Additional Tax Issues When Buying Canadian Companies

Tuesday, December 28, 2004

Kenneth Snider, Canadian Tax Considerations Of Acquisitions Of Canadian Businesses By US Persons, http://

Abstracted from: (Part II)
By: Kenneth Snider - Blake Cassels & Graydon, Toronto, ON
M&A Tax Report - Vol. 13, No. 3, Pgs. 4-8

Financing factors to consider.
In the first part of this two-part series, Canadian tax attorney Kenneth Snider described how to structure an American buyer’s purchase of a Canadian company acquisition so as to minimize US and Canadian tax. [Editor’s Note: Part I is abstracted in the November 2004 issue of the REVIEW.] In the second, he covers factors to consider in deciding how to finance the deal, focusing particularly on using a Canadian holding company. The key components of any financing scheme include maximizing the interest deduction in the country with the highest tax rates and avoiding tax withholding. Interest is generally deductible under Canadian law when it is incurred for a legitimate business purpose, no matter what the source of the loan. However, the US parent must be aware of Canada’s thin-capitalization rules, which deny the deduction if the loan is payable to certain nonresident shareholders or is not at arm’s length. Unfortunately, any nondeductible interest is still subject to Canadian withholding tax when the interest is paid to a nonresident.

How to avoid major tax withholding.
Should the US parent make a loan to the Canadian holding company, most likely the interest will be subject to Canadian withholding tax, the author cautions. (An exception is possible if the company makes the loan as part of financing a branch of the business in Canada, but such is not usually the case.) The withholding rate is 25% of any interest the borrower pays or credits to the US lender, although sometimes an independent lender will gross up the withholding taxes and not take a credit for them. All is not lost, however: hoping to maintain an active capital market for Canadian companies, the regulators have implemented several exemptions to the withholding rules. To qualify for the leniency, a Canadian corporation (and not a trust) must pay the interest, and the borrower and lender must be dealing at arm’s length.
25% rule subject to exceptions. A further requirement to avoid the tax withholding is that the loan agreement must not require the borrower to repay 25% of the principal of the note within five years. Therefore, certain standard forms of financing, such as revolving loan agreements and demand loans, are automatically disqualified. The author notes that under certain circumstances, the borrower may repay more than 25% of the loan in less than five years and still qualify for the withholding exemption. These common-sense exceptions to the rule include a borrower’s default, if the courts or other legal authority find the agreement to be illegal, and a lender’s death. Under other, complicated rules, a US partnership that is formed under Canadian rules and that elects to be taxed as a US corporation can buy out the Canadian holding company’s debt and deposit the interest into a Canadian bank. The withholding rate drops then to 10% (rather than the standard 25%).

Disposing of shares may reduce tax.
When the US parent decides to liquidate its Canadian interests, the author suggests that the best tax-wise strategy is to sell the shares (rather than the assets or the stock of any subsidiary). The seller­assuming that it is a US corporation­may avoid the tax that most Canadian companies pay as well as the tax on any dividends it pays out of the proceeds. A Canada/US tax convention enables the American company to avoid the tax when selling a private Canadian corporation, provided the seller owned at least 25% of the stock and registered the sale with the Canadian authorities on a timely basis. Unfortunately, the purchaser must pay 25% of the cost of the shares on behalf of the nonresident seller. The author suggests that buyers retain 25% of the purchase price until they obtain a clearance certificate relieving them from the obligation. Obtaining the clearance is usually not a problem, but allow plenty of time (normally six to eight weeks) for the process to run its course.

Abstracted from M&A Tax Report, published by CCH Tax and Accounting, 2700 Lake Cook Road, Riverwoods, IL 60015

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