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Cross-border Financing

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  1. FROM PRINCIPLES TO PLANNING Cross-border Financing

  2. Cross-border Financing Knox Teague, Dixon Hughes Goodman LLP Tim Bloos, MNP LLP Mark Pearlman, MNP LLP

  3. Inbound Financing to the U.S.: Considerations Knox Teague, Dixon Hughes Goodman LLP

  4. Earnings Stripping Debt / Equity Withholding Tax U.S. Inbound Financing Considerations

  5. Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) Who is Subject to Earnings Stripping A U.S. company, or A foreign company with a U.S. branch that pays or accrues interest expense: Deducts interest expense paid or accrued to a related person if no U.S. income tax (or reduced U.S. income tax) is imposed with respect to such interest, OR Paid or accrued to an unrelated person if (a) no gross basis U.S. tax is imposed with respect to such interest, and (b) there is any guarantee by a related person which is either foreign or a tax exempt organization U.S. Inbound Financing Considerations

  6. Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) Earnings Stripping General Rule: Statute IF Taxpayer pays disqualified interest Net interest expense exceeds 50% of adjusted taxable income plus any excess limitation carry forward and The debt to equity ratio is > 1.5 to 1 THEN Some portion of disqualified interest disallowed and treated as paid next year U.S. Inbound Financing Considerations

  7. Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) Disallowed Interest Expense Can be indefinitely carried forward Can be deducted to the extent of “excess limitation” in future years Excess Limitation 50% of ATI minus net interest expense Can be carried forward (and added to current year limitation) for three succeeding years U.S. Inbound Financing Considerations

  8. Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) Proposed regulations “Exempt related person interest expense” is “Disallowed interest expense” to the extent that it does not exceed “Excess interest expense” Proposed regulations predate 1993 enactment of disallowance for unrelated person interest guaranteed by a related foreign or exempt person U.S. Inbound Financing Considerations

  9. Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) Key Definitions Exempt related person interest expense Related party Tax-exempt interest Debt-equity ratio Debt Equity Excess Interest Expense (EIE) Net Interest Expense (NIE) Adjusted Taxable Income (ATI) Excess limitation Guarantee U.S. Inbound Financing Considerations

  10. IRC § 163(j) – Key Technical Differences – Affiliated Group Rules U.S. Inbound Financing Considerations Earning Stripping and Form 8926: Technical Rules IRC § 163 (j) • FCois not an includible corporation under IRC §1504(b)(3). Thus, US1 and US2 are not members of an affiliated group under IRC §1504(a) • US1 and US2 are treated as affiliated corporations under Prop. Reg. §1.163(j)-5(a)(3). Under IRC §318(a)(3)(C) US1 and US2 are treated as owning indirectly 100% of each other FCo US1 US2 US3

  11. Section 385 Debt or Equity The regulations prescribed under this section shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. The factors so set forth in the regulations may include among other factors (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest, (2) whether there is subordination to or preference over any indebtedness of the corporation, (3) the ratio of debt to equity of the corporation, (4) whether there is convertibility into the stock of the corporation, and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question. U.S. Inbound Financing Considerations

  12. Section 385 Debt or Equity Judicial guidance MIXON, JR., EST. OF v. U.S., 30 AFTR 2d 72-5094, 07/05/1972. “Mixon factors” Laidlaw Transportation Inc., et al. v. Commissioner, TC Memo 1998-232. Intent of parties, etc. U.S. Inbound Financing Considerations

  13. US Withholding Tax Certain income received by foreign persons is subject to US gross basis taxation. The income must be: Fixed, determinable, annual or periodic (“FDAP”) US source If these conditions are met, the income will generally be subject to withholding under IRC Sections 1441 or 1442 (generally at a 30% rate) The withholding rate can be reduced or eliminated based on an applicable tax treaty or Code section (e.g., portfolio interest exception) FDAP includes interest US compliance requirements U.S. Inbound Financing Considerations

