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FROM PRINCIPLES TO PLANNING Cross-border Financing FROM PRINCIPLES TO PLANNING

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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 - PowerPoint PPT Presentation

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Page 1: Cross-border Financing

FROM PRINCIPLES TO PLANNING

Cross-border FinancingFROM PRINCIPLES TO PLANNING

Page 2: Cross-border Financing

Cross-border FinancingKnox Teague, Dixon Hughes Goodman LLP

Tim Bloos, MNP LLPMark Pearlman, MNP LLP

Page 3: Cross-border Financing

Inbound Financing to the U.S.: Considerations

Knox Teague, Dixon Hughes Goodman LLP

Page 4: Cross-border Financing

Earnings Stripping

Debt / Equity

Withholding Tax

U.S. Inbound Financing Considerations

Page 5: Cross-border Financing

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,

ORPaid 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

Page 6: Cross-border Financing

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

Page 7: Cross-border Financing

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

Page 8: Cross-border Financing

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

Page 9: Cross-border Financing

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

Page 10: Cross-border Financing

IRC § 163(j) – Key Technical Differences – Affiliated Group Rules

• FCo is 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

US2US1

US3

U.S. Inbound Financing Considerations

Earning Stripping and Form 8926: Technical Rules IRC § 163 (j)

Page 11: Cross-border Financing

Section 385 Debt or EquityThe 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

Page 12: Cross-border Financing

Section 385 Debt or EquityJudicial 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

Page 13: Cross-border Financing

US Withholding TaxCertain 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 interestUS compliance requirements

U.S. Inbound Financing Considerations

Page 14: Cross-border Financing

Financing U.S. Operations/Acquisitions by Canadian MNCs

Tim Bloos, MNP LLP

Page 15: Cross-border Financing

“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

Page 16: Cross-border Financing

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 rulesAnti-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

Page 17: Cross-border Financing

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 Finco recharacterized 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

Page 18: Cross-border Financing

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 transactionsLegislative change

• Level of Complexity: High• General Acceptance: Disclosed in a number of public prospectuses• Unwind: Relatively easy

Financing U.S. Operations of Canadian MNCs

Page 19: Cross-border Financing

DEDUCTION

DEDUCTION

Preferred Share (Repo) Financing Arrangement (cont’d)

Canco

OpcoFinco

Third party borrowing

Sale and repurchase

Preferred Shares

Financing U.S. Operations of Canadian MNCs

Page 20: Cross-border Financing

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

Page 21: Cross-border Financing

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

Page 22: Cross-border Financing

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

Page 23: Cross-border Financing

Third Party Debt

US Holdco

US Opco

Loan

Canco

Cansub

NSULC

USLLC

USLP

Tower Financing Structure (cont’d)

Financing U.S. Operations of Canadian MNCs

Interest Deduction

Interest Deduction

Page 24: Cross-border Financing

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 USLPU.S. withholding tax on dividends paid by USLP. (No Treaty – “Hybrid Issue”)

Financing U.S. Operations of Canadian MNCs

Page 25: Cross-border Financing

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

Page 26: Cross-border Financing

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

Page 27: Cross-border Financing

Luxembourg Finance Intermediary

Financing U.S. Operations of Canadian MNCs

Canco

CanHoldco

Capital

Interest Deduction

Financing Arrangement

Lux FinanceCo

US Holdco

US

Opco

Interest Deduction

Loan (Bank)

Loan

Page 28: Cross-border Financing

Luxembourg Finance Intermediary (cont’d)Canco borrows to capitalize the Financing Arrangement

Financing Arrangement

CAN Holdco uses capital from Canco to either:

i. Make an interest free loan to LuxFinanceCo; or

ii. 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

Page 29: Cross-border Financing

Luxembourg Finance Intermediary – Risks and IssuesCanada

‒ 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

Page 30: Cross-border Financing

Outbound Financing from the U.S.

