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Canada's thin-capitalization rule has
changed. Intra-group loans into Canada must be
reviewed if adverse tax consequences are to be avoided. Most
importantly, those lenders who accepted the non-deductibility of
interest by the borrower must now look to their own tax liability
under a rule which is already in effect.
Thin-Cap As It Was
The policy behind the thin-cap rule is to prevent the erosion of
Canada's tax base given that interest payments are deductible
whereas dividends are not. This rule applies to debt owed by
Canadian-resident corporate taxpayers to non-residents that own 25%
or more of the corporation's votes or value—such a
lender is referred to as a "specified non-resident". The
effect of this rule is to deny an interest deduction to the extent
that a 2:1 debt to equity ratio is exceeded.
To apply the 25% test, we include the specified
non-resident's shareholdings on a fully diluted basis; that is,
all stock options or other contractual rights to acquire shares are
deemed to have been exercised. We also include such shareholdings
of persons who do not deal at arm's length with the specified
non-resident. This refers to persons who, in general terms,
control, are controlled by, or are controlled by the same third
party as, the specified non-resident—i.e., a member of
the same corporate group.
Debt is then calculated by averaging the greatest amount of debt
owed to all specified non-residents in each month of the year.
Equity is calculated as the sum of: (i) the borrower's retained
earnings at the beginning of the year; (ii) the average of the
contributed surplus maintained by specified non-residents in the
borrower at the beginning of each month of the year; and, (iii) the
average of the paid-up capital maintained in the borrower by
specified non-residents at the beginning of each month of the
year.
A further rule then provides that if a specified non-resident
(or a non-resident not dealing at arm's length with the
specified non-resident) lends to a third party on condition that
this third party lend funds to the borrower, the borrower is deemed
to have borrowed those funds directly from the specified
non-resident. The thin-cap rule cannot, then, be avoided by
indirect loans.
Oddly, the thin-cap rule used to apply only to corporations and
could therefore be avoided by organizing the borrower as a
partnership.
Canada's recent federal budget has now introduced some
complexity into the foregoing.
The New Debt:Equity Ratio
The debt to equity ratio has been changed from 2:1 to 1.5:1. If,
for example, $50k of equity had been maintained in respect of $100k
of debt, it is now necessary to either increase the equity to
$66.67K or reduce the debt to $75K. This measure applies to
taxation years that begin after 2012.
Application to Lenders
Until these latest changes, the thin-cap rule only denied an
interest deduction to the borrower. Now, however, the amount of
non-deductible interest is also deemed to be a dividend to the
non-resident lender and is taxed accordingly. This is consistent
with recent amendments to Canada's tax treaty with the United
States, which wholly exempt interest payments (but not dividends)
from Canada's Part XIII tax.
This measure applies to that portion of the current taxation
year that ends on or after March 29, 2012. This measure therefore
applies now, notwithstanding that the new debt to equity ratio
applies only to taxation years that begin after 2012.
Application to Partnerships
Partnerships are no longer exempt from the application of the
thin-cap rule. The Canada Revenue Agency will look through
partnerships, denying each corporate partner its proportionate
share of the interest deduction. This measure applies to taxation
years that begin on or after March 29, 2012.
Conclusion
All intra-company loans inbound to Canada must be carefully
reviewed to ensure that they comply with the newly amended thin-cap
rule. Moreover, financing structures that accept the
non-deductibility of the interest expense must be reconsidered
given the additional tax consequence to lenders.
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guide to the subject matter. Specialist advice should be sought
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