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FROM PRINCIPLES TO PLANNING. Cross-border Financing. Cross-border Financing Knox Teague, Dixon Hughes Goodman LLP Tim Bloos , MNP LLP Mark Pearlman, MNP LLP. Inbound Financing to the U.S.: Considerations Knox Teague, Dixon Hughes Goodman LLP. Earnings Stripping Debt / Equity

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slide1

FROM PRINCIPLES TO PLANNING

Cross-border Financing

slide2

Cross-border Financing

Knox Teague, Dixon Hughes Goodman LLP

Tim Bloos, MNP LLP

Mark Pearlman, MNP LLP

slide3

Inbound Financing to the U.S.: Considerations

Knox Teague, Dixon Hughes Goodman LLP

slide4

Earnings Stripping

Debt / Equity

Withholding Tax

U.S. Inbound Financing Considerations

slide5

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

slide6

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

slide7

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

slide8

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

slide9

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

slide10

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

slide11

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

slide12

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

slide13

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

slide15

“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

slide16

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

slide17

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

slide18

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

slide19

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

slide20

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

slide21

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

slide22

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

slide23

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

slide24

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

slide25

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

slide26

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

slide27

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

slide28

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

slide29

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

slide31

Financing Canadian Operations/Acquisitions of U.S. MNCs

Mark Pearlman, MNP LLP

Tim Bloos, MNP LLP

slide32

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

slide33

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
slide34

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

slide35

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

slide36

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
slide37

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

slide38

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

slide39

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

slide40

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

slide41

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
slide42

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

slide43

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)

slide44

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
slide45

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
slide46

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.)
slide47

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)

slide48

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
slide49

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

slide51

Contact Information

Knox Teague

knox.teague@dhgllp.com

Tim Bloos, MNP LLP

tim.bloos@mnp.ca

Mark Pearlman, MNP LLP

mark.pearlman@mnp.ca