Equipment Finance in Canada: Changes to the Income Tax Act May Have an Impact

The most common exceptions to avoid the requirement to remit withholding tax utilized in equipment finance transactions was the so-called '5/25' rule, whereby if no more than 25% of the principal amount is repaid in the first five years of the loan and a few other conditions are satisfied, then the interest payment would not be subject to withholding. The other major exception was entering into purchase money finance obligations.

The 5/25 exception tended to be used to finance assets that had a relatively long useful life or where the credit quality of the borrower was relatively strong. Further, as there were significant structuring and transaction costs, these transactions tended to be large in dollar value and were used mostly by larger institutions. The purchase money finance obligation exception, which really was a financing of conditional sales agreements, was only available if certain specific conditions existed where the equipment was sourced out of the United States and the vendor of the equipment was willing to cooperate in the financing. Accordingly it was utilized in a relatively limited market.

Proposed Changes in Budget And Timetable

The Budget proposes to eliminate withholding tax on interest payments to U.S. arm's length parties. Currently, the timetable seems to be 2008 ' 2009. The Budget always proposes to provide Treaty benefits to limited liability companies within the same time frame.

What did not change in the Budget are:

1) Lease payments will continue to be subject to withholding tax. There is currently no legislation being proposed that will eliminate withholding tax in this environment; and

2) The rules with respect to whether a U.S. entity will be carrying on business in Canada and having a permanent establishment have not been amended. As will be discussed below, this is probably a significant limiting factor in the broad implementation of the impact of the change in the Budget.

Analysis of Impact: Framework

Oversimplified, there are three types of U.S. lenders: 1) those who are more global in stature and have offices throughout the world, 2) those that are mainly national in scope, and 3) a hybrid of the two. For those global lenders, the establishment or non-establishment of a Canadian office is really one more of corporate policy and general strategic planning. They will either enter or not enter a market based on an overall global strategy. We will call them Type 1 lenders, but this is not the focus of this discussion.

The second type of U.S. financier, Type 2 lenders, are those that have active U.S. businesses with mostly U.S. borrowers, who often have operations in other countries. These U.S. finance companies wish to be able to provide as many services to their existing client base as possible but do not have the aspiration to be an international lender. They tend to be regional banks and smaller to mid-market commercial finance companies. The hybrid lenders, which we will call Type 3 lenders, are emerging finance companies that are recognizing that in order to continue growth they must establish operations in foreign countries but do not yet have the scope and/or business plan to establish such operations. These tend to be larger regional banks (usually in more than one U.S. region) and multi-state commercial finance companies.

A typical request to for a Type 2 or Type 3 U.S. financier is that one of its current clients have either: 1) a Canadian subsidiary ('Canco Sub') or 2) an existing vendor program finance program ('U.S. Vendor') with the bank and desire to expand that into Canada. In each of these cases, the U.S. client requires a finance partner who will either lend to the subsidiary in the case of the Canco Sub or finance the sale of the equipment in the case the of the U.S. Vendor Program.

Prior to the introduction of the proposal under the Budget, the options available for a U.S. lender to finance directly to Canco Sub were limited, as typically neither the Canadian borrower nor the U.S. lender would be willing to pay for the withholding tax. Typically, in these situations the U.S. lender would advance the money directly to the U.S. borrower and obtain a Canadian guarantee, which guarantee would provide for, among other things, gross-up language in the event of a default. The U.S. borrower would then have to structure an inter-company loan to its Canadian subsidiary. While not ideal, these structures have worked in the past but may have had certain accounting and tax issues not related to the lending of money.

The U.S. vendor structure was more problematic unless the transaction could be structured as a conditional sales agreement in order to use the Treaty Exemption for a purchase money finance obligation. The other options were: 1) to find a Canadian finance source who would fund this particular deal. This also was problematic as the U.S. finance companies did not like exposing their client to other funding sources; or 2) to structure the transaction as a 5/25 structure, but this often did not provide sufficient collateral coverage for short-term assets. It would require that the borrower have a stronger credit profile, as the lender would likely be under-secured for a portion of the debt.

Regulatory and Tax Overview

In addition to the withholding tax issue, a U.S. lender is also concerned that its overall tax position not be negatively impacted. A U.S. lender would likely be unwilling to enter into Canadian transactions if its U.S. operation were to become subject to Canadian tax. Generally, and vastly oversimplifying, if a U.S. entity was determined to have a permanent establishment or 'P.E.' in Canada, then it would be subject to tax in Canada on all of its worldwide income. The rules as to what constitutes having a permanent establishment are complex; but again oversimplified, if a U.S. lender were simply to undertake the odd one-off transaction with a Canadian borrower where it did not solicit the Canadian borrower's business in Canada, then it would be unlikely to be deemed as having established a PE. On the other extreme, if the U.S. lender had employees in Canada and was actively soliciting business in Canada, then it would be deemed to have a PE in Canada. Needless to say, most companies fall somewhere in between the spectrum of these two examples.

