Coupon Strips: An Easy Avoidance of Withholding Tax No More
May 2, 2011
Robert W. Nearing
In Lehigh Cement Limited v. The Queen, 2010 DTC 2081 (FCA) (Lehigh), the Federal Court of Appeal considered the application of the general anti-avoidance rule (GAAR) contained in section 245 of the Income Tax Act (Canada) (Act) to a coupon stripping transaction used to avoid withholding tax on interest under the former 5/25 rule contained in subsection 212(1)(b) of the Act. Although Lehigh was decided under the 5/25 rule, the decision has broad implications relevant to current law given that non-arm's length interest (subject to a treaty override) remains statutorily subject to withholding tax following the repeal of the 5/25 regime.
The simplified facts in Lehigh involved a group of companies in the business of manufacturing cement, headed by a German public company, Heidelburger Zement. A Canadian subsidiary of the group, Lehigh Cement Limited, was debt financed by an affiliated Belgian group finance company (Finco) with a $140 million term loan (Loan). Finco acquired the Loan in 1994 from a syndicate of Canadian bank lenders and its maturity date was September 15, 2009. In 1994 the Loan carried a floating interest rate tied to the Canadian prime rate. Notwithstanding that the terms of the Loan generally satisfied the exclusion from withholding tax under the 5/25 rule contained in 212(1)(b)(vii) of the Act, it was subject to withholding tax since it was held by a non-arm's length party.
In 1997 and immediately before the coupon strip, the terms of the Loan were amended to provide for a 7% fixed coupon rather than the floating coupon tied to prime. Finco then sold the right to receive the interest payments on the Loan through 2002 to an arm's length bank, Bank Brussels Lambert (BBL), for approximately $42.674 million. The interest paid quarterly on the 7% coupon from Q4 1997 through Q3 2002 aggregated to approximately $49.456 million in undiscounted dollars. Following the sale of the right to interest to BBL, Lehigh Cement paid the full 7% coupon without withholding any amount as may be required under subsection 215(1) of the Act. BBL and Lehigh Cement took the position that interest paid to BBL satisfied the exception to primary liability then provided under subparagraph 212(1)(b)(vii) of the Act.
The Minister of National Revenue reassessed Lehigh Cement on the basis that Part XIII withholding tax was payable (by virtue of the GAAR) in respect of the interest and assessed a corresponding 10% penalty for its failure to withhold the tax. The Minister’s sole basis for reassessing Lehigh Cement pursuant to the GAAR was a 1975 budget paper which suggests that the purpose of the 5/25 rule was to facilitate Canadians' access to funds in international capital markets. The Federal Court of Appeal rejected the Minister’s invitation to infer from the 1975 budget paper a purpose that limits the literal language of the 5/25 rule because the 1975 budget paper was a "shaky foundation" on which to base a GAAR assessment and held that the Minister did not meet the evidentiary burden as set out in Canada Trustco (2005 DTC 5523 (SCC)). In what is arguably a novel approach to its GAAR analysis, the Court reasoned that it should not infer a purpose from the 1975 budget paper because:
… no trace of the alleged fiscal policy can be discerned or reasonably inferred from subparagraph 212(1)(b)(vii) itself, from the statutory scheme of which subsection 212(1)(b)(vii) is a part, or from any other provision of the Income Tax Act that could possibly be relevant to the textual, contextual and purposive interpretation … it is fatal to the Crown's misuse argument that it finds no support in any provision of the Income Tax Act, or in any jurisprudence or other authority saying or suggesting that the splitting of the interest and principal obligations of a debt have any income tax implications in relation to subparagraph 212(1)(b)(vii), or any analogous provision or relevant statutory scheme. [emphasis in original]
Since the textual and contextual prongs of the GAAR analysis are those rooted in the statute, the decision in Lehigh may be interpreted as requiring there be at least some positive textual or contextual support for the purported purpose.
The Supreme Court of Canada declined to grant leave to appeal the Federal Court of Appeal decision.
Lehigh is welcome confirmation that the full amount of interest payments following a coupon strip retains its character as interest from the perspective of the payor. This, coupled with the elimination of withholding tax on most interest paid to arm’s length non-residents, provides for an easily accessible planning opportunity since transactions such as those undertaken in Lehigh no longer need to comply with the more onerous requirements of the 5/25 regime.
Sensing that this planning to avoid withholding tax on interest could proliferate, the Department of Finance announced draft legislative proposals (Proposals) on March 16, 2011. Pursuant to the Proposals, Part XIII withholding tax will apply to interest paid or credited by a Canadian resident to a non-resident person in respect of a debt that is owed to a person who does not deal at arm’s length with the payor. That is, withholding tax will apply unless the Canadian resident payor deals at arm’s length with both the holder of the stripped coupons and the residual principal. The Proposals will apply to interest paid or payable after March 16, 2011, other than interest paid in respect of a debt obligation incurred before March 16, 2011 and paid to a recipient that acquired the entitlement to the interest as a consequence of an agreement or other arrangement entered into by the recipient, and evidenced in writing, before March 16, 2011. Interestingly, the explanatory notes which were issued with the Proposals suggest that the Proposals will not apply to interest paid where the entitlement to the principal of the debt obligation is held by a Canadian resident.
As noted above, withholding tax on non-arm’s length interest is subject to treaty override, such that the Proposals do not affect, for example, the exemption from withholding tax on interest paid by a Canadian resident to a non-arm’s length person who qualifies for relief under the Canada-United States Income Tax Convention (1980), as amended.