The Federal Government’s recent decision to eliminate the tax charged on interest that Canadian corporate borrowers pay to foreign lenders removes a frustrating barrier that prevented foreign capital from entering the domestic market, observers say.

“Greater access to capital is a positive development [for the Canadian capital markets],” says Marc Mercier, partner in the financial services group of Cassels Brock & Blackwell LLP in Toronto. “It should provide Canadian borrowers with more competition for their borrowing needs.”

As foreign lenders — particularly those in the U.S. — begin to hear of the change, they express interest in doing business in Canada, Mercier says: “I have seen a very significant increase in calls from U.S. lenders and U.S. tax and finance lawyers [asking about the changes].”

On Dec. 14, 2007, the federal government amended the Income Tax Act to remove the withholding tax on the interest a Canadian resident pays to an arm’s-length non-resident lender, regardless of the country in which the lender originates. The change came into effect Jan. 1.

Before the change, a withholding tax of up to 25% (which was often reduced to 10% by tax treaties negotiated with foreign jurisdictions) was charged on interest paid by a Canadian borrower to a foreign lender.

“It was a brake on foreign direct investment in Canada that was unnecessary and uncompetitive, in an international sense,” says Nancy Hughes Anthony, president and CEO of the Canadian Bankers Association, which had long asked for the elimination of the tax.

“The legislation sends the right signal — particularly to lenders and to some who might not otherwise conduct business in Canada — that we’re now open for business,” she says.

The so-called “5/25 exemption,” which allowed Canadian residents to borrow from a foreign lender as long as no more than 25% of the principal amount of the loan was payable within five years of the loan, had given Canadian borrowers a way around the withholding tax. But it was cumbersome, complex and difficult to administer. As a result of the removal of the withholding tax, the 5/25 exemption will no longer be needed.

The announcement of the withholding tax’s removal came as something of a surprise, because the federal government made the decision unilaterally, without negotiating reciprocity agreements with each foreign country, even though an agreement with the U.S. is close to becoming law.

The U.S. and Canada signed an update to the tax convention between the two nations this past September, which, among a number of changes, eliminated the withholding tax on interest paid by a resident to an arm’s-length non-resident.

The change not only gave U.S. lenders greater access to Canadian markets, but also gave Canadian lenders greater access to the U.S. That’s part of the reason why Canadian banks are pleased with the removal of the withholding tax — even though it will probably mean more competition at home.

“The Canadian banking sector already has competitors from all corners of the globe,” Hughes Anthony says, noting that Canadian banks don’t need to rely on such “artificial barriers” to the free flow of capital.

The treaty update, known as the Fifth Protocol to the Canada-U.S. Tax Convention, also allowed for the phased-in elimination of the cross-border withholding tax on so-called related parties, such as a parent firm and its subsidiary. The legislative changes to the Income Tax Act made in December did not extend to related parties except as otherwise stipulated in tax treaties.

The protocol to the U.S.-Canada tax convention has received royal assent in this country, but has yet to be ratified by the U.S. government. But that is widely expected to happen. Once the U.S. ratifies the protocol, the changes to the tax treaty will come into force.

Canadian lawyers who specialize in cross-border financing deals say the removal of the withholding tax provides new opportunities for U.S. companies wanting to invest in Canada, especially in the area of the Canadian securitization market.

Before the legislative changes were passed to remove the withholding tax, Canadian short-term receivables such as mortgages, automobile loans and credit card debt did not attract foreign investors. The 5/25 exemption, which helped lenders sidestep the withholding tax, was better suited for structuring long-term debt.

“Removal of the withholding tax makes it possible to fund those conduits that are securitizing things such as auto loans, which are less than five years [in term], cross-border,” says Albert Hudec, senior securities practitioner with Davis LLP in Vancouver. “You can now fund those types of securitization conduits with U.S. or European money.”

@page_break@Although the elimination of the withholding tax should open up the securitization market for short-term receivables to foreign lenders, the current state of the debt-financing market in the U.S. and the recent problems with asset-backed commercial paper in Canada will probably mean the flow of cross-border capital into the securitization market will be slow, at least initially, Hudec says.

But even though some believe the removal of the withholding tax will greatly ease the flow of foreign capital, especially from the U.S., into Canada, others aren’t convinced. “I’m not sure anything’s going to change that much,” says Larry Chapman, national leader of the tax services practice at PricewaterhouseCoopers LLP in Toronto. “We haven’t seen a lot of activity, though that may well be because of the debt markets being in a bit of turmoil.” IE