An often overlooked change proposed in the Canadian federal
budget of March, 2012, may have a significant impact on how
Canadian subsidiaries of foreign corporations are financed. The
thin capitalization rules will be changing effective January 1,
2013. Existing Canadian tax law limits the ability of a corporation
resident in Canada to incur deductible interest expense on
cross-border debt owing to non-residents who are, or are related
to, significant shareholders.
Many Canadian subsidiaries, particularly finance companies are
capitalized with heavy debt leverage. Current rules permit a debt
to equity ratio of 2:1 in order to obtain tax efficiency. The
change proposed in the budget will change this ratio to 1.5 to 1.
The impact will be that Canadian subsidiaries will require more
equity in order to obtain tax efficiency. The proposed changes in
the budget will treat these non-deductible interest payments (the
portion that exceeds the ratio) as dividends paid by the
corporation for withholding tax purposes, resulting in the
imposition of a 5%, 15% or 25% withholding tax, depending on the
The budget also extends the application of the thin
capitalization rules to partnerships where a corporation resident
in Canada is a partner.
One area that was not changed is if the leverage to the Canadian
subsidiary was provided by arm's-length third parties. A common
structure utilized is to have the non-Canadian parent of a Canadian
subsidiary provide a guarantee of its Canadian subsidiary to either
its main creditor or a Canadian national bank and then have that
financial institution provide debt to the Canadian subsidiary. The
debt provided by the financial institution is not factored into the
calculation of the debt/equity ratio for thin capitalization
purposes. The interest payable by the subsidiary to the third party
finance company would remain deductible. The new rules should have
no impact on this structure.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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Under the Income Tax Act, the Employment Insurance Act, and the Excise Tax Act, a director of a corporation is jointly and severally liable for a corporation's failure to deduct and remit source deductions or GST.
Under the Income Tax Act, the Employment Insurance Act, the Canada Pension Plan Act and the Excise Tax Act, a director of a corporation is jointly and severally liable for a corporation's failure to deduct and remit source deductions.
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