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Asset/equipment
finance and leasing represents a significant alternative
source of business capital. Moreover, it typically relies
upon cash flow–based credit analysis over a particular
asset rather than "net worth" lending,
traditionally provided by banks. There is a substantial
market for asset-based loans (ABLs), which are loans
secured by inventory and accounts receivable rather than
equipment. There is also a growing need for project
finance solutions for infrastructure, including power
assets (hydro, wind, gas turbines, nuclear and alternative
fuels), hospitals, toll roads and transportation.
Traditionally, advice to this market has focused on the
relationship between the lender/ lessor and the asset user
(i.e., on implementation of asset-based finance products),
but finance companies and lessors often use specialized
securitization financing to reduce their cost of providing
asset-based finance products. Asset-based financing (as
well as securitization) is highly dependent upon a complex
and sometimes conflicting set of tax and accounting rules.
The
structure of the Canadian finance and lease market is
strongly influenced by financial services regulation and
tax considerations. This article surveys the Canadian
asset-based financing environment, highlighting uniquely
Canadian issues and identifying recent developments.
CANADIAN
ISSUES
Financial
Services Regulations
The
Bank Act (Canada) provides that Canadian banks are not
permitted to undertake the business of leasing consumer
automobiles or any asset-leasing business unless the lease
is a "financing lease" as defined in the Bank
Act (Canada). Accordingly, the automobile lease industry
has been dominated by manufacturers’ financing companies
and smaller fleet lessors (typically operated by
independent auto dealers) rather than banks. Further,
banks have not generally been able to offer
"operating" leases to consumers for leased
assets. Banks can offer a form of operating lease whereby
residual value guarantees are purchased to offset a
substantial portion of the equipment risk. Smaller
industrial entities provide operating leases by taking
residual value and remarketing risk for specific assets.
Smaller
financing entities often do not have as ready access to
capital as larger financial institutions, which results in
operating leases being relatively expensive (unless credit
can be obtained from pension funds, insurance companies or
through a securitization of a portion of the financing).
Although banks are not permitted to directly engage in
this type of leasing, they typically make credit available
to vehicle leasing companies, often on a non-recourse
basis.
There
is also an increasing desire for US-style monoline
insurers and residual value providers to offer services to
Canadian customers, banks and other large financial
institutions to permit more cost-effective access to
asset-backed financing. Financial guarantee insurance or
credit wraps are generally not permitted to be provided by
regulated insurers in Canada. Moreover, there are
significant impediments to foreign unlicensed insurers who
provide financial guarantee insurance to Canadian assets
or projects. In addition, insurance premium taxes, sales
taxes, excise taxes and withholding taxes can apply to
such products. Recently, several asset-based project
financing transactions have used financial guarantee
insurance. This development may lead to other forms of
financial guarantee/credit wraps being available on
equipment loans and equipment-based securitization
transactions.
Tax
Rules Applicable to Leasing
The
Canadian tax system generally provides tax incentives to
encourage the purchase of goods by allowing an owner of an
asset to claim depreciation expenses (known in Canada as
"capital cost allowance," or CCA) calculated on
a declining balance basis at rates established for
particular classes of assets (subject to a half-year
convention in the year of acquisition). In secured loan or
conditional sale financings, the borrower acquires the
goods and, as owner, obtains the benefit of CCA. For many
borrowers, however, there may be only marginal benefit
from the CCA because, for example, they operate on a
break-even basis, have losses or are exempt from tax.
Leasing often results in lower after-tax cost of financing
for these borrowers because lessors who obtain the benefit
of CCA as owners usually use part of the CCA benefit to
subsidize rent charges.
To
eliminate the CCA benefit to lessors on certain types of
assets, Canada adopted the "specified leasing
property rules." These rules effectively bifurcate
the lease market into small-ticket leasing of "exempt
assets" and the leasing of all other assets that are
non-exempt. In general, a lessor of exempt assets obtains
tax incentives for its assets, whereas a lessor of
non-exempt assets does not. Exempt assets include general
purpose office furniture and office equipment, including
computers (which have a value per item of less than $1
million), residential equipment such as furniture,
appliances, televisions, furnaces and hot-water tanks,
passenger vehicles, vans, pickup trucks, truck/tractors
for hauling road freight, and rail cars. A taxpayer can
elect to treat locomotives acquired after February 27,
2000 as exempt property (at a CCA rate of 13 per cent as
opposed to 15 per cent if no election is made). Non-exempt
assets constitute the remainder, such as industrial
machinery, vessels, energy generation assets, oil and gas
equipment, flight simulators and telephone switching
assets.
