The Income Tax Act (Canada) (the "Tax Act") contains a detailed set of statutory provisions, commonly referred to as the "thin capitalization" rules (the "Thin-Cap Rules"), that restrict the deductibility of interest payments made to certain connected, non-resident lenders. Building off the legislative changes enacted last year, which resulted in, among other things, a tightening of the operative debt-equity ratio (to more closely align Canadian rules with those found in other jurisdictions, including the United States) and the application of the Thin-Cap Rules to partnerships with Canadian corporate partners, Budget 2013 proposes to apply the Thin-Cap Rules to Canadian-resident trusts, along with certain non-resident trusts and non-resident corporations with Canadian business activities. The proposals also contemplate the application of the Thin-Cap Rules to partnerships where one of the aforementioned entities is a member.
The proposals, which the Government has indicated are intended "to further improve the integrity and fairness of the Thin-Cap Rules", would, if enacted, have application to both existing and new borrowings in respect to taxation years beginning after 2013, and could negatively impact a number of in-bound investment structures making use of non-resident operating vehicles.
Canadian thin-capitalization rules – an overview
The Thin-Cap Rules are contained in subsections 18(4) to (6) of the Tax Act and generally prohibit a Canadian-resident corporation (or a partnership in which such a corporation holds a membership interest) from deducting interest expenses in respect of the portion of its "outstanding debts to specified non-residents" that exceed one and a half (1.5) times the corporation's "equity", measured as the corporation's non-consolidated retained earnings plus equity contributed by, or attributed to shares owned by, "specified non-resident shareholders".
The Thin-Cap Rules were designed to protect the Canadian tax base by discouraging the capitalization of Canadian-resident corporations with interest-bearing debts from significant offshore shareholders, or persons who do not deal at arm's length with such shareholders, in a manner that would otherwise permit an undue proportion of such corporations' profits to escape full Canadian taxation.
At present, the Thin-Cap Rules generally only apply in situations where a Canadian-resident corporation (or a partnership in which it holds a membership interest) owes interest-bearing obligations to a "specified non-resident shareholder" of the corporation or a non-resident person who does not deal at arm's length with a "specified shareholder" of the corporation (collectively, "Specified Non-Residents").1
budget 2013: thin-capitalization proposals
As described in further detail below, Budget 2013 proposes to dramatically expand the scope of taxpayers that can be caught by the Thin-Cap Rules. The three additional entity categories are: (i) Canadian-resident trusts, (ii) non-resident trusts and corporations with Canadian business activities; and (iii) partnerships in which any entity identified in (i) and (ii) is a member.
expansion of the thin-cap rules to Canadian-resident trusts
Budget 2013 proposes to apply the Thin-Cap Rules to Canadian-resident trusts in substantially the same manner as Canadian-resident corporations (including the same debt-to-equity ratio of 1.5:1), subject to the following principal modifications:
(a) in general terms, trust beneficiaries will be used in the place of corporate shareholders for the purpose of determining whether a person is a Specified Non-Resident of the trust,2 and thus whether any indebtedness owing by the trust to such persons is to be included in the trust's Thin-Cap Rule computations. Special rules for determining a beneficiary's interest will be applied in the context of discretionary trusts (i.e., a trust where the interests are not fixed but are subject to trustee discretion).
(b) subject to (c) below, a trust's "equity" under the proposed rules will generally equal (i) the contributions to the trust from Specified Non-Residents, (ii) plus the tax-paid earnings of the trust (if any), (iii) less any capital distributions from the trust to Specified Non-Residents; and
(c) as an elective transitional measure, existing trusts will be entitled to compute their starting equity with reference to the fair market value of the trust's equity as of March 21, 2013.3
Interest expenses which are denied to a Canadian-resident trust under the proposed measures may nevertheless (by way of designation) be deducted by the trust as an income distribution in favour of the Specified Non-Resident beneficiary (i.e., the recipient of the non-deductible interest amount). However, the designated payment will be subject to non-resident withholding tax under Part XIII of the Tax Act and potentially tax under Part XII.2 of the Tax Act, depending on the character of the income earned by the trust.
As indicated previously, the proposed amendments in relation to Canadian-resident trusts will also potentially extend the Thin-Cap Rules to partnerships in which a Canadian-resident trust is a member.
expansion of the thin-cap rules to non-resident trusts and corporations
Budget 2013 also proposes to extend the Thin-Cap Rules to non-resident corporations and trusts that carry on business in Canada, on the theory that Canadian branches of such entities are in many respects comparable to a wholly-owned Canadian subsidiary of a foreign corporate group, and should accordingly be treated comparably from a Canadian income tax perspective, including insofar as appropriate debt/equity capitalization levels are concerned.
While the Budget 2013 measures relative to non-resident trusts and corporations seek to achieve results that are substantially analogous to those applicable to Canadian-resident corporations, the implementation mechanics differ. For example, Thin-Cap Rule indebtedness will generally include any loan or advance that is used in a Canadian branch of a non-resident corporation or trust, to the extent it is owing to a non-resident person who does not deal at arm's length with the non-resident corporation or trust. In addition, rather than employing a debt to equity ratio, the measures applicable to non-resident corporations and trusts will make use of a debt-to-asset ratio of 3:5 (which is expected to yield substantially similar results as the