In order to prevent non-residents of Canada from stripping profits from their Canadian subsidiaries (each a "Canadian Subsidiary") in the form of deductible interest, the Income Tax Act (Canada) (the "ITA") contains a set of rules (the "thin cap rules") designed to (a) limit the amount of deductible interest that can be paid by a Canadian corporation to a specified non-resident shareholder (a "Foreign Parent") and (b) treat any excess interest as a dividend paid to the Foreign Parent, subject to withholding tax under Part XIII of the ITA ("Part XIII Tax").
In response to concerns that Canadian Subsidiaries and Foreign Parents were engaging in transactions with third-party lenders structured to avoid the application of the thin cap rules, the Department of Finance ("Finance"), in the 2014 Federal Budget, proposed significant changes to the thin cap rules to extend the application of those rules to a broader universe of transactions (the "Budget Proposals"). While Finance's objective - to prevent the inappropriate avoidance of the thin cap rules - was uncontroversial, the Budget Proposals, if enacted, would have expanded the reach of the thin cap rules such that they would apply to most, otherwise innocuous and inoffensive, lending transactions involving Canadian Subsidiaries. In particular, as discussed in our earlier Bulletin "Budget 2014: Thin Cap and Withholding Tax Rules Get Tougher", under Finance's original proposals, the thin cap rules would apply to ordinary course third party lending transactions involving Canadian Subsidiaries where the lender takes security over property of the Foreign Parent (or a related non-resident) to secure repayment of the loan - a standard practice for most lending transactions involving Canadian Subsidiaries.
Recognizing the inappropriate breadth of its original proposals, on October 23, 2014, Finance tabled revised amendments (the "Revised Proposals") in the House of Commons to address those concerns. The Revised Proposals significantly narrow the scope of the thin cap rules relative to what had originally been proposed in the 2014 Budget.
In particular, under the Revised Proposals, the thin cap rules will not apply to a conventional third-party loan to a Canadian subsidiary unless the Parent Entity (or a related non-resident) granted, as a condition of making the a particular loan, the lender (or a related party) a "specified right" in respect of its property. For the purposes of these rules, a "specified right", at any time, in respect of a particular property means a right to, at that time.
A "specified right" would not include a typical security interest or any similar right in respect of property of the Foreign Parent (or a related non-resident) that is intended to secure the Canadian Subsidiary's obligation to repay the third-party loan. As a result, a conventional loan to a Canadian Subsidiary that is secured by property of a Foreign Parent (or a related non-resident) should generally not be subject to the thin cap rules under the Revised Proposals. This is good news for Canadian Subsidiary borrowers (and their Foreign Parent entities) as well as for lenders who lend to Canadian Subsidiaries, as they should ensure that most conventional corporate lending structures will not trigger the application of the thin cap rules.
Notwithstanding the significantly reduced scope of the Revised Proposals relative to the Budget Proposals, parties (whether borrowers or lenders) involved in financing transactions for Canadian Subsidiaries should continue to consult with their Canadian tax advisors to ensure such transactions will not inadvertently trigger the application of the thin cap rules.
Currently, the Revised Proposals have received second reading in the House of Commons, although they are expected to be enacted before the end of the year. If enacted, the Revised Proposals will be effective for taxation years commencing after 2014.