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LEGAL REPORT: TAX LAW Changes to withholding tax will have repercussions Amendments make the Canadian securitization market far more visible and appealing to foreign financial players. BY SUSAN HUGHES L ast November's unexpected an- nouncement by Ottawa that the Canadian withholding tax on arm's-length, cross-border interest pay- ments to foreign residents, including those in the U.S., will be eliminated ef- fective Jan. 1, 2008, will have many re- percussions in Canadian markets. The most visible and important of these should be increased foreign competition in Canada's securitization market. Withholding taxes on interest paid to foreign sources on the vast majority of Canadian securitized issues will be im- mediately eliminated. This is in advance of the implementation of the Fifth Pro- tocol, which amends the Canada-U.S. Income Tax Convention signed Sept. 21, 2007. The change will eliminate the need for foreign and U.S. residents to await ratification of the Fifth Protocol in order to take advantage of the withholding tax exemption in most circumstances. The proposed in the Canadian Income Tax Act will apply to interest payments gen- erated after Dec. 31, 2007, regardless of the date the protocol becomes effective. Payments of interest between Canadian and U.S. non-arm's-length or related par- ties, however, will continue to be subject to a withholding tax rate of 10 per cent. The existing treaty rate of 10 per cent will be reduced to seven per cent during the calendar year in which the amendment comes into force, and further reduced to four per cent the next year, and to zero the following year. Non-arm's-length parties with existing loans on which withhold- ing tax is eligible should consider defer- ring interest payments until these reduc- tions occur, since the withholding tax is payable when interest is paid or credited. Participating interest — that dependent or contingent upon the use or produc- tion of property in Canada — will still be subject to the current withholding taxes. Subject to some exceptions, with- holding taxes will remain with respect 40 FEBRU AR Y 2008 www. C ANADIAN Law ye rmag.com to dividends, trust distributions, lease payments, rents, and royalties. The with- holding tax exemption also will not apply to unreasonable interest — that which is in excess of interest that, absent a special relationship between the parties, would otherwise have been charged. So what exactly is securitization and how is the elimination of the withhold- ing tax on these vehicles going to affect the Canadian legal community? Simply put, securitization is the pool- ing of such Canadian-based assets as mortgages, loans, and credit card receiv- ables into securitized investment prod- ucts and packages that are subsequently sold to foreign investors and concerns. More specifically, it is the process of con- verting existing, non-marketable assets, or future cash flows, into marketable se- curities. Even such future cash flows as car rental payments and ticket sales can be converted into securitized investment products. JOE WEISSMANN