  14. Financing U.S. Operations/Acquisitions by Canadian MNCs Tim Bloos, MNP LLP

  15. “Double Dip” Financing Strategy Canco has wholly-owned Opco in the US that carries on active business Opco requires capital in order to finance operations/expansion/acquisition Canco borrows to capitalize a newly formed Finco which makes a loan to Opco Opco uses the funds from the loan in its active business and pays interest to Finco which it deducts from its active business earnings Earnings of Finco from the interest are exempt surplus earnings and may be repatriated to Canco by way of dividend without any incremental taxation at the Canadian corporate level. Ideally, there should be no withholding tax on the dividends paid to Canco. Canco makes interest payments to a third party lender and takes an interest deduction against its earnings. Financing U.S. Operations of Canadian MNCs

  16. Canadian Tax Issues Interest Deductibility Borrowing for purpose of earning income both at the Canco level and at the Opco level Section 17 interest imputation rules Anti-avoidance rule ensures inclusion in income certain amounts or loans owing by non-residents to Canadian corps that are outstanding for one year or longer Exception: Debts owed by CFA in course of active business Financing U.S. Operations of Canadian MNCs

  17. Canadian Tax Issues (cont’d) Character of financing arrangement Must qualify as a foreign affiliate (FA) and a controlled FA (CFA) Interest income earned by Fincorecharacterized as active business income under recharacterization rules of Canadian foreign affiliate rules Direct Lending Acquisition Financing Finco and Opco must both be resident in a designated treaty country Opco should be able to deduct the interest paid on the Finco loan against its active business earnings Interest income earned by Finco is taxed at a low effective rate Anti-avoidance Ss. 95(6)(b) should not apply as long as the financing involved is new financing Financing U.S. Operations of Canadian MNCs

  18. 1. Preferred Share (Repo) Financing Arrangement Application: For Canadian-based external financing Structure: Transaction has different treatment between Canada - U.S. Profile: Companies with $10m or more in financing requirements Maintenance: Annual maintenance costs relatively low Main Risk Areas: Legal and tax treatment of transactions Legislative change Level of Complexity: High General Acceptance: Disclosed in a number of public prospectuses Unwind: Relatively easy Financing U.S. Operations of Canadian MNCs

  19. Financing U.S. Operations of Canadian MNCs • Preferred Share (Repo) Financing Arrangement (cont’d) Third party borrowing Canco DEDUCTION Sale and repurchase Finco Opco DEDUCTION Preferred Shares

  20. Preferred Share (Repo) Financing Arrangement (cont’d) Results (U.S.) Transaction based on substance as a borrowing secured by a pledge of the preferred shares Interest deduction in the U.S. No withholding tax under treaty on interest payments to Canco (Canada) Transaction based on form as a subscription for preferred shares by Canco funded from borrowed money Interest deduction in Canada Payments from U.S. received as dividends exempt from tax to Canco Financing U.S. Operations of Canadian MNCs

  21. Preferred Share (Repo) Financing Arrangement (cont’d) (U.S.) Characterization of transaction as collateralized debt Locked in termination date Provision for “stated interest” (Canada) Must establish beneficial ownership of the preferred shares Fully U.S.-Canadian income tax treaty compliant No disregarded entities No contingent interest in the structure Financing U.S. Operations of Canadian MNCs

  22. 2. Tower Financing Structure Application: For third party U.S. or Canadian lender Structure: Use of multiple hybrid entities Profile: Companies with US$40 million or more in financing requirements Maintenance: Low to moderate Main Risk Areas: Legislative changes (hybrid entities) Treaty changes (hybrid entities) Level of Complexity: High Acceptance: Fairly commonly used for large financings Unwind: Complex Financing U.S. Operations of Canadian MNCs

  23. Financing U.S. Operations of Canadian MNCs • Tower Financing Structure (cont’d) Canco Interest Deduction Cansub USLP Third Party Debt US Holdco NSULC Interest Deduction US LLC US Opco Loan

  24. Tower Financing Structure (cont’d) Interest deduction in Canada and the U.S. in respect of the same borrowing. No Canadian or U.S. withholding tax on the interest paid by USLP if the borrowing is from an unrelated US or Canadian lender under the U.S.-Canada income tax treaty. U.S. tax paid on net income of USLP U.S. withholding tax on dividends paid by USLP. (No Treaty – “Hybrid Issue”) Financing U.S. Operations of Canadian MNCs

