Generally, when a person borrows a share, he or she is obligated to make payments to the lender as compensation for any dividends paid on the share until such time as the borrower returns the share or an identical share. The Act contains rules that characterize such dividend compensation payments for withholding tax purposes. Where the transaction qualifies as a “securities lending arrangement” as defined in the Act, and the borrowed security is a share, payments made as compensation for dividends on the borrowed share are deemed either to be interest or dividends depending on how the transaction is collateralized. Where the Canadian resident securities borrower has provided cash or qualifying government debt in an amount equal to at least 95 per cent of the value of the borrowed shares, such dividend compensation payments are deemed to be dividends for withholding tax purposes. Otherwise, such payments are deemed to be interest for withholding tax purposes.
Since interest other than “participating debt interest” paid by a Canadian resident to an arm’s length non-resident is generally exempt from withholding tax under the Income Tax Act (Canada) (the Act), the existing rules create an incentive for parties entering into cross-border securities loans not to meet the collateralization requirements described above. Thus, subject to avoidance considerations, a non-resident could lend its dividend paying Canadian shares to a Canadian resident securities borrower under a securities lending arrangement that did not meet the collateralization requirements described above and could receive dividend compensation payments that were not subject to withholding tax. If the non-resident had not loaned the shares, the dividends that such non-resident would have received would have been subject to withholding tax.
The 2019 Budget proposes to eliminate the ability to avoid withholding tax in the manner described above where the borrowed shares are those of a Canadian issuer. Dividend compensation payments made to a non-resident securities lender under a securities lending arrangement will be deemed to be Canadian source dividends for withholding tax purposes regardless of how the transaction is collateralized. Related rules will ensure that such treatment will apply for treaty purposes.
The 2019 Budget also introduces rules that are intended to ensure that withholding tax on dividend compensation payments on Canadian shares made to a non-resident securities lender cannot be avoided by “tainting” the stock loan so that it does not qualify as a “securities lending arrangement” as defined in the Act. This is done by extending the concept of a “specified securities lending arrangement” to the withholding tax rules governing securities lending arrangements. This term had been introduced in Canada’s 2018 federal budget and is now applicable in the context of withholding tax. This is intended to ensure that the rules governing the withholding tax treatment of payments under a securities lending arrangement cannot be avoided by not meeting all of the technical requirements set out in the definition of a “securities lending arrangement”.
These changes will apply to compensation payments that are made on or after Budget Day. Where, however, a securities loan was in place before Budget Day, only compensation payments made after September 2019 will be subject to these new rules.
Finally, the 2019 Budget includes a proposal intended to end a longstanding trap in the rules governing the withholding tax treatment of payments under securities lending arrangements. Under the existing rules, where the borrowed share is a foreign share rather than a Canadian share and the transaction is collateralized as described above, dividend compensation payments are deemed to be Canadian source dividends subject to withholding tax. The 2019 Budget includes changes that are generally intended to address this issue such that dividend compensation payments relating to shares of a non-resident corporation would generally not be deemed to be Canadian source dividends subject to withholding tax where the transaction is “fully collateralized”. This change will apply to dividend compensation payments made on or after Budget Day.