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.
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.
Patrick Westaway is a Partner at Dale & Lessmann LLP, a Toronto-based full service law firm. Patrick practises in the area of taxation law with a specialization in international tax structuring. To speak with Patrick, please call 416-369-7857 or e-mail him at email@example.com.