The thin capitalization rules limit the ability of a Canadian corporation to deduct interest paid to a non-resident parent, a non-resident affiliate and certain other non-residents. The purpose of these rules is to restrict the repatriation of funds with tax-deductible payments that reduce Canadian tax.
Amendments to the thin capitalization rules introduced in the 2012 Federal Budget became law in December 2012. The changes include the following:
Reduced Debt-to-Equity Ratio
The debt-to-equity ratio in the thin capitalization rules restricts a Canadian corporation's interest deductions. Specifically, where the corporation's debt to certain non-residents relative to its equity exceeds the ratio specified in these rules, the corporation's interest deductions are reduced.
The debt-to-equity ratio has been lowered from 2:1 to 1.5:1 for taxation years beginning after 2012. This means that more equity will be required to support a given level of internal debt.
Taxpayers should ensure that they will not have non-deductible interest payments as a result of the reduced ratio.
Partnerships with Canadian Resident Partners
The thin capitalization rules have been extended to debts of partnerships with (direct or indirect) Canadian resident corporate partners. The rules apply in respect of partnership debt on a look-through basis and test the relationship between the lender and corporate partner to determine whether the partner has non-deductible interest. Because partnership income is calculated at the partnership level and allocated out to the partners, the deduction denial is achieved by including the denied interest allocable to a particular partner in that partner's income. This new rule applies for taxation years beginning after March 28, 2012.
Disallowed Interest Deemed Dividend Subject to Withholding Tax at Dividend Rates
Interest that is disallowed under the thin capitalization rules is now deemed to be a dividend for Canadian withholding tax purposes. Previously, disallowed interest maintained its character as interest for withholding tax purposes.
This means that where the non-resident recipient of the interest is not entitled to treaty benefits, the 25% withholding rate continues to apply. However, where a treaty applies, the withholding rate will now in most cases be the 5% or 15% treaty rate generally applicable to dividends rather than the nil (Canada-US treaty) or 10% (other treaty) rate generally applicable to interest.
The corporation can designate which interest payments are subject to the thin capitalization rules to minimize the withholding tax impact. Without a designation, the appropriate portion of each interest payment is deemed to be a dividend.
The deemed dividend rule applies in respect of interest included in a corporate partner's income under the new partnership rule discussed above.
This change applies to taxation years ending after March 28, 2012 (with pro-rating for taxation years that include March 29, 2012).
Loan from Controlled Foreign Affiliate
A relieving provision has been added to prevent double taxation where a Canadian resident corporation owes an amount to its controlled foreign affiliate. Specifically, interest on the debt that would otherwise have been disallowed under the thin capitalization rules will be deductible if the interest is included in the Canadian corporation's income as "foreign accrual property income." In simplified terms, foreign accrual property income is generally passive-type income earned offshore and taxed in Canada on an accrual basis even though it remains offshore. This relieving measure applies for taxation years ending after 2004.
Foreign Affiliate Dumping Rules
Under the foreign affiliate dumping rules (the "FAD Rules"), share paid-up capital may be automatically or electively reduced to avoid a deemed dividend under the FAD Rules where a foreign-controlled corporation makes an "investment" (as defined) in a foreign affiliate (including as part of a series of transactions). This ensures that the paid-up capital that would otherwise arise is not included in "equity" for thin capitalization purposes, thereby preventing leveraging based on equity relating to foreign affiliate investments. The FAD Rules generally apply after March 28, 2012 (subject to certain grandfathering).
Normally, contributed surplus from a "specified non-resident shareholder" (as defined) of a corporation is included in "equity" for thin capitalization purposes. However, an amendment to the thin capitalization rules ensures that contributed surplus arising in connection with a foreign affiliate investment described in the FAD Rules will not count as equity for the purposes of the thin capitalization rules, thereby again preventing leveraging based on equity relating to such investments. This change takes effect on March 29, 2012.
Please refer to the Fasken Martineau Tax Bulletin on the FAD Rules.
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.