A
lessor of exempt assets is entitled to full CCA. A lessor
of non-exempt assets is limited to a CCA deduction equal
to the lesser of (i) full CCA and (ii) the notional amount
of principal it would receive if the lease were treated as
a loan of an amount equal to the fair value of the leased
property, with interest at a prescribed rate based on
long-term Government of Canada bond rates. For most
non-exempt assets, the amount of notional principal is
much lower than the amount of depreciation that would
otherwise be deductible, so there is little, if any, net
present value tax benefit for a lease of a non-exempt
asset. For leases to poor credits (whose lease rate
exceeds the prescribed rate), there may still be a net
present value benefit to a lessor. Generally, the
specified leasing property rules do not apply to lessees
for the purposes of determining the deductibility of
rental payments; the lessee is treated as paying rent.
Leases
of non-exempt assets at lease rates lower than the
prescribed rate (which may occur if the lessee is of
substantial credit quality (i.e., investment grade)) can
result in "phantom income" to a lessor because
the higher prescribed rate will treat less of the rent
payment as principal and almost all as interest. This can
be particularly problematic if the lessor is a
specialpurpose entity. In addition, US-dollar leases can
create phantom income because CCA is calculated in
constant Canadian dollars, but rent and interest are
reported in Canadian-dollar equivalents and, therefore,
vary with currency effects. Currency effects may also be
treated as on capital account, and losses (if any) would
not be deductible against lease income.
Specified
Leasing Property Rules and Section 16.1 Election
A
unique rule applies to lessees of non-exempt assets that
can provide ownership benefits without passing ownership
to the lessee. If the lessee and lessor make an election
under section 16.1 of the Income Tax Act (Canada) (Tax
Act) (a so-called section 16.1 election), the lessee is
treated as the owner of the equipment (but only for the
purpose of calculating its income for tax purposes) and is
entitled to treat the rent payments as a blend of
principal and deductible interest. To make a valid section
16.1 election, the lessor and lessee must deal at arm’s
length and the lessor must be a resident of Canada or a
non-resident carrying on business through a permanent
establishment in Canada that is not tax-exempt. However,
only the portion of the rent payment that is not
considered to be a principal repayment can be deducted.
Making the section 16.1 election does not affect the tax
position of the lessor. Section 16.1 elections are made
extensively by lessees, and many lessors have lease
programs and documents developed to facilitate such terms.
Withholding
Tax on Interest and Rents
Canada
levies a withholding tax of 25 per cent (reduced in many
circumstances under Canada’s bilateral tax treaties) on
payments of interest and rent made by Canadians to
nonresidents of Canada. In certain circumstances, Canada
also imposes withholding tax on payments by non-residents
to other non-residents if the payment is for the use of or
the right to use property in Canada. Withholding taxes are
a significant factor in determining the legal structure of
a transaction–that is, it depends on whether the lessor
is Canadian and whether debt is raised wholly in Canada or
wholly or partly outside Canada. Withholding taxes also
affect the cost and availability of credit insurance. A
Canadian lessor receiving rent from a Canadian is not
subject to withholding tax, but the lessor is taxable.
Thus, a Canadian lessor will likely be used for any lease
transaction involving a Canadian lessee unless a
withholding tax exemption applies.
Canada
has exemptions from withholding tax on rent payments for
aircraft and for payments to US residents on some computer
software, resulting in a number of cross-border lease
financing transactions for such assets. US lessors of
other types of property can avoid being subject to
withholding tax by operating in Canada through an
unlimited liability company (ULC) under the laws of either
Nova Scotia or Alberta, which becomes the tax owner of the
property. The lease payments are not subject to
withholding tax because they are made to a Canadian
resident. Since ULCs are treated as disregarded entities
for US tax purposes, the US owner would still be in the
position for US taxes as if it had purchased the assets
directly.
