Canada: U.S. Federal Tax Rules Applicable To Loans From A Canadian Parent To A U.S. Subsidiary

Financing a U.S. subsidiary

When a Canadian company creates a U.S.-based subsidiary, one of the first issues to be addressed is how to fund those operations. Generally, funds may be advanced in the form of equity, debt or a combination of both.

Where funds are contributed by way of equity, they may be returned to the Canadian parent by way of a distribution from the U.S. subsidiary. For U.S. tax purposes, that distribution is treated as a dividend to the extent of the U.S. subsidiary's current or accumulated earnings and profits. A dividend is subject to U.S. withholding tax of five per cent in the case of a Canadian corporation owning at least 10 per cent of the voting stock of the U.S. subsidiary under the Canada-U.S. Tax Convention. The U.S. subsidiary does not receive an income tax deduction for this dividend payment.

Alternatively, where funds are loaned to the U.S. subsidiary, the subsidiary is entitled to an income tax deduction for interest paid on the loan, subject to various limitations discussed below. The interest payment is not subject to U.S. withholding tax under the Canada-U.S. Tax Convention. Repayments of loan principal are not deductible by the borrower. Because of the potential tax rate differential on funds flowing through to the ultimate Canadian shareholders of the Canadian parent by way of interest rather than dividends, debt financing of Canadian-owned U.S. subsidiaries can be an attractive option.

What constitutes a debt?

For U.S. federal tax purposes, indebtedness exists only if the parties to the obligation intended to create a debt. The debt must be legally enforceable, provable and unconditional. The Internal Revenue Code (IRC) does not define "debt," leaving taxpayers to look to judicial history on the subject. In classifying a security as debt or equity, the courts have looked to many factors, including:

  1. the intent of the parties;
  2. the existence of a written document evidencing the indebtedness;
  3. the presence or absence of a fixed maturity date;
  4. the presence or absence of a stated interest rate;
  5. the right to enforce payment of principal and interest;
  6. adequacy of the borrower's capitalization, typically interpreted as not more than a 3:1 debt to equity ratio; and
  7. the expected ability of the borrower to satisfy the loan in accordance with terms at the inception of the loan.

No single factor is dispositive. The challenge in making a debt-equity determination in the case of non-arm's length parties is even greater as there is often an existing equity relationship. This is an area of Internal Revenue Service scrutiny, so particular care must be taken to ensure the economic realities of the transaction match the stated form. The determination of debt-equity status is made at the time the security is issued. That initial characterization is binding on both the issuer and the holder – but unfortunately not on the IRS.

If a taxpayer fails to satisfy these requirements for debt characterization upon examination by the IRS, payments from the U.S. subsidiary to its Canadian parent that were thought to be deductible interest payments and subject to 0 per cent withholding could be recharacterized as non-deductible dividend payments, subject to five per cent withholding tax. Additionally, the payment that is recharacterized as a non-deductible dividend for U.S. tax purposes may still be characterized as interest and subject to tax for Canadian tax purposes. Care is required to ensure that the U.S. debt characterization requirements are satisfied whenever there is U.S. indebtedness.

General deductibility requirements

Assuming the debt classification requirements discussed above are satisfied, further analysis is required to determine the deductibility of interest for U.S. federal income tax purposes. In computing a taxpayer's income, a deduction shall be allowed for interest paid or accrued within the taxable year on indebtedness. Despite the general allowance for interest deductibility, there are numerous provisions within the IRC that could defer or deny the deduction.

Capitalization provisions

Several IRC provisions can defer deductibility of interest by requiring that it be capitalized into the tax basis of an asset. For instance, IRC §263 requires that certain expenses (including interest) be included in the cost of inventory. IRC §279 can require the capitalization of interest on indebtedness incurred by a corporation to acquire the stock or assets of another corporation.

Related party interest

A common trap for the unwary is found in IRC §267, dealing with transactions between related parties. Generally, an accrual basis taxpayer may deduct interest when accrued. However, in the case of interest to a foreign related person, the interest must actually be paid for it to be deductible by the taxpayer. The term "related person" is defined broadly and includes a person with a greater than 50 per cent ownership interest in the corporation. Furthermore, constructive ownership rules apply. For example, assume a Canadian parent loans funds to its wholly owned U.S. subsidiary and interest is accrued but unpaid by the end of the taxable year. IRC §267 would deny the U.S. subsidiary a deduction for the accrued interest. However, under Canadian tax principles the accrued interest may be taxable to the Canadian parent, creating a current income inclusion in Canada without a corresponding current deduction in the U.S. The U.S. subsidiary should be allowed a deduction in future periods if the interest is actually paid, subject to other limitations.

Although one might assume that what constitutes a payment should be straightforward, there are many situations in which it may, in fact, be unclear. A payment is considered made when the amount would be includible in the income of the beneficial owner under U.S. tax principles governing the cash basis method of accounting. Under this method, amounts not in the taxpayer's possession are constructively received only when they are credited to the taxpayer's account, set apart for him/her, or otherwise made available so that they may be drawn upon at any time. Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

Earnings stripping rules

The IRS uses several tactics to prevent the diminution of the U.S. tax base by a foreign corporation's excessive leveraging of its U.S. subsidiaries. The first tactic is the thin-capitalization factor of the debt-equity analysis discussed above. Where the amount of a shareholder debt far exceeds that shareholder's capital in the subsidiary, the IRS can question whether the shareholder/lender would treat the debtor in the same manner as an unrelated lender would. It is widely assumed that a debt to equity ratio that does not exceed 3:1 generally will be respected by the IRS. In calculating this ratio, the fair market value of assets and liabilities rather than their historical or book values should be used.

IRC §163(j) targets earnings stripping by disallowing current deductions for interest paid to foreign related parties under certain circumstances. The provision applies only to taxpayers with a debt to equity ratio in excess of 1.5:1. The calculation is complex, but as a general rule, interest paid to a related party (or to a third party on debt guaranteed by a related party) may be disallowed to the extent it exceeds 50 per cent of the payer's earnings before interest, depreciation, amortization and taxes. Disqualified interest amounts may be carried forward to future years but may not be carried back. When considering the amount of foreign related party debt to put into the U.S., careful modeling is required to ensure full U.S. interest deductibility.

Transfer pricing

The U.S. has extensive transfer pricing rules that seek to ensure related party transactions are conducted on an arm's-length basis (i.e., in the same manner as unrelated parties would act). Under these rules, the IRS has the authority to make adjustments to a taxpayer's income to prevent the evasion of taxation or to reflect the taxpayer's income more clearly. Related party interest is subject to these rules that might potentially deny the interest deduction, in whole or in part, if the arm's-length standards are not satisfied. Furthermore, the U.S. transfer pricing rules require that contemporaneous documentation be prepared to substantiate that the related party interest is at arm's length.


Although loans from a Canadian parent to its U.S. subsidiary might appear straightforward at first glance, there are numerous traps that must be avoided to ensure debt treatment and full deductibility of interest payments for U.S. income tax purposes. Careful tax planning is required. Contact your Collins Barrow advisor for help.

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions