The federal budget delivered in March 2012 contained two tax initiatives that are of particular concern to foreign companies with Canadian subsidiaries. Affected taxpayers need to assess the effect of these proposals on their particular businesses and where necessary take steps to mitigate the adverse impact of these changes, which are summarized below and discussed at greater length in Steve Suarez’s budget commentary published in Tax Notes International, available here.
THIN CAPITALIZATION RULES TIGHTENED
Many multinational groups lend money to their Canadian subsidiaries. If the debt is incurred for use in the Canadian subsidiary’s business, the resulting interest expense typically meets the general requirements to be deductible in computing the Canadian subsidiary’s Canadian income tax. When such interest is paid by the Canadian subsidiary to a foreign member of the related multinational group, Canadian interest withholding tax is typically fairly low (0% on payments to U.S. residents in many cases, and 10%-15% on payments to creditors resident in most countries with which Canada has a tax treaty). As a result, there can be an incentive to maximize the Canadian subsidiary’s debt owing to related non-residents, in order to strip out Canadian profits as tax-deductible interest that bears little or no Canadian withholding tax.
Canada’s tax system includes “thin capitalization” rules designed to limit this type of planning, by restricting the amount of debt owing to related non-residents that a Canadian corporation can deduct interest expense on for tax purposes. Essentially, under the pre-Budget rules, if the amount of debt owing to related non-residents is more than 2 times the Canadian corporation’s “equity” for this purpose (basically the sum of its retained earnings and the paid-up capital of shares held by non-resident group members), no deduction is permitted on interest accruing on the excess debt.
The Budget proposes the following changes to these rules:
- most importantly, the 2:1 debt/equity limit is being changed to 1.5:1, effective January 1, 2013;
- debt incurred by a partnership of which a Canadian corporation is a member will now come within the thin capitalization rules; and
- interest that has been disallowed under these rules will be treated as a dividend (not interest) for Canadian withholding tax purposes (this will typically be adverse for U.S. creditors).
Thus, for example, effective 2013 a Canadian subsidiary of a foreign corporation that owes $200 to that foreign parent and has only $100 of equity for these purposes will only be able to deduct interest expense relating to $150 of that debt.
FOREIGN AFFILIATE DUMPING
One of the ways in which some Canadian subsidiaries of foreign corporations increased their tax-deductible Canadian interest expense on debt owing to foreign group members was to purchase shares of foreign group members. Interest on the debt owing by the Canadian subsidiary for the purchase price would typically meet the general interest-deductibility requirements, and in most cases any dividends received by the Canadian subsidiary on the shares purchased would effectively be non-taxable in Canada.
A sweeping new proposal introduced in the Budget (labelled as countering “foreign affiliate dumping”) attacks this type of planning, and much more. In very general terms, the new rule applies where the following conditions are met:
- a Canadian corporation (Canco) that is controlled by a foreign corporation (Parent) makes an “investment” in another foreign corporation (Forco) after March 28, 2012;
- Forco is (or as part of the same series of transactions becomes) a “foreign affiliate” of Canco, which occurs where Canco holds at least 1% of Forco’s equity and the Parent group (including Canco) collectively holds at least 10% of Forco’s equity; and
- it cannot be shown that Canco’s purpose in making the investment was primarily for business reasons rather than to reduce or defer Canadian taxes.
The definition of what constitutes an “investment” is extremely broad, and is not limited to situations in which a payment is made to other Parent group members: transactions with third parties can trigger this rule. Where applicable, this new rule may deem Canco to have paid a dividend (to which Canadian dividend withholding tax applies), or may eliminate any increase in Canco’s paid-up capital otherwise occurring (which will reduce “equity” for thin capitalization purposes and reduce Canco’s ability to make distributions without dividend withholding tax applying). This proposal seems broad enough to apply to many transactions that appear completely inoffensive from a tax policy perspective, and as a result Canadian subsidiaries of foreign companies need to be extremely careful in undertaking any transactions that relate to entities that are (or may subsequently become) “foreign affiliates” of the Canadian subsidiary.
Foreign corporations with Canadian subsidiaries should be reviewing the impact of these changes at the earliest opportunity.