The Partnership, a general partnership governed by the laws of a U.S. state that was a Canadian partnership under s. 102 as its partners were Canco and a wholly-owned Canadian sub of Canco, held all the shares of a U.S. LLC (the “Creditor Affiliate”), which had made an interest bearing loan to the Partnership (the “Loan”). The Loan was not recognized for U.S. tax purposes because Creditor Affiliate was a disregarded entity.
The Partnership subsequently transferred all of its assets, including the shares of the Creditor Affiliate, to a newly formed wholly-owned U.S. subsidiary of Partnership (the “Debtor Affiliate”), the consideration for which included the Debtor Affiliate assuming the Partnership’s liability to repay the Loan and to pay the accrued but unpaid interest thereon (the “Accrued Interest”) to the Creditor Affiliate. The Partnership was thereupon released of its obligations to the Creditor Affiliate by the Creditor Affiliate.
In response to a query as to whether Part XIII withholding tax applies to the Accrued Interest pursuant to paragraph 212(1)(b), the Directorate indicated its “preliminary conclusion” that there was a novation of the Partnership’s Loan obligation and then stated:
[A]t the time of this novation, the Partnership would be considered to have made a payment or credit in kind of the Accrued Interest to the Creditor Affiliate by delivering the Debtor Affiliate’s covenant to make the payments under the Loan agreement to the Creditor Affiliate.
After noting that s. 212(13.1)(a) deemed the Partnership to be a person resident in Canada respecting then kind payment of the Accrued Interest, it concluded:
[P]ursuant to paragraph 212(1)(b), the Creditor Affiliate would have an obligation to pay a tax of 25% on the amount of the Accrued Interest that was paid or credited to it in kind by the Partnership at the time the obligation to pay the Accrued Interest was assumed by the Debtor Affiliate as a result of the novation.