After the near collapse of the Canadian securitization market in August 2007, 2010 saw a strong resurgence in term ABS issuance in Canada. Among other things, there were 16 public deals with combined total issuance of more than CAD$11 billion. There were also signs of renewed activity in the ABCP market with conduits taking on new deals with originators who had been largely frozen out of this market over the last few years. Overall, there is a general sense of optimism about the market and, as a result of both market forces and government action, it's fair to say that the Canadian securitization market is, if not perfectly well, at least comfortably on the road to recovery.
The public term deals in 2010 were largely auto (including retail and wholesale floorplan as well as fleet leasing assets) and credit card, with some equipment and mortgage deals as well. Four of the public deals were done (at least in part) through the government-sponsored Canadian Secured Credit Facility (CSCF - our equivalent of TALF), but the remaining 12 public deals were done with no government support, and even some of the CSCF deals had tranches that went to market investors rather than the government. All of this suggests growing investor confidence in this market, with 2011 likely to see at least as much issuance and perhaps even more originators and asset classes re-entering the Canadian market.
Apart from the very real benefit of the CSCF in effect "kick-starting" the Canadian term market, two other factors have helped to grow the Canadian market: firstly, the much slower course of regulatory reform affecting Canadian securitization; and secondly, the elimination of withholding tax on most cross-border payments of interest.
So Far, No Dodd-Frank in Canada
Regulatory reform in Canada affecting the securitization market has been relatively limited to date. Apart from a few fairly limited proposals affecting the derivatives side, Canada has not yet seen the type of sweeping regulation of securitization that has impacted the U.S. (Correspondingly, we also never saw the same type of collapse of our mortgage market, so while Canadian investors were certainly hurt by what happened in the U.S., our own assets performed relatively well.) Perhaps the most significant changes in our ABCP market were the moves to multiple ratings and away from "Canadian-style liquidity" support to global-style liquidity, but these were the result of market forces rather than government regulation.
That is not to suggest that nothing is afoot. The Canadian Securities Administrators indicated in June 2010 that they intend to provide draft proposals for reform of the term ABS market this summer. It is too early to tell what direction they will take, but the general expectation is that we are unlikely to see anything in Canada as encompassing or intrusive as Dodd-Frank.
Elimination of Canadian Withholding Tax
One of the most important developments in the Canadian securitization market (as well as our credit markets generally) since August 2007 has been the elimination of Canadian withholding tax on most types of cross-border interest payments effective as of January 1, 2008. Prior to that date, Canadian withholding tax was a significant impediment to the cross-border securitization of most asset classes. Typically, the only cross- border securitizations one would see were deals involving non-interest bearing trade receivables or five-year-plus deals structured to comply with complex exemptions from Canadian withholding tax rules.
The good news is that Canadian withholding tax has now been largely eliminated on cross-border payments of interest and, therefore, this has become a much less significant concern. It is now possible to sell virtually any interest bearing asset cross border, or to sell the assets as part of a domestic sale in Canada, but fund the transaction with a cross-border loan (or the issuance of notes) into the U.S. Nonetheless, there are still important withholding tax issues that must be considered.
(i) Withholding Tax on Rent and Certain Other Payments.
Withholding tax still applies to certain cross-border payments, including payments of rent (subject to certain exceptions for aircraft leases and rolling stock) and dividends. Therefore, for example, it is not practical to securitize lease receivables directly cross border. Typically, we securitize lease receivables within Canada to a Canadian SPE, and then fund that SPE with a cross-border loan.
(ii) Deemed Dividend for Cross-border Notes.
The typical two-step structure whereby assets are sold from an originator to an SPE in consideration for, among other things, a note payable by the SPE to the originator, can give rise to a different Canadian withholding tax concern when it is used for a cross-border sale to a U.S. SPE. Unless the Canadian originator holds shares in the U.S. SPE (which may raise other Canadian tax issues), the entire amount of the intercompany note can be deemed to be a dividend under Canadian tax rules if it remains outstanding over a year end. Since dividends are still subject to Canadian withholding tax, that "deemed dividend" will also be subject to Canadian withholding tax. That tax is refundable when the note is ultimately paid, but the refund is without interest and there is therefore a cost notwithstanding that the tax is refunded.
There are various techniques to avoid this particular withholding tax, including using a Canadian SPE rather than a U.S. one or, where possible, making sure that no part of the purchase price of the Canadian assets remains owing to the Canadian company - in other words, ensuring that all amounts owing to the Canadian company for its receivables are paid in cash.
(iii) Services Rendered in Canada.
Withholding tax also applies to amounts paid to a non-resident of Canada for services rendered in Canada. Therefore, where service fee receivables are sold cross border, this withholding tax needs to be considered. Depending on the circumstances, it may be possible to conclude that this withholding tax will not apply to a cross-border sale of service fee receivables, but the particular circumstances need to be reviewed.
(iv) Related Parties.
Withholding tax will apply on cross- border payments of interest between related parties, if the U.S. lender entity in question is not entitled to the benefits of the Canada-U.S. Tax Convention (or if the payments are made by a Canadian person to a related entity resident outside the U.S.).
(v) Participating and Convertible Debt
If the interest is "participating" or payable under a convertible instrument, withholding tax may apply. Participating debt is basically debt where the rate of return is a function of the performance of the debtor.
(vi) Applicable Rates.
The normal withholding tax rate, where it applies, is 25% unless reduced by treaty. In cases where the tax applies, a Canadian resident payor is required to withhold 25% (or any lower applicable rate) of the interest (or other applicable amount being paid, such as rent) and remit the withheld amount to the Canadian tax authorities. If the payor fails to do so, both it and the non-resident payee (e.g., a U.S. conduit or investor) will be jointly and severally liable for the amount that should have been withheld.
Overall, there is reason to be optimistic that the resurgence of the Canadian securitization market will continue and that securitization will resume its role as a key liquidity leg to many Canadian companies.