  25. Tower Financing Structure (cont’d) Level of equity funding for USLP (thin cap) Potential application of Section 894 DRHE rules if Plantation Patterns treats Canco as the “true obligor” of third party debt Potential for check-the-box reform and whether the use of a NSULC that is a DRE is an abusive structure Financing U.S. Operations of Canadian MNCs

  26. 3. Treaty-based Finance Structure - Luxembourg Application: For third party Canadian or internal borrowings Structure: Use of foreign financing intermediary (Luxembourg, Netherlands, etc.) Profile: Companies with US$20 million or more in financing requirements Maintenance: Annual costs can be relatively high Main Risk Areas: Treaty changes (US-Luxembourg treaty) Level of Complexity: High Acceptance: Commonly accepted and well understood. Unwind: Relatively easy Financing U.S. Operations of Canadian MNCs

  27. Financing U.S. Operations of Canadian MNCs • Luxembourg Finance Intermediary Loan (Bank) Interest Deduction Canco Capital US Holdco Can Holdco Financing Arrangement Interest Deduction US Opco Lux FinanceCo Loan

  28. Luxembourg Finance Intermediary (cont’d) Canco borrows to capitalize the Financing Arrangement Financing Arrangement CAN Holdco uses capital from Canco to either: Make an interest free loan to LuxFinanceCo; or Capitalize Lux Finance Co. with equity using special preferred shares. Notional Interest deduction in Lux reduces tax base in Lux so that effective tax rate is between 1-2% on interest income from US Opco Financing U.S. Operations of Canadian MNCs

  29. Luxembourg Finance Intermediary – Risks and Issues Canada Interest deductibility Application of CFC rules Characterization of Financing Arrangement US Anti –conduct financing rules Substance over from rulings on debt characterization Application of derivative benefits clause in US-Lux treaty Interest stripping rules Economic substance tests Characterization of Financing Arrangement Luxembourg Application of Notional interest deduction (ruling) Transfer pricing on interest rate differential Financing U.S. Operations of Canadian MNCs

  30. Outbound Financing from the U.S.

  31. Financing Canadian Operations/Acquisitions of U.S. MNCs Mark Pearlman, MNP LLP Tim Bloos, MNP LLP

  32. Canadian Tax Issues Application of treaty Withholding tax on interest Nil, if treaty protected, otherwise 25% Thin capitalization Deemed dividends Foreign Affiliate Dumping Provisions Unpaid amounts Deemed year ends Paid up capital Financing Canadian Operations of U.S. MNCs

  33. Financing Canadian Operations of U.S. MNCs • Thin Capitalization • Ratio changed from 1.5:1 for fiscal periods beginning after 2012 • Expanded to include partnerships for fiscal periods beginning after March 29, 2012 • Disallowed interest will be treated as dividend triggering withholding tax for years after March 28, 2012

  34. Thin Capitalization (cont’d) 1.5:1 Debt to Equity Debt Debt to related non-resident parties (at least 25% votes or value or right to obtain share or redeem share to get to that level) Debt needs to be interest-bearing Average of highest balance in each month Financing Canadian Operations of U.S. MNCs

  35. Thin Capitalization (cont’d) 1.5:1 Debt to Equity Equity Retained earnings (do not deduct deficits); plus Average of opening monthly contributed surplus contributed by non-resident; plus Average of opening paid-up capital of shares owned by non-resident Financing Canadian Operations of U.S. MNCs

  36. Financing Canadian Operations of U.S. MNCs • Thin Capitalization (cont’d) • Partnership • Debt obligation owed by a partnership with a Canadian Resident Corp member to a specified non-resident now captured • Allocation done pro rata to their partnership interest • Now applies to Branches too

  37. Deemed Dividends Loans from Canadian sub to U.S. parent cannot be on 2 balance sheets If not repaid treated as a deemed dividend Withholding due Can make an election to have loan remain outstanding Interest rate needs to be at least 4% higher than treasury bill rate, currently 1% Election can not be changed Loan by Loan Basis Financing Canadian Operations of U.S. MNCs

  38. Unpaid Amounts Applies to deductible amounts accrued to non arms length parties and not paid If on three balance sheets must be added back Can make an election to treat it as paid May trigger withholding tax Financing Canadian Operations of U.S. MNCs

