Interest payments between arm’s-length parties are exempt from Part XIII tax if the interest is not ‘participating debt interest’. This concept refers to debt on which interest is contingent upon the use of, or production from, property in Canada or that is computed by reference to revenue, profit, cash flow, commodity price, etc. or by reference to dividends paid or payable on the shares of a corporation (not necessarily the debtor corporation). In other words, participating debt is debt the interest on which could be characterized as disguised dividends.
Given this exemption from non-resident tax on arm’s length interest payments, there is no tax disincentive to sourcing project financing abroad. When, however, debtor and creditor are not at arm’s length, we must rely upon a tax treaty for a reduction or exemption of the non-resident tax which would otherwise apply at a rate of 25%. Pursuant to recent amendments to the Canada-United States Tax Convention (1980), interest payments between the two countries are wholly exempt from taxation in the source country. Under Canada’s other tax treaties, including those with China and Hong Kong, the typical rate is 10%.
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