From a regulatory concern, the PE rules are more significant for a bank. If the U.S. lender is a 'bank' in the United States and is seen as transacting business in Canada, it must ensure that it does not have a permanent establishment for purposes of the Bank Act as otherwise it would be subject to the Canadian banking regulatory environment. Complying with Canadian banking regulations is both complex and expensive. Clearly, it would not be desirable unless there is a systematic plan on entering into Canada. The rules as to what is a PE are different than those for tax, but similar.

The key factors in establishing if there is a PE will be the method the transaction was made known to the lender and what, if any, operations the U.S. lender has in Canada. If we are correct in our assumption that a U.S. lender does not wish to be subject to Canadian tax law on its worldwide income and, in cases of banks, does not wish to obtain approval of regulatory authorities, then any cross-border transaction will need to be structured to ensure a PE is not established. This will be a limiting factor in the number of entities that can take advantage of the new rules.

A Type 2 or Type 3 lender will not be able to establish a sales force in Canada but will be able to finance deals that its clients present to it. Previously, these lenders would have to lose these transactions or structure them with greater risk. Under the Budget proposal, the lender can enter into the transaction directly. This should increase competition. Limiting this factor is that these lenders who are not currently in the market will not want to expand such that they have a PE unless the business model justifies. It will likely mean many more one-off transactions cross-border particularly for the smaller transactions but not a significant change in dollar value. A possible result is it will allow Type 3 lenders to establish enough of a base in Canada to justify the establishment of a subsidiary who would then enter the market and create competition. For the regulatory purpose set out above, this will be more likely for commercial finance non-banks than banks.

The other change, and much less controversial, is that a lender will no longer structure deals using a 5/25 payout and utilize normal credit analysis which is not driven by tax planning. This could have a negative impact on Canadian companies as their cash flow may be impeded by having to pay principal amounts back faster. On a competitive side, it should provide for more U.S. lenders to undertake Canadian transactions as the risk may be lower as the collateral could more easily match the risk profile. Further, transaction costs will be greatly reduced. This likely will result in enhanced competition and lower rates. To the extent that these transactions tended to be large, they were undertaken by Type 1 lenders and, as such, there may not be more entrants to the market. As noted above, there will be more competition from smaller lenders and on smaller transactions.

Summary of Expected Changes

Based on the foregoing, it appears that the removal of the withholding tax on interest payments will enhance the Type 2 lender who would otherwise be forced out of the market on smaller debt or debt-like equipment financing to Canadian companies. This is most likely to occur where there are relatively small finance companies that have had to avoid these transactions in the past owing to the cost of the transactions. It is these small finance companies that will be able to provide a new product to their existing client base to assist in their client's Canadian expansion. This should increase finance activity between the two markets and, as such, lower costs.

Limiting this growth will be a concern of setting up a permanent establishment in Canada. It is unlikely that any of these companies will desire to run the risk of having a permanent establishment in Canada for these relatively unusual transactions and, as such, while there should be an increase in the number of transactions cross-border, it is unlikely that it will be a significant change. It is anticipated that the greatest growth will come from the small and medium finance companies, as they will be able to expand the products that they are able to provide to their clients.

Jonathan E. Fleisher is a partner of the Toronto-based firm of Cassels Brock & Blackwell LLP. He writes extensively about leasing issues in Canada and sends out e-mail updates on new legal issues in the Canadian leasing environment. He may be reached at [email protected] or 416-860-6596. Andrew M. Reback, also an attorney with Cassels Brock & Blackwell LLP, specializes in tax law and has extensive experience in mergers and acquisitions/divestitures, domestic and international tax planning, corporate reorganizations, public offerings, and financings. He may be reached at 416-860-2980 or [email protected].

Canada's conservative minority government recently passed its 2007 Financial Budget (the 'Budget'), which will likely impact the equipment finance industry and particularly cross-border (U.S./Canada) transactions. Central to the Budget was the proposal to eliminate withholding tax on interest payments on loan transactions. As will be discussed below, the likely impact will be that traditional cross-border transactions will be restructured to: 1) provide for quicker repayment of the principal portion of the loan, and 2) provide a means for a greater number of less internationally focused commercial banks and finance companies to undertake cross-border transactions which, prior to the enactment of the new legislation, would have be seen as too complex. This second impact may cause a more competitive environment and further add liquidity to any already liquid market. It is not clear, however, that the proposed legislation will have a significant impact on larger transactions or the activities of internationally focused lenders. While there will likely be enhanced competition for smaller straightforward transactions than currently exists, the market for complex large transactions, while restructured, will have the same level of competition as currently exists.