  39. Deemed Year Ends On acquisition of control On amalgamations On signing of letter of intent if target is Canadian- controlled Private Corp (CCPC) and will lose status Financing Canadian Operations of U.S. MNCs

  40. Paid up Capital Similar to share capital Relates to amount paid to company for the issuance of shares Determined on a class by class basis PUC of a share = PUC of the class__ # Shares of the class Treated effectively in Canada as a non interest bearing loan Can be repatriated at any time with no withholding tax implications PUC part of equity for Thin Cap Calc. Denomination is # of shares of the class Financing Canadian Operations of U.S. MNCs

  41. Financing Canadian Operations of U.S. MNCs Double Dip-Hybrid Instrument • U.S. Company uses 3rd party debt to make a loan to Canco 3rd Party debt U.S. Co. Support agreement 100 % Loan 100 % ULC Forward Canadian Co. Subscription agreement • Support Agreement between U.S. Co & ULC for U.S. Company to purchase shares for cash so ULC can fund the forward subscription agreement

  42. Financing & Inbound Investment: Debt Double Dip-Hybrid Instrument (cont’d) U.S. Co. 3. Support Agreement ULC 4. Guarantee 1. Loan 100 % 2. Forward Subscription Agreement Canco Summary Loan from U.S. Co. to Canco Forward subscription agreement between LLC and Canco Support agreement between U.S. Co. and LLC Guarantee from U.S. Co. to Canco

  43. Steps U.S. Co takes out 3rd party loan U.S. Co to make a loan to Canco ULC enters into Forward Subscription Agreement with Canco to purchase Canco shares for cash for an amount equal to the principal amount of the loan at maturity Simultaneously, U.S. Co enters into a support agreement with the ULC to purchase the share for cash so the ULC can fund the Forward Subscription Agreement Simultaneously, U.S. Co provides Canco with a guarantee of the ULC’s performance under the Forward Subscription Agreement Financing & Inbound Investment: Debt Double Dip-Hybrid Instrument (cont’d)

  44. Financing Canadian Operations of U.S. MNCs Double Dip-Hybrid Instrument 3rd Party debt U.S. Co. Forward Support Agreement 100 % Loan 100 % ULC Forward Canadian Co. Subscription Agreement • US Tax Consequences • Loan treated as equity • Payments on loan (interest and principal) treated as distributions

  45. Financing Canadian Operations of U.S. MNCs Double Dip-Hybrid Instrument • U.S. Company uses 3rd party debt to make a loan to Canco 3rd Party debt U.S. Co.. Forward Support agreement 100 % 100 % Loan ULC Forward Canadian Co. Subscription agreement • Canadian Tax Consequences • Deductible interest in CanCo • No withholding tax under the treaty • Consider Thin Corp

  46. Financing Canadian Operations of US MNCs Foreign Affiliate Dumping Provisions • Introduced in Aug 2012, amended in October 2012 for transactions after March 2012 • Applies to Canadian resident corp. (CRIC) controlled by a non-res corp. (Parent) that invests in foreign affiliate (subject corp.)

  47. Financing U.S. Operations of Canadian MNCs Foreign Affiliate Dumping (cont’d) • Rules apply beyond traditional debt dumping: • Transactions constituting an “Investment”... • acquire shares • contribute capital • indebtedness* • options • extension of maturity, redemptions, acquisition or cancellations date on debt/shares • acquisition of CDN target where >75% of FMV is in FA shares of target • By a CRIC... • In a subject corporation... US (Parent) Canco (CRIC) US Co Loan Pref Shares FA (SC) FA (SC)

  48. Financing U.S. Operations of Canadian MNCs • Foreign Affiliate Dumping (cont’d) • Where rules do not apply (exceptions): • Loans qualifying as PLOI (pertinent loan/indebtedness) • CRIC and Parent jointly elect on loan owing to CRIC • Imported interest applies instead of deemed dividend • Closely connected test • Business activities of FA are closely connected to CRIC • Certain corporate reorganizations • Indirect funding test • 3 conditions to meet • PUC Redirection • Deemed dividend reduced by PUC of CRIC or through a Dividend Substitution Rule. • Note: PUC can also be reinstated for purposes of the rule under certain circumstances

  49. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. IRS Circular 230 Disclosure

  50. Questions?