8 March 2007 Internal T.I. 2006-0214291I7 - Part XIII withholding tax

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: How do we apply Part XIII withholding on the gross-up amount where a loan agreement provides that a borrower is to gross up the interest payments made to a non-resident lender such that the amount received by the non-resident, net of the required Part XIII tax required to be withheld, equals the amount of interest that would have been received by the non-resident if there were no withholding taxes?

Position: For the purposes of Part XIII, the gross-up amount would be considered as an interest.

Reasons: As the gross-up amount is provided for in the loan agreement, the total cost of each interest payment is the stipulated amount of interest paid to the non-resident plus the gross-up amount calculated in respect of the interest payment.

							March 8, 2007

	Kelly Buchsdruecker			HEADQUARTERS
	Edmonton Tax Services Office		Income Tax Rulings
	TL Non Resident Audit	  		Directorate
	3rd Floor Canada Space			Sylvie Labarre
	9700 Jasper Avenue			(613) 957-8953
	Edmonton
							2006-021429

Withholding tax on gross-up amount

We are writing in response to Eric Hammond's electronic message of November 10, 2006 in which he requested our views on the application of the Part XIII withholding tax in the following situation.

A loan agreement provides that a Canadian borrower is to gross up the interest payments to a non-resident lender stipulated in the agreement such that the amount received by the non-resident, net of the required Part XIII tax, equals the amount of interest that would have been received by the non-resident if there were no withholding taxes.

Our comments

When a loan agreement provides for a gross-up of the interest payments, our position is that paragraph 18(1)(t) of the Act does not apply to the gross-up amount and that the gross-up amount may be considered as additional interest for the purpose of paragraph 212(1)(b) of the Act. In the situation described, the amount of the interest payment (hereinafter "the total amount") is the amount of interest paid to the non-resident stipulated in the agreement plus the gross-up amount calculated in respect of the interest payment. The required amount of Part XIII tax payable is calculated on the total amount. In other words, the non-resident lender receives a net amount (i.e. the stipulated interest amount) after the required amount of Part XIII tax has been withheld (and remitted) by the borrower from the total amount of the interest payment pursuant to subsection 215(1) of the Act.

By way of example, let us assume that the interest amount stipulated in the agreement, which must be paid to the non-resident net of Part XIII tax, is equal to $1,000. The total amount would include the initial $1,000, plus the amount of Part XIII tax required on the total amount. Assuming an effective Part XIII withholding rate of 15%, the total amount would be equal to $1,176.44 ($1,176.44 -176.44 (15% of the total amount) = $1,000). Mathematically, the total amount is determined by the following formula:

Total amount of interest  	= 			net interest amount
							_______________________
							(1 minus Effective Withholding Rate)

$1,176.44                       =			$1,000
							______
							.85

To use this formula, the amount of the gross-up must be paid or credited by the Canadian borrower to the non-resident lender.

The same logic would apply to royalty payments where a contract provides for the legal obligation to gross-up the amount of royalty paid to the non-resident so the non-resident receives a net amount equal to the gross amount of royalty.

However, our position would be different where the loan agreement (or a royalty agreement, as the case may be) between a Canadian and a non-resident does not provide for the payment of the gross-up amount to the non-resident and the Canadian borrower only has an obligation to pay to the non-resident the interest amount net of the Part XIII withholding. In such a case, the Canadian would have to withhold and remit the correct amount of Part XIII tax from the initial payment of interest (or royalty) as required in accordance with paragraph 212(1)(b) and subsection 215(1) of the Act. If the Canadian failed to withhold the Part XIII tax from the interest paid to the non-resident and has to pay, pursuant to subsection 215(6) of the Act, the amount of tax payable by the non-resident, the amount of tax that the Canadian did not recover from the non-resident would not be a deductible outlay pursuant to paragraph 18(1)(t) of the Act. The amount could not be considered as a payment of interest (or as a royalty, as the case may be) for the purpose of Part I and Part XIII. If the non-resident is a shareholder of the Canadian payor, the payment of the shareholder's tax would have been a subsection 15(1) benefit to the shareholder if Part I were applicable. Consequently, it is deemed to be a dividend under subsection 214(3) of the Act (dividend which is subject to withholding tax pursuant to subsection 212(2) of the Act). In other situations, even though the payment of the Part XIII tax was made with the concurrence of the non-resident and for the benefit of the non-resident, it would not be possible to say that the payment of the Part XIII tax would be included in the income of the non-resident if Part I were applicable (condition for the application of subsection 56(2) of the Act). Therefore, in those situations, paragraph 214(3)(a) would not be applicable.

We trust that our comments will be of assistance.

Yours truly

Alain Godin
Section Manager
For Division Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch