Tax Structuring Opportunities Through Canada and Luxembourg
By Robert Worthington, Shea Nerland Calnan LLP
A recent ruling from the Canada Revenue Agency (CRA) has approved a financing structure that creates substantial tax benefits. The tax plan utilizes a hybrid instrument issued by a Luxembourg entity. It also relies on Canada's tax system which may allow for repatriation of income of foreign affliates on a tax-free basis. This planning may benefit not only Canadian companies, but also non-Canadian companies that structure through Canada and Luxembourg.
Luxembourg is a leading jurisdiction in creating innovative financing structures. The "double dip" strategy described below effectively results in tax deductions in two or more countries in connection with interest expenses on the same economic debt. Although tax authorities and the OECD often disparage tax planning that entails so-called "double non-taxation", the CRA ruled favourably on this particular structure. The facts in CRA ruling 2012-0452291R3 are complex, but the following is a simplification of the relevant transactions. A Canadian corporation (Canco) is partly owned by a non-Canadian corporation (Forco). "Opco" is a foreign affliate of Canco that carries on business in a country that has a treaty with Canada. Generally, a "foreign affliate" is a corporation in which the Canadian taxpayer has at least a 10% equity interest. As shown in the diagram, Canco invests in mandatory redeemable preferred shares (MRPSs) of "Finco", a corporate entity resident in Luxembourg.
Finco makes an interest-bearing loan (Loan 1) to a foreign affliate of Canco (FA 1). FA 1 then makes an interest-bearing loan (Loan 2) to another foreign affiliate of Canco (FA 2). FA 2 uses the proceeds of Loan 2 to acquire shares of Opco and to make an interest-bearing loan (Loan 3) to Opco.
The MRPSs have attributes of both debt and equity. They have a mandatory redemption at a specified date, are also redeemable at the holder's option, are subordinated to debt, are not entitled to dividends, have voting rights, and are convertible to common shares of Finco. The MRPSs are considered debt for Luxembourg tax purposes but equity for accounting purposes. The CRA ruling has three important components. First, interest paid on Loan 1 and Loan 3 are recharacterized as active business income under Canada's foreign affliate rules and added to "exempt surplus". Second, distributions paid by Finco on the MRPSs are considered dividends for Canadian taxpayers. Third, these "dividends" are effectively exempt from Canadian tax under the exempt surplus rules.
The ruling that interest on the loans is re-characterized as active business income is key. This is because interest income earned by a controlled foreign affiliate of a Canadian taxpayer is normally taxable on an accrual basis, subject to deductions to recognize any foreign tax paid. In addition, interest income is not normally added to exempt surplus. Consequently, dividends paid to a Canadian corporation that are sourced in interest income of a foreign affliate are not exempt, but are only entitled to a deduction recognizing any foreign income tax paid. On the other hand, where a foreign affliate's income is sourced in an active business, dividends paid to the Canadian corporation are generally exempt, provided that the business is carried on in a country with which Canada has a tax treaty or tax information exchange agreement.
In certain instances, however, interest income can be re-characterized as active business income and included in exempt surplus. In general terms, interest income earned by one foreign affiliate on money lent to another foreign affiliate can be treated as active business income and added to exempt surplus if the second foreign affliate uses the borrowed money in its active business. Accordingly, the CRA ruled that the interest income on Loan 1 and Loan 3 would be re-characterized as active business income.
As a result of re-characterization of the interest income, when Finco pays a distribution to Canco it is considered an exempt surplus dividend. This goes to the heart of the hybrid nature of the MRPSs. As mentioned, an MRPS is treated as debt for Luxembourg tax purposes. If the CRA followed the Luxembourg tax treatment and considered the MRPSs debt for Canadian tax purposes, distributions from Finco would not be considered dividends, and therefore Canco would have taxable interest income instead of exempt dividends.
The CRA also ruled in favour of the taxpayer regarding the non-application of several specific anti-avoidance rules and the general anti-avoidance rule.
The tax benefits of a structure such as this are substantial. Assuming Opco is in a high-tax jurisdiction, it may obtain deductions on interest it pays to FA 2 on Loan 3, subject to thin capitalization restrictions or other vitiating tax rules. Dividends paid to Canco by Finco and FA 1 to Cancoare fully deductible in Canada. For Luxembourg tax purposes, distributions on the MRPSs should be treated as deductible interest payments and not subject to withholding tax, whereas dividends distributions would be subject to a 5% withholding. Finally, although not dealt with in the ruling, Canco or Forco may be leveraged with external debt, potentially creating additional interest deductions. In sum, this structure potentially allows for interest deductions in three countries in respect of the same economic debt.
The CRA ruling is a very welcomed clarification for businesses that route internal financing through Canada and Luxembourg. Although the ruling is only binding with respect to the taxpayer who requested the ruling, it is indicative of a business-friendly stance on the MRPS financing structure.
Robert R. Worthington
Shea Nerland Calnan LLP, Calgary, Canada
published: July 2013