Canada
exempts interest if a loan is between arm’s-length
parties, the term of the obligation is greater than five
years and no more than 25 per cent of the principal amount
of the obligation may be required to be repaid within five
years except through the failure or default of the
borrower. This 5/25 exception is not well-suited to assets
that depreciate quickly or to credits on which principal
is repaid quickly. Moreover, the 5/25 exception is limited
to corporate borrowers and cannot be used by a trust.
Consequently, if a trust structure is used, any borrowing
must be from Canadian lenders to avoid withholding tax.
The Canada Revenue Agency (CRA) has issued several advance
tax rulings that have permitted the use of indirect
finance entities to allow for the 5/25 exception for
partnerships and trusts that finance infrastructure
assets. The choice between selecting a trust or a
corporation as a lessor is based primarily on withholding
tax, calculated according to the source of funds (i.e.,
non-resident or Canadian lender), and on capital taxes
(see below).
Goods
and Services Tax
Canada
levies a value-added goods and services tax (GST) at the
rate of 6 per cent (reduced from 7 per cent on July 1,
2006) on most goods and services provided in Canada. GST
generally applies to lease payments. In most commercial
situations, the tax is fully recoverable through input tax
credits. However, where government sector participants are
involved, sale-leaseback transactions can give rise to
unrecovered amounts from these taxes. This is a
significant impediment to public/private infrastructure
finance projects. Most financial products (loans and other
forms of credit) are exempt from GST, but the credit
provider is generally not permitted to obtain input tax
credits on its input costs to provide exempt financial
products.
In
addition, dealing with unregistered non-residents may
present problems where GST is payable but the appropriate
party cannot recover the GST. The CRA adopted a revised
policy expanding the circumstances in which it considers a
foreign lessor to carry on business in Canada for GST
purposes. Policy P-051R2 entitled Carrying on Business in
Canada provides examples relating to leases that provide,
among other things, that a sale-leaseback of property to a
non-resident lessor constitutes the lessor’s carrying on
business in Canada if the property is delivered in Canada.
Foreign lessors should carefully review this policy.
Lease
Characterization
The
characterization of a lease as being a "true
lease," as opposed to a "loan," is an
important issue in determining the amount and timing of
taxes applicable to lessors and lessees (e.g., GST,
provincial retail sales tax and provincial capital tax),
as well as eligibility for relief from withholding tax.
There has been considerable uncertainty regarding this
characterization since the CRA withdrew Interpretation
Bulletin IT-233R, Lease Option Agreements. The CRA revoked
the bulletin because it believed that certain Supreme
Court of Canada cases dictated that a more formalistic
approach should be taken. However, we believe that the
case law supports an approach that acknowledges that
certain legal relationships (such as "lease" or
"loan" or "sale") have certain legal
elements that must exist between the parties before a
court will conclude that such a relationship exists. A
mere label is not sufficient.
Hybrid
Structures for US Leases or US Assets into Canada
Hybrid
structures allow consolidation of a Canadian lessor with a
US resident so that the US resident may claim
"ownership" of the assets for US tax purposes.
The entity, however, qualifies as a Canadian resident,
including in respect of Canadian withholding tax on rent.
This allows a US lessor to offer Canadian lessees benefits
from domestic Canadian leases that mirror the results that
would have occurred had the lessor been a direct US
entity. It also allows a US operating entity to own a
Canadian asset. Hybrid structures are available to a
lessor that is a ULC. ULCs are eligible for the US
"check-the-box" rules and thus can be treated as
a partnership or sole proprietorship for US tax purposes.
Due to the unlimited liability aspect of the ULC, US
participants would typically use a US limited liability
flow-through entity to be the sole shareholder of the ULC.
Note that Canadian law restricts "foreign banks"
from directly owning Canadian entities, including ULCs,
without regulatory compliance.
Hybrid
structures are especially attractive for non-exempt assets
(there is no competing domestic lease market for these
assets), because the lease can be structured as an
operating lease for capital tax purposes, and the lessor
(being a Canadian entity) can offer to make the section
16.1 election with the lessee.
