Suggestions for Drafting Tax Indemnity Clauses To Reduce Exposure to Unexpected Withholding Tax Obligations
There are an increasing amount of banks getting involved in loan syndications. One of the reasons why syndications are attractive to banks is because they allow lenders to decrease exposure to losses, which will result from a borrower’s default, by bringing other lenders into either direct or indirect lending relationships with borrower.[i] In addition, the bank can also increase its return on assets if fees are shared between multiple lenders.[ii]
Generally, from the borrower’s perspective whether the loan is a single lender or syndicated lender loan the results are the same. However, after the credit facility has been executed, the bank can make some changes to the parties to the agreement that may increase the tax burden of the loan. Two examples of when this may arise are:
1. where a non-resident is granted a participation in a loan that was originally executed between the borrower and resident lenders; or
2. where the loan is assigned to a non-resident.
Tax indemnity clauses are often used to apportion these increased costs. Normally, these clauses require the borrower to bear the burden of the increase in costs by grossing-up their payments so that the amount received by the lender is equal to the amount lender would have received. The increase to the borrower’s gross up obligation will make the cost of the financing more expensive for the borrower.
In participations, lenders have an indirect relationship with the borrower. Essentially, the bank initiating the transaction sells an undivided percentage interest to other lenders. The interest sold to the other lenders includes the present and future obligations of the borrower.[iii] Generally, participations are treated like a transfer of beneficial interest. One author describes the participation and potential tax consequences where non-resident participants are involved as follows:
There are two separate payments of interest in such a transaction: the borrower pays interest to the lead bank and the lead bank pays interest to the participants. This arrangement … presents a relevant issue for withholding tax purposes. On the one hand, the arrangement may be seen as two separate loans with two separate obligations to pay interest – one loan is from the participant to the lead bank, and the second loan is from the lead bank to the participant. The two possibilities may result in different liabilities for the payment of withholding tax[iv]
Although the lead bank, operating as agent is responsible for paying the withholding tax in this situation, the Act does not exempt the participant from withholding tax requirements. The result is that the borrower’s cost of borrowing is increased by withholding tax that is applied twice to the same transaction.
A further issue arises because the borrower may not aware of the transfer. Where a Canadian resident borrower initially enters into a loan facility where all the lenders are resident in Canada the borrower makes payments based on the lender’s Canadian residency. Where a participation is granted to a US lender, the Agent is required to withhold taxes[v] for any payments made to a non-resident. The withholding tax amount is generally passed on to the borrower under the tax indemnity gross-up clause in the loan agreement. Where the agreement does not require the lender to notify the borrower of this change the borrower is sometimes not aware of this increased tax obligation. From the borrowers perspective this is an unfair result. In most situations, although, the facility may have provided the lender with the option to enter into a participation agreement, it likely did not contemplate a transfer of interest to a non-resident. For this reason the borrower should negotiate to include language in the tax indemnity that requires the lender to notify the borrower when a non-resident is granted a participation interest.
An assignment also creates tax issues for a borrower where the assignee is a non-resident. In an assignment, the initiating bank assigns a contractual interest in an existing loan agreement to another bank. The assignee bank will be in a direct relationship with the borrower after the assignment. For this reason, the borrower must be notified of this change. A basic assignment clause generally provides as follows:
Each bank may at any time assign or transfer all or part of its rights or obligations hereunder without the prior written consent of the Borrower to any other bank or financial institution. Each Bank shall promptly thereafter give notice thereof to the Agent who will then forthwith give notice thereof to the Borrower. Each Bank may disclose to any potential assignee or to any person who may otherwise enter into contractual relations with such Bank in relation to this Agreement, such information about the Borrower as such Bank shall consider appropriate.[vi]
Similar to the participation, where a loan has been assigned to a non-resident, the borrower’s withhold tax obligation is increased, unless an exemption applies. To ensure that the lender's risk is not increased, the borrower must gross-up the amount paid under the tax indemnity clause. Although, the borrower is required to be notified of an assignment they have little control over whether the assignment is to a resident or non-resident. This is problematic since the ultimate burden for the increased withholding tax obligation is the borrower’s responsibility. To reduce its exposure to increased tax liability in these situations, it is recommended that a borrower negotiate to have the following terms included in a tax indemnity clause:
1) No gross up permitted unless there is an event of default: Requirement to gross up should only apply if there is a continuing event of default or the borrower provided consent, otherwise transaction should be structured so no withholding tax will apply;
2) Lender does not have the ability to assign interest if it increases cost to the borrower;
3) Where the borrower was not notified of its withholding tax obligation, or the lender did not contest an assessment, the borrower should have the right to appeal a withholding tax assessment and any related penalties that have accrued as a result of assignment or participation.
4) Where the lender receives tax credit for foreign taxes paid, the borrower costs of borrowing should be reduced by the same amount. Lender actually incurred no loss by paying WHT just a timing difference for the payment.
Issuances of a Letter of Credit (“LOC”) through a syndicated group of lenders may also increase tax obligations where any of the parties are non-residents. LOC commitment fees are deemed to be interest payments under subparagraph 214(15)(b) of the Act. The provision states:
where a non-resident person has entered into an agreement under the terms of which the non-resident person agrees to lend money, or to make money available, to a person resident in Canada, any amount paid or credited as consideration for so agreeing to lend money or to make money available shall, if the non-resident person would be liable to tax under this Part in respect of interest payable on any obligation issued under the terms of the agreement on the date it was entered into, be deemed to be a payment of interest
The rule generally applies where only one LOC is issued and the lead lender resides in one jurisdiction but the fee is divided equally between syndicated lenders residing in different jurisdictions. However, this will be decided on a case-by-case basis.[vii]
[i] P. Lewarne and K. E. Thorlakson, “Syndications, Assignments and Participations by Canadian Banks”, 6 BFLR 1 at 2.
[ii] Lewarne and Thorlakson at 2.
[iii] See Lewarne and Thorlakson at 2
[iv] A. Mugasha, “The Law of Multi-Bank Financing: Syndications and Participations”, (Kingston, Ont: McGill-Queen’s University Press) at 297.
[v] See section 215(3).
[vi] D. Desjardin, “Assignment and Sub-participation Agreements – A Basic Overview”,  65 Can. Bar Review 224 at 231
[vii] See Revenue Canada Document 2003-0014145 where the letter of credit was found not to be subject to subparagraph 214(15)(b).