"Tainting" of Non-Participating Interest Under the Canada-US Treaty

A question at the 2019 IFA round table, later released as CRA document no. 2019-0798741C6 (May 15, 2019), provides some helpful clarity. It explains that, under the Canada-US tax treaty, periodic, non-participating interest is not "tainted" by virtue of being paid under an instrument that also provides for participating interest—this is contrary to the treatment under the ITA. Since the treaty generally takes precedence over Canadian domestic law, and the treaty provides the better tax result, taxpayers concerned about the CRA's interpretation of the domestic rule in regard to withholding tax may now be able to take some comfort in the Canada-US context.

Under the ITA, non-arm's-length interest payments to non-residents of Canada are generally not subject to withholding tax, unless the interest paid is "participating debt interest" (defined in subsection 212(3), essentially as interest the amount of which is dependent on the performance of the payer's business).

In ruling 2016-0664041R3 (released May 2, 2018), the CRA considered a debt instrument that featured both periodic, non-participating interest payments ("the periodic interest") and additional payments that could be triggered if the price of a commodity hit a specific price ("the additional amounts"), which were clearly participating debt interest. The CRA ruled that the periodic interest is initially not participating debt interest, but it becomes participating debt interest after the triggering of payment of the first additional amount. This ruling was based on a literal interpretation of the definition of "participating debt interest," which includes "interest . . . that is paid or payable . . . all or any portion of which" has a participating feature. Thus, as soon as an additional payment is triggered (thereby becoming payable), a portion of all the interest payments is participating, which means that all of the interest on the debt (including the periodic interest) is tainted.

At the IFA round table, the CRA was asked whether its view above applies under the Canada-US treaty. Under the treaty, interest payments are generally exempt from withholding tax, but participating interest (as described under article XI(6)(b)) is carved out from this treatment, and is instead subject to the same withholding rate as dividends. The definition of participating interest under the treaty is similar, but not identical, to the definition of participating debt interest under the ITA. Participating interest is described in article XI(6)(b) as

[i]nterest arising in Canada that is determined with reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor to a related person . . .
The CRA responded that the determination of whether an interest payment is captured by article XI(6)(b) "has to be made in respect of each amount of interest paid or credited." Therefore, the triggering of an additional amount that is participating interest would not necessarily taint a subsequent periodic non-participating interest payment. The CRA's rationale appears to be that, unlike subsection 212(3) of the ITA, article XI(6)(b) does not refer to "all or any portion" of the interest.

In other words, it is possible for a debt instrument with both periodic non-participating interest payments and participating interest payments to result in certain interest payments being characterized as participating debt interest for the purposes of the ITA, but not for the purposes of the Canada-US treaty.

Annika Wang
Blake Cassels & Graydon LLP, Toronto

Canadian Tax Focus
Volume 9, Number 3, August 2019
©2019, Canadian Tax Foundation