Securitizations
Finance
companies involved in asset/equipment finance often carry
out securitizations to reduce their cost of providing
asset-based finance products. Securitizations involving
secured loans or conditional sale contracts are generally
structured to result in a sale of a pool of secured loans
or conditional sale contracts to a bankruptcy remote
special purpose vehicle that funds such purchase with the
proceeds from the issuance of highly rated debt. Such
transactions can be structured to be either on-balance
sheet or off-balance sheet for the seller/ originator of
the secured loans or conditional sale contracts.
Securitizations
involving leases in Canada tend to be more complicated
than securitizations involving secured loans or
conditional sale contracts because of several, often
competing, tax and legal parameters. A typical
securitization involves the sale of a financial asset. In
the context of a lease transaction, the financial asset is
the lease receivable that generally has no tax cost. The
lessor also owns a non-financial asset in the form of the
leased property that generally has tax cost. The principal
tax constraint is that if a lessor merely sold its lease
rights (i.e., the right to receive future rents) to obtain
funds, it would realize an immediate inclusion in its
income equal to the proceeds of sale without any
offsetting deduction or reduction of cost. This
effectively accelerates the recognition of what would have
been future rental income. The lessor could still retain
the beneficial ownership of the physical asset and would
remain entitled to CCA.
To
avoid accelerating income, lease securitization
transactions are structured so that the lease payments
received by the lessor/owner are treated as prepaid rent,
not as proceeds of disposition of the leases themselves.
In general, prepaid rent must itself be brought
immediately into income; however, a deduction of a
reasonable reserve in respect of future rent periods is
allowed as a deduction. Two structures allow for this to
be accomplished: the sale/sale leaseback and the
concurrent lease.
RECENT
DEVELOPMENTS
Elimination
of Withholding Taxes on Interest
In
the 2007 federal budget, the Minister of Finance announced
that Canada and the United States expected to complete a
revised protocol to the Canada-US Tax Treaty that would,
once effective, eliminate withholding tax on arm’slength
debt and would phase in an elimination for non-arm’slength
debt over three years. In addition, Canada announced that
it would eliminate withholding tax on arm’s-length debt
to all non-residents, although the announcement and
subsequent public statements were not clear about the
implementation date for this exemption (i.e., whether it
would take effect simultaneously with the effective date
of the revised protocol or be effective only after the
three-year phase-in for non-arm’slength debt). It is
widely speculated that the effective date will be January
1, 2008. The elimination of withholding tax is expected to
have a significant impact on cross-border finance. Rent,
however, will remain subject to withholding tax.
Capital
Taxes
Canada
no longer levies the federal "large corporations
tax" (LCT) and thus the cost of borrowing has been
reduced, as has the tax bias of using single-purpose
corporations for large capital financings. Many of the
provinces are also reducing or eliminating capital taxes.
Several Canadian provinces (including Ontario and Quebec),
however, continue to levy a similar tax. Ontario entered
into an agreement with the federal government to have the
federal government administer Ontario’s corporate taxes,
including the capital tax. As part of that initiative, on
December 13, 2006, Ontario introduced legislation to
replace the Ontario capital tax with the now repealed
federal capital tax provisions. In addition, Ontario has
announced that it will gradually reduce the capital tax
rate until its elimination for taxation years beginning
after 2011. Where capital taxes apply, they are generally
imposed on the corporation’s taxable capital used in
Canada. "Taxable capital" generally means the
amount of a corporation’s total liabilities and
owners’ equity. Most single-purpose entity structures
are designed to reduce the amount of income taxes payable,
so that capital taxes can be a significant additional
unrecovered cost for the transaction. Since capital taxes
are not levied on trusts, trusts are often the preferred
form of entity. This preference for the use of trusts in
single-purpose entity structures are likely to continue
until both federal and provincial capital taxes are
eliminated completely.
Although
the LCT is now eliminated for federal purposes, the
existing policy for LCT will be relevant to Ontario
commencing in 2009. In particular, the application of
capital tax to leases and to back-to-back debt will adopt
the federal rules. In IT-532, Part I.3 Tax on Large
Corporations, the CRA stated that the determination of
whether a transaction is a lease or a sale is to be made
by using a legal test, not an accounting test, to identify
whether the lessor or lessee is subject to capital tax.