Background

Under the existing Income Tax Act Canada (the 'Act') and Canadian/ U.S. Tax Treaty (the 'Treaty') and subject to certain specific exceptions, any payment of interest by a Canadian company to a U.S. lender that is not an authorized foreign bank as defined by the Act, will be subject to the borrower withholding a portion (10%) (Reduced from 25% by the operation of the Canada/U.S. Tax Treaty so long as the lender is not a limited liability company; however, this may soon change) of the interest payment and delivering this withheld amount to the Canadian Government on behalf of taxes to be paid by the U.S. lender. In cases of equipment lease payments, the amount to be withheld is 10% of the entire lease payment (25% if the lessor is a limited liability company). This will not be changed by the proposed changes. Generally speaking, the U.S. lender would require the Canadian borrower to gross-up the amount of the repayment such that the actual dollar amount received by the U.S. lender would be the same absent the withholding tax. Clearly, these structures would make a U.S. lender less competitive than its Canadian counterpart. In order to avoid these non-competitive situations, international-oriented U.S. lenders set up cross-border subsidiaries in Canada or utilized some of the exemptions under the Act/Treaty.

The most common exceptions to avoid the requirement to remit withholding tax utilized in equipment finance transactions was the so-called '5/25' rule, whereby if no more than 25% of the principal amount is repaid in the first five years of the loan and a few other conditions are satisfied, then the interest payment would not be subject to withholding. The other major exception was entering into purchase money finance obligations.

The 5/25 exception tended to be used to finance assets that had a relatively long useful life or where the credit quality of the borrower was relatively strong. Further, as there were significant structuring and transaction costs, these transactions tended to be large in dollar value and were used mostly by larger institutions. The purchase money finance obligation exception, which really was a financing of conditional sales agreements, was only available if certain specific conditions existed where the equipment was sourced out of the United States and the vendor of the equipment was willing to cooperate in the financing. Accordingly it was utilized in a relatively limited market.

Proposed Changes in Budget And Timetable

The Budget proposes to eliminate withholding tax on interest payments to U.S. arm's length parties. Currently, the timetable seems to be 2008 ' 2009. The Budget always proposes to provide Treaty benefits to limited liability companies within the same time frame.

What did not change in the Budget are:

1) Lease payments will continue to be subject to withholding tax. There is currently no legislation being proposed that will eliminate withholding tax in this environment; and

2) The rules with respect to whether a U.S. entity will be carrying on business in Canada and having a permanent establishment have not been amended. As will be discussed below, this is probably a significant limiting factor in the broad implementation of the impact of the change in the Budget.

Analysis of Impact: Framework

Oversimplified, there are three types of U.S. lenders: 1) those who are more global in stature and have offices throughout the world, 2) those that are mainly national in scope, and 3) a hybrid of the two. For those global lenders, the establishment or non-establishment of a Canadian office is really one more of corporate policy and general strategic planning. They will either enter or not enter a market based on an overall global strategy. We will call them Type 1 lenders, but this is not the focus of this discussion.

The second type of U.S. financier, Type 2 lenders, are those that have active U.S. businesses with mostly U.S. borrowers, who often have operations in other countries. These U.S. finance companies wish to be able to provide as many services to their existing client base as possible but do not have the aspiration to be an international lender. They tend to be regional banks and smaller to mid-market commercial finance companies. The hybrid lenders, which we will call Type 3 lenders, are emerging finance companies that are recognizing that in order to continue growth they must establish operations in foreign countries but do not yet have the scope and/or business plan to establish such operations. These tend to be larger regional banks (usually in more than one U.S. region) and multi-state commercial finance companies.

A typical request to for a Type 2 or Type 3 U.S. financier is that one of its current clients have either: 1) a Canadian subsidiary ('Canco Sub') or 2) an existing vendor program finance program ('U.S. Vendor') with the bank and desire to expand that into Canada. In each of these cases, the U.S. client requires a finance partner who will either lend to the subsidiary in the case of the Canco Sub or finance the sale of the equipment in the case the of the U.S. Vendor Program.

Prior to the introduction of the proposal under the Budget, the options available for a U.S. lender to finance directly to Canco Sub were limited, as typically neither the Canadian borrower nor the U.S. lender would be willing to pay for the withholding tax. Typically, in these situations the U.S. lender would advance the money directly to the U.S. borrower and obtain a Canadian guarantee, which guarantee would provide for, among other things, gross-up language in the event of a default. The U.S. borrower would then have to structure an inter-company loan to its Canadian subsidiary. While not ideal, these structures have worked in the past but may have had certain accounting and tax issues not related to the lending of money.

The U.S. vendor structure was more problematic unless the transaction could be structured as a conditional sales agreement in order to use the Treaty Exemption for a purchase money finance obligation. The other options were: 1) to find a Canadian finance source who would fund this particular deal. This also was problematic as the U.S. finance companies did not like exposing their client to other funding sources; or 2) to structure the transaction as a 5/25 structure, but this often did not provide sufficient collateral coverage for short-term assets. It would require that the borrower have a stronger credit profile, as the lender would likely be under-secured for a portion of the debt.

