Canadian Financial Services Sector: U.S.

UNCLAS SECTION 01 OF 02 TORONTO 002634

SIPDIS

STATE FOR EB TONY WAYNE
STATE FOR WHA/CAN, EB/IFD, INR
STATE FOR WHA DAS WHITAKER
USDOC FOR 3000/ITA U/S RHONDA KEENUM
USDOC FOR 432/ITA/IAA/BASTIAN/RUDMAN/FOX
TREASURY FOR U/S (INTERNATIONAL AFFAIRS) TIMOTHY ADAMS
TREASURY FOR U/S (DOMESTIC FINANCE) RANDY QUARLES
DEPT ALSO PASS USTR FOR J. MELLE AND S. CHANDLER
DEPT PASS SEC - MARISA LAGO
DEPT PASS FEDERAL RESERVE BOARD
DEPT PASS TO IRS COMMISSIONER MARK EVERSON
WHITE HOUSE/NSC - KIM BRIER AND SUE CRONIN

SENSITIVE

E.O. 12958: N/A
TAGS: EINV EFIN KTIA PREL CA US
SUBJECT: Canadian Financial Services Sector: U.S.
Banks Say, "Ax the Withholding Tax on Interest"

Refs: (A) 04 Toronto 0514 (B) 01 Toronto 1069

Sensitive But Unclassified - Please Protect
Accordingly.


1. (U) This message is one in a series reviewing the
Canadian financial services sector from a cross-border,
North American integration perspective. In September
2005 the Toronto Financial Services Alliance sponsored
roundtables for ConGen Toronto with industry sector
experts in venture capital (septel),banking (septel),
securities (septel),and insurance (septel).


2. (SBU) SUMMARY: American banks that operate
wholesale banking branches in Canada say that the
Canadian and U.S. withholding taxes on income paid to
non-residents impedes the development of a secondary
loan market in Canada. U.S. banking interests in
Canada are the major victims but Canada and North
America as a whole are losing out when Canada's
secondary loan market remains relatively illiquid. The
Foreign Banks' Executive Committee (FBEC) at the
Canadian Bankers Association (CBA) has mobilized the
major domestic Canadian banks to lobby senior Finance
Department officials in Ottawa to deal with this issue
during upcoming bi-lateral Tax Treaty negotiations with
the United States. U.S. bank representatives located
in Toronto ask that the USG encourage Canada to remove
the withholding tax on income paid to non-residents.
END SUMMARY.

U.S. Bankers Complain about Withholding Tax
--------------


3. (SBU) In late September, two CEOs and one senior
representative of Bank of America (Canada),Citibank
(Canada),and JP Morgan Chase (Canada) approached the
Consul General privately to complain bitterly about the
Canada-U.S. withholding tax on income paid to non-
residents. At issue is paragraph 212 (1) (b) of the
Canadian Income Tax Act (ITA),which deals with
withholding tax on interest paid to non-residents. The
U.S. bankers said current bilateral withholding taxes
on cross-border interest payments have a very
detrimental effect on liquidity and, therefore, a
correspondingly negative impact on the possibility of
establishing a strong Canadian secondary loan market.
They argued that they would be strong players in the
Canadian secondary loan market, if it were permitted to
become as dynamic as it is in the U.S. In practice,
the Canadian ITA keeps U.S. investors all but out of
the secondary loan market, hitting U.S. banking
interests, robbing the Canadian market of liquidity,
and adversely affecting the strength and depth of North
American integration in financial services.


4. (SBU) Elimination of withholding tax (or, at least,
an expansion of the available exemptions) is a major
priority for the Foreign Banks' Executive Committee
(FBEC) at the Canadian Bankers Association (CBA). The
FBEC has been successful in gaining the support of the
domestic banks on this issue and is now working to gain
the support of senior Finance Department officials in
an attempt to change the ITA. Canadian Finance
Department officials have been reluctant to address
this issue because the projected cost of abolishing
this withholding tax on interest and dividend earnings
is worth C$2 billion per year in revenues. The U.S.
banking community in Canada would welcome strong U.S.
support for removing the withholding tax as part of the
current bilateral tax treaty negotiations.

Withholding Tax Can Lead to Double Taxation
--------------


5. (SBU) Canada levies a 25 percent withholding tax on
interest paid or credited to non-residents. This rate
has been reduced to 10 percent under many of Canada's
tax treaties, including the present Canada-United
States Income Tax Convention. Canadian withholding tax
is applied to interest payments made to all non-
resident non-arm's-length lenders (i.e., related party)
and to non-resident arm's-length (i.e., unrelated
party) lenders. Both countries allow their residents
to credit foreign withholding taxes against their
domestic income tax liability to avoid double taxation.
However, the foreign withholding tax liability
(applicable to earnings before expenses) can be larger
than the domestic corporate tax liability (applicable
to profits),making it a net "border tax" that
effectively amounts to double taxation (reftel).

Withholding Tax Impedes Secondary Loan Market
--------------


6. (U) The withholding tax impedes the development of
a dynamic secondary loan market in Canada by
effectively shutting U.S. investors out. For example,
one of the deepest and most liquid markets in the U.S.
is the Public and Conduit Asset Backed Securitization
market. In 2002 this market represented approximately
US$730 billion of liquidity in the U.S. By contrast,
the Canadian Securitization market was some US$60
billion in 2002. According to the FBEC members of the
CBA, the withholding tax is one of the main reasons why
U.S. liquidity does not flow to Canada.


7. (U) Credit cards, auto loans, leases, and mortgage-
backed securities are some of the most actively
financed interest-bearing assets in this market.
Currently, a Canadian financial institution desiring to
boost its liquidity by selling a bundle of similarly
priced and timed interest bearing assets in this market
will find that U.S. banks, with deep pockets of
liquidity, are not interested in buying because the
interest earnings on Canadian assets will be too low to
make the deal fly once the withholding tax on those
interest earnings is factored in.

Comment: Time to Ax this Tax
--------------


8. (SBU) Both U.S. and Canadian banks believe that the
withholding tax on income paid to non-residents should
be axed and measures taken to encourage and develop a
secondary loan market in Canada. Bankers argue that
elimination of (or, at least, significant cuts to) the
current withholding tax would have a widespread
positive impact on both the banking and corporate
marketplace with corresponding positive effects for
investment and economic development in Canada and North
America at large. They argue that the most viable
method of amending the withholding tax provisions in
the Income Tax Act is through changes to the bilateral
Tax Treaty between the United States and Canada.

LECROY