A large percentage of countries that have income taxes levy withholding taxes on interest paid by residents of those countries to non-residents.
Up until fairly recently, Canada generally applied withholding tax under Part XIII of the Income Tax Act (“the Act”) on Canadian-source interest payments to non-residents. This general rule was subject to many exceptions, including one commonly used one that applied to five-year corporate debt, as well as exception for government obligations and foreign currency debt. In the absence of a lower rate being applied under a tax treaty, interest that was not eligible for an exemption was subject to 25% tax.
However, that all changed in 2008. As a general rule, Canadian-source interest payments to non-residents made after 2007 will only be subject to Part XIII withholding tax in two types of situations:
1) Where the payer and the payee are not dealing at arm’s length. This would most commonly apply in connection with payments by a Canadian subsidiary corporation to its foreign parent corporation, or
2) Where the interest is “participating debt interest”. This is defined in subsection 212(3) of the Act as interest “that is paid or payable on an obligation….all or any portion of which interest is contingent or dependent on the use of or production from property in Canada or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.”
In the case of U.S. residents, because of the general exemption found in Article X1(1) of the Canada-U.S. Tax Convention, even interest paid between non-arm’s length parties should be exempt from Canadian tax. This could apply to interest paid by a Canadian subsidiary to a U.S. parent corporation.
However, an exception to the general exemption in Article XI(1) applies with respect to participating debt interest. Under Article XI(6)(b), Canadian tax can be applied in such cases, subject to a maximum rate of 15%.