Regulatory and Tax Overview

In addition to the withholding tax issue, a U.S. lender is also concerned that its overall tax position not be negatively impacted. A U.S. lender would likely be unwilling to enter into Canadian transactions if its U.S. operation were to become subject to Canadian tax. Generally, and vastly oversimplifying, if a U.S. entity was determined to have a permanent establishment or 'P.E.' in Canada, then it would be subject to tax in Canada on all of its worldwide income. The rules as to what constitutes having a permanent establishment are complex; but again oversimplified, if a U.S. lender were simply to undertake the odd one-off transaction with a Canadian borrower where it did not solicit the Canadian borrower's business in Canada, then it would be unlikely to be deemed as having established a PE. On the other extreme, if the U.S. lender had employees in Canada and was actively soliciting business in Canada, then it would be deemed to have a PE in Canada. Needless to say, most companies fall somewhere in between the spectrum of these two examples.

From a regulatory concern, the PE rules are more significant for a bank. If the U.S. lender is a 'bank' in the United States and is seen as transacting business in Canada, it must ensure that it does not have a permanent establishment for purposes of the Bank Act as otherwise it would be subject to the Canadian banking regulatory environment. Complying with Canadian banking regulations is both complex and expensive. Clearly, it would not be desirable unless there is a systematic plan on entering into Canada. The rules as to what is a PE are different than those for tax, but similar.

The key factors in establishing if there is a PE will be the method the transaction was made known to the lender and what, if any, operations the U.S. lender has in Canada. If we are correct in our assumption that a U.S. lender does not wish to be subject to Canadian tax law on its worldwide income and, in cases of banks, does not wish to obtain approval of regulatory authorities, then any cross-border transaction will need to be structured to ensure a PE is not established. This will be a limiting factor in the number of entities that can take advantage of the new rules.

A Type 2 or Type 3 lender will not be able to establish a sales force in Canada but will be able to finance deals that its clients present to it. Previously, these lenders would have to lose these transactions or structure them with greater risk. Under the Budget proposal, the lender can enter into the transaction directly. This should increase competition. Limiting this factor is that these lenders who are not currently in the market will not want to expand such that they have a PE unless the business model justifies. It will likely mean many more one-off transactions cross-border particularly for the smaller transactions but not a significant change in dollar value. A possible result is it will allow Type 3 lenders to establish enough of a base in Canada to justify the establishment of a subsidiary who would then enter the market and create competition. For the regulatory purpose set out above, this will be more likely for commercial finance non-banks than banks.

The other change, and much less controversial, is that a lender will no longer structure deals using a 5/25 payout and utilize normal credit analysis which is not driven by tax planning. This could have a negative impact on Canadian companies as their cash flow may be impeded by having to pay principal amounts back faster. On a competitive side, it should provide for more U.S. lenders to undertake Canadian transactions as the risk may be lower as the collateral could more easily match the risk profile. Further, transaction costs will be greatly reduced. This likely will result in enhanced competition and lower rates. To the extent that these transactions tended to be large, they were undertaken by Type 1 lenders and, as such, there may not be more entrants to the market. As noted above, there will be more competition from smaller lenders and on smaller transactions.

Summary of Expected Changes

Based on the foregoing, it appears that the removal of the withholding tax on interest payments will enhance the Type 2 lender who would otherwise be forced out of the market on smaller debt or debt-like equipment financing to Canadian companies. This is most likely to occur where there are relatively small finance companies that have had to avoid these transactions in the past owing to the cost of the transactions. It is these small finance companies that will be able to provide a new product to their existing client base to assist in their client's Canadian expansion. This should increase finance activity between the two markets and, as such, lower costs.

Limiting this growth will be a concern of setting up a permanent establishment in Canada. It is unlikely that any of these companies will desire to run the risk of having a permanent establishment in Canada for these relatively unusual transactions and, as such, while there should be an increase in the number of transactions cross-border, it is unlikely that it will be a significant change. It is anticipated that the greatest growth will come from the small and medium finance companies, as they will be able to expand the products that they are able to provide to their clients.

Jonathan E. Fleisher is a partner of the Toronto-based firm of Cassels Brock & Blackwell LLP. He writes extensively about leasing issues in Canada and sends out e-mail updates on new legal issues in the Canadian leasing environment. He may be reached at [email protected] or 416-860-6596. Andrew M. Reback, also an attorney with Cassels Brock & Blackwell LLP, specializes in tax law and has extensive experience in mergers and acquisitions/divestitures, domestic and international tax planning, corporate reorganizations, public offerings, and financings. He may be reached at 416-860-2980 or [email protected].