The Canadian federal budget tabled on March 29, 2012 (the
"Budget") proposed a number of important
amendments that affect cross border planning with Canadian
corporations. One proposal modifies the Canadian "thin
capitalization" rules. This change is likely to affect a
significant number of existing financing structures involving
foreign-owned Canadian corporations, and may affect future
The Income Tax Act (Canada) limits the deductibility of
interest paid or payable by Canadian corporations in respect of
debts owing to certain non-resident lenders (generally lenders who
own more than 25% of the votes or value of the Canadian
corporation, or who do not deal at arm's length with such a
shareholder). The rules do not apply to third-party debt, nor does
third-party debt affect the permitted ratio. The current legislated
maximum debt to equity ratio is 2:1, and interest deductibility may
be denied if the Canadian corporation has debt to such lenders
which exceeds this ratio. The Budget, however, proposes to reduce
this ratio to 1.5:1, effective for taxation years of the Canadian
corporation commencing after 2012.
As a result, Canadian corporations financed with foreign debt
which is subject to the thin capitalization rules will need to
address their debt to equity ratios and may need to capitalize a
portion of such debt if the 1.5:1 ratio would otherwise be
exceeded. Assuming a current 2:1 debt to equity ratio,
approximately 10% of the outstanding debt may need to be
capitalized in order to comply with the new rule. Additional
transactions and tax planning may be required where the value of
the debt is less than its principal amount, or where foreign
exchange gains may be realized because the debt is denominated in a
The Budget also extends the thin capitalization rules to debt
owing by a partnership of which a Canadian corporation is a member.
In general terms, the debt of the partnership is allocated
proportionately to its Canadian corporate members.
In addition, the Budget proposes to treat denied interest as a
deemed dividend subject to Canadian withholding tax, regardless of
whether such interest is paid. Previously, denied interest may not
have been subject to withholding tax. Taken together, these
proposed changes make it even more important for Canadian
corporations to ensure that they comply with the thin
capitalization rules and the reduced permitted debt to equity
The content of this article does not constitute legal advice
and should not be relied on in that way. Specific advice should be
sought about your specific circumstances.
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