The Dirt: Goodbye 5/25

Just about any page of just about any newspaper since October, indeed earlier if one is selective in one’s reading materials, has been filled with reminiscences of the Great Depression.

There’s been details of market losses and new record lows; plans (and more plans) for the deployment of hundreds of billions of dollars of United States government bailout funds; and incessant talk of the failures, near-failures, and forced recapitalizations of dozens of venerable U.S. economic institutions. It’s truly apocalyptic stuff for those so inclined. Lost amongst all of this economic doom and gloom is the news of the recent ratification on Sept. 23, by a unanimous U.S. Senate, of the Fifth Protocol to the U.S.-Canada Tax Treaty.
Although the Fifth Protocol has yet to be signed by the U.S. secretary of state and the president (both expected during the current administration), Canada has already gone ahead and eliminated, effective Jan. 1, 2008, withholding taxes on interest paid to any U.S. arm’s length lenders (equivalent provisions doing likewise for non-arm’s length lenders are being phased in over the next couple of years). The repeal of this withholding tax is considered to be one of the critical planks of the Fifth Protocol, and Canada struck first with legislation implementing the repeal even before it is fully approved in the U.S.
Prior to such repeal, Canadian borrowers making interest payments to foreign lenders were required to remit a withholding tax (10 per cent in the case of American lenders) on top of the interest otherwise payable. That’s not unlike a situation where a purchaser would have to withhold and remit income tax on a purchase from a non-resident vendor under s.116 of the Income Tax Act. While there are some obvious domestic policy reasons for a withholding tax regime, by turning Canadian mortgage borrowers into tax collectors, Canadians have, for decades now, been largely shut out from freely available capital pools south of the border, in light of
recent events; some might say, gratefully so.
One historic exception to this general rule has been the mortgage lending in Canada by U.S. insurance companies. The reason that U.S. insurance companies have not been as reticent to mortgage lend in Canada is because the withholding tax was only ever intended to apply to short-term debt.
The litmus test for whether any given loan was “short-term” became commonly known as the “5/25 exemption,” which tested whether the borrower could be forced (or potentially forced) to repay more than 25 per cent of the principal within the first five years of the term of the loan, other than by default or illegality.
If not, then the loan was deemed not to be a short-term loan and would then be exempt from the withholding tax. If so, then the loan was deemed to be short term and therefore subject to withholding tax.
Unlike almost all other mortgage lenders, insurance companies typically lend for long terms with gradual amortization schedules. As such, U.S. life insurance companies, with their appetite for low-risk, long-term mortgages, would generally have met the 5/25 exemption requirements with regularity when lending in Canada. Other U.S. mortgage lenders with “less than life” underwriting criteria were, however, generally not so lucky.
The 5/25 exemption was always intended to provide certainty for U.S. mortgage lenders and their Canadian borrowers in respect of withholding tax eligibility. In theory, by applying the tests for the 5/25 exemption, both borrowers and lenders could tell, before signing the commitment, whether taxes would have to be withheld by the borrower. In reality, however, the 5/25 exemption gave little such comfort. The intricacies, complications and technicalities of the exemption, and the consequences of failing to meet its requirements, eventually meant that the simplest loan involving a U.S. lender and a Canadian borrower eventually required sophisticated structuring and equally sophisticated tax opinions to complete.
Even U.S.-based mortgage lenders that otherwise qualified under the former 5/25 exemption, often had to make substantial adjustments to their normal loan documents in order to make the cut. Standard mortgage terms that would not raise an eyebrow on purely domestic mortgage loans on either side of the border (such as cash sweeps, material adverse change clauses, and insurance proceed scoops) have historically been considered offside of the former 5/25 exemption. That’s because they all permitted the possibility of a mandatory prepayment within five years even if the borrower was not otherwise in default.
With the withholding tax now eliminated, lenders’ counsel can expect a return to documentary normalcy in such cross-border loans. Likewise, from a legal documentation standpoint, borrowers’ counsel will find less structuring issues driven by a need to comply with the 5/25 exemption and overall less borrowing transaction costs for their clients.
As history would have it, of course, the
Canadian government’s pre-emptive repeal of the withholding tax could not have been more inadvertently ill-timed, opening the Canadian mortgage market to greater U.S. mortgage short-term and medium-term lending just in time to see those targeted U.S. mortgage lenders, at least those still standing, all but shut down their mortgage loan operations for other reasons.
 Although this current credit freeze and market meltdown has all but eliminated any immediate benefits to be seen by the repeal of the withholding tax, the long-term benefits of eliminating withholding taxes on U.S. mortgage loans into Canada cannot be understated. When Australia eliminated its withholding taxes in 2006 on similar cross-border loans, it experienced a huge influx of foreign mortgage financing, and there is no reason why the repeal of Canadian withholding taxes will not eventually expand the attractiveness of Canadian mortgages for American and other foreign lenders.
In due course, once the world’s economies return to normal, Canadian borrowers and American lenders will see the repeal of the withholding tax as a “win-win” situation, with only Canadian domestic lenders lamenting the loss of what had previously been their tax-
driven near-monopoly on the Canadian shortand medium-term mortgage markets.

Jeffrey W. Lem is a partner in the real estate group at Davies Ward Phillips & Vineberg LLP. His e-mail address is [email protected].

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