Page 31: Cross-border Financing

Financing Canadian Operations/Acquisitions of U.S. MNCs

Mark Pearlman, MNP LLP Tim Bloos, MNP LLP

Page 32: Cross-border Financing

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

Page 33: Cross-border Financing

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

Financing Canadian Operations of U.S. MNCs

Page 34: Cross-border Financing

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

Page 35: Cross-border Financing

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

Page 36: Cross-border Financing

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

Financing Canadian Operations of U.S. MNCs

Page 37: Cross-border Financing

Deemed DividendsLoans 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

Page 38: Cross-border Financing

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

Page 39: Cross-border Financing

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

Page 40: Cross-border Financing

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

Page 41: Cross-border Financing

ULCCanadian

Co.

U.S. Co.

100 %100 %

Loan

3rd Party debt

Subscription agreement

Forward

• Support Agreement between U.S. Co & ULC for U.S. Company to purchase shares for cash so ULC can fund the forward subscription agreement

Support agreement

Double Dip-Hybrid Instrument• U.S. Company uses 3rd party debt to make a loan to Canco

Financing Canadian Operations of U.S. MNCs

Page 42: Cross-border Financing

Summary 1. Loan from U.S. Co. to Canco2. Forward subscription agreement between LLC and Canco3. Support agreement between U.S. Co. and LLC4. Guarantee from U.S. Co. to Canco

Financing & Inbound Investment: Debt

ULC

Canco

U.S. Co.

100 %4. Guarantee 1. Loan

2. Forward Subscription Agreement

3. Support Agreement

Double Dip-Hybrid Instrument (cont’d)

Page 43: Cross-border Financing

Steps1. U.S. Co takes out 3rd party loan

2. U.S. Co to make a loan to Canco

3. 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

4. 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

5. 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)

Page 44: Cross-border Financing

ULCCanadian

Co.

U.S. Co.

100 %100 %

Loan

3rd Party debt

Subscription Agreement

Forward

ForwardSupport Agreement

• US Tax Consequences• Loan treated as equity• Payments on loan (interest and principal) treated as distributions

Double Dip-Hybrid Instrument

Financing Canadian Operations of U.S. MNCs

Page 45: Cross-border Financing

ULCCanadian

Co.

U.S. Co..

100 %100 %

Loan

3rd Party debt

Subscription agreement

Forward

• Canadian Tax Consequences• Deductible interest in CanCo• No withholding tax under the treaty• Consider Thin Corp

ForwardSupport agreement

Double Dip-Hybrid Instrument• U.S. Company uses 3rd party debt to make a loan to Canco

Financing Canadian Operations of U.S. MNCs

Page 46: Cross-border Financing

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.)

Traditional debt dumping

Foreign-owned Canco acquires shares of FA, creating additional debt in Canada with potential tax fee dividends (active business)

Effect of Rule

Deem dividend to be paid by CRIC to Parent to extent of non-share consideration and PUC reduction (withholding tax)

Financing Canadian Operations of US MNCs

Page 47: Cross-border Financing

Foreign Affiliate Dumping (cont’d)

Financing U.S. Operations of Canadian MNCs

‒ Rules apply beyond traditional debt dumping:

US (Parent)

US Co

Pref Shares FA (SC)

Canco (CRIC)

FA (SC)

Loan

1. 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

2. By a CRIC...3. In a subject corporation...

Page 48: Cross-border Financing

Foreign Affiliate Dumping (cont’d)‒ Where rules do not apply (exceptions):

1. Loans qualifying as PLOI (pertinent loan/indebtedness)‒ CRIC and Parent jointly elect on loan owing to CRIC‒ Imported interest applies instead of deemed dividend

2. Closely connected test‒ Business activities of FA are closely connected to CRIC

3. Certain corporate reorganizations4. Indirect funding test

‒ 3 conditions to meet5. 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

Financing U.S. Operations of Canadian MNCs

Page 49: Cross-border Financing

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

Page 50: Cross-border Financing

Questions?