign branch (purchaser) to a non-arms' length foreign counterparty (seller) would either be subject to withholding tax pursuant to subparagraph 212(1)(d)(i) of the Act for use of property in Canada or be considered "business profits" of the foreign counterparty for the purposes of the relevant tax treaty if the foreign branch carries on a business in the foreign jurisdiction through a fixed place of business.
11.It is a question of fact as to what provisions of Part XIII would be applicable to amounts that the foreign branch pays to a non-arm's length foreign counterparty as compensation for any interest or dividends that the foreign branch would have received had the securities not been purchased.
Finally, we note that the opinions expressed by us are subject to the relevant treaty provisions that may apply in particular fact situations.
While we trust the foregoing comments are useful they are given in accordance with the practice referred to in paragraph 22 of the IC 70-6R3 and are not binding upon the Department.
Yours truly,
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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