At the Canada Revenue Agency (CRA) Round Table held on November 24, 2015 at the 2015 Canadian Tax Foundation Annual Conference in Montréal, the CRA made an announcement that will be helpful to many Canadian subsidiaries of multinational groups who borrow from non-Canadian group members in currencies other than the Cdn.$. This announcement indicates that the CRA applies Canada's "thin capitalization" rules limiting the deductibility of interest expense so as to ignore F/X fluctuations on the debt principal occurring after the debt is incurred. This confirmation will be of considerable assistance to many Canadian debtors, given the recent depreciation of the Cdn.$ (in particular against the USD) that might otherwise have caused such borrowers to exceed the permitted thin capitalization limits.
Canada's Thin Capitalization Rules
Canadian corporate income tax rates (combined federal-provincial) currently range from about 25%-30%, depending on the relevant province. Thus, a dollar of interest expense incurred by a Canadian corporation on debt owing to a non-arm's-length non-resident creditor (e.g., a foreign parent or sister corporation) yields roughly 25-30 cents in Canadian income tax saved, at a typical cost of 10 cents (or zero, for U.S. creditors entitled to benefits under the Canada-U.S. tax treaty) in Canadian interest withholding tax. This can create an incentive for multi-national groups to "thinly capitalize" their Canadian operations, with high (interest expense-generating) debt and little equity.
Canada's thin capitalization rules restrict the amount of interest-deductible debt that a Canadian corporation (Canco)1 can incur owing to related non-residents, so as to limit the potential for cross-border intra-group interest stripping. Essentially these rules prevent Canco from deducting interest on outstanding debt owing to specified nonresidents2 to the extent that such debt exceeds 150% of Canco's "equity."
For example, a Canco that owes $100 million to its foreign parent and has only $50 million of "equity" for thin capitalization purposes will be able to deduct interest expense relating to only $75 million of that debt (see Figure 1.). Interest on the remaining $25 million of debt will be non-deductible for Canadian tax purposes and will be recharacterized as a dividend to which 25% Canadian non-resident dividend withholding tax will apply (subject to reduction under an applicable tax treaty), instead of as interest (which as noted above would generally be received by most U.S. recipients free of Canadian withholding tax).
"Debt" and "Equity" in 1.5:1 Debt/Equity Test
Canco's "outstanding debt owing to specified nonresidents" is determined for a given taxation year by adding the maximum amount of such debt at any time in each calendar month that ends in that year, and dividing the total by the number of such calendar months in the year (i.e., to produce an average). Canco's equity is calculated as the sum of the following three amounts:
- Canco's unconsolidated retained earnings at the beginning of the year;
- the total of the start-of-month contributed surplus received by Canco from specified nonresident shareholders3 of Canco for each calendar month ending in the year, divided by the number of such calendar months; and
- the total of the start-of-month paid-up capital of Canco shares owned by specified non-resident shareholders of Canco for each calendar month ending in the year, divided by the number of those calendar months.
Where Canco borrows in a currency other than the Cdn.$ (the "loan currency"), the CRA's historical position has been that fluctuations in the exchange rate between the Cdn.$ and the loan currency affect the thin capitalization computations.4 Specifically, the CRA's position has been that each time the calculation of Canco's "outstanding debt" needs to be made under the thin capitalization rules, non-Cdn.$ debt would need to be recomputed in Cdn.$ terms by converting the outstanding principal to Cdn.$ at the current exchange rate. Given the significant (25%) decline in the Cdn.$ versus the USD during 2014-2015, having to express a constant amount of USD-denominated "outstanding debt owing to specified nonresidents" at current Cdn.$ exchange rates would cause many Canadian subsidiaries of multinational groups with USD intra-group borrowings to exceed the 1.5:1 debt/equity ratio permitted under the thin capitalization rules, simply due to F/X movements.
Happily, on November 24, 2015, the CRA confirmed that the enactment of s. 261 ITA some years ago (2007) means that its historical administrative position is no longer applicable. At the 2015 CTF annual conference, the CRA stated that its historical administrative position pre-dated the enactment of s. 261 ITA, and that the appropriate interpretation of s. 261(2) ITA is to require that the principal amount of the debt be converted into Cdn.$ based on the F/X rate on the date the loan was made, with that Cdn.$ amount being the relevant amount for thin capitalization purposes. As a result, it is not necessary to recompute non-Cdn.$ debt principal amounts for thin capitalization purposes simply because of subsequent fluctuations in F/X rates. This is a fair tax policy result, and from a practical perspective this interpretation confirms that many Canadian members of multinational groups will not be penalized under the thin capitalization rules solely due to F/X fluctuations over which they have no control.
1 The thin capitalization rules apply not only to Cancos, but also to Canadian resident trusts and to corporations and trusts not resident in Canada that either carry on business in Canada or elect to be taxed as Canadian residents. Partnerships in which those kinds of entities are members are also generally included.
2 A specified nonresident as regards Canco is defined as a nonresident person who either (1) owns at least 25% of Canco's shares (by votes or value, and including any shares held by non-arm's-length persons); or (2) does not deal at arm's length with shareholders holding at least 25% of Canco's shares.
3 That is, a shareholder holding at least 25% of Canco's shares who is a nonresident.
4 CRA Document RCT 8031-5, dated September 28, 1988. For Canadian tax purposes all taxpayers must compute relevant amounts in Cdn.$, unless they have validly elected under s. 261 of the Income Tax Act (Canada) (ITA) to use a different permitted functional currency.
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.