IT-532 also provides that an appropriate use of financial
instrument offset accounting may allow netting of certain
amounts to reduce the overall carrying value of an
obligation for LCT purposes. Case law conflicts regarding
the application of capital tax and the characterization
and determination of amounts for accounting purposes.
Superpriority
Rules
In
several recent insolvency situations, the CRA has asserted
that it can use the superpriority garnishment powers under
the Tax Act to garnish proceeds due to lessors, not just
for outstanding rental arrears but for the value of the
leased assets that the lessor is attempting to recover.
Generally, the superpriority rules allow the CRA to
garnish amounts due to secured creditors where the CRA is
owed amounts for employee source deductions, withholding
taxes, the employer and employee portions of Canada
Pension Plan and Employment Insurance premiums, and GST
(in some circumstances).
Vicarious
Liability
A
large publicized motor vehicle settlement brought the
issue of tort liability for lessors sharply into focus and
galvanized the industry to lobby in Canada for specific
exemptions from liability. Several provinces have or are
enacting legislation that would reduce this liability.
These initiatives are similar to the US initiatives to bar
vicarious liability in every state.
Changes
to Bankruptcy and Insolvency Laws: Aircraft
On
February 24, 2005, the International Interests in Mobile
Equipment (aircraft equipment) Act (Mobile Equipment Act)
received royal assent in Canada. The purpose of the Mobile
Equipment Act is to implement the Convention on
International Interests in Mobile Equipment and the
Protocol to the Convention on International Interests in
Mobile Equipment on Matters Specific to Aircraft Equipment
(Protocol). The Mobile Equipment Act makes a number of
changes to the Bankruptcy and Insolvency Act (Canada) (BIA)
and the Companies’ Creditors Arrangement Act (Canada) (CCAA),
resulting in allowing a lessor of "aircraft
objects," to exercise its remedies in insolvency
proceedings unless (i) after commencement of insolvency
proceedings, the debtor protects and maintains the
equipment in accordance with the applicable agreement; and
(ii) within 60 days of the commencement of the insolvency
proceedings, the debtor (a) remedies all defaults under
the applicable agreement (other than insolvency defaults),
and (b) agrees to perform its obligations (other than
insolvency defaults) under the applicable agreement both
during and after the insolvency proceedings and continues
to perform such obligations without further default (other
than insolvency defaults).
The
Protocol came into force on March 1, 2006, but will not be
in force in Canada until the first day of the month
following the expiration of three months after Canada’s
formal ratification. As of the date of writing this
article, Canada had not yet ratified the Protocol.
Changes
to Bankruptcy and Insolvency Laws: Lease Disclaimer
On
November 25, 2005, An Act To Establish the Wage Earner
Protection Program Act, To Amend the Bankruptcy and
Insolvency Act and the Companies’ Creditors Arrangement
Act and To Make Consequential Amendments to Other Acts
(Bill C-55) was passed, but the date on which it will be
proclaimed into force has not yet been determined. When
proclaimed into force, Bill C-55 will make certain changes
to the BIA and CCAA, which, if implemented in their
current form, would permit a debtor under the BIA or CCAA
to disclaim a lease of personal property regardless of
whether it is the lessee or lessor. In addition, the CCAA
would be amended to prevent the nondebtor party to an
agreement from terminating or amending an agreement solely
on the basis that an order under the CCAA has been made in
respect of the debtor.
Further
amendments to the BIA and CCAA were proposed in a
government motion tabled on December 8, 2006. One of the
proposed amendments to the changes contemplated in Bill
C-55 would require approval by the trustee in bankruptcy
prior to disclaiming a lease in respect of personal
property. However, parliamentary debate on this motion has
not yet commenced, nor is there a projected timetable for
these amendments to be drafted in bill form. Furthermore,
the Standing Senate Committee on Banking, Trade and
Commerce responsible for reviewing Bill C-55 has not
discussed the bill or any proposed changes in committee
since November 2005.
Source
: Lessors Network (press release) - Atlanta, GA, USA,
dated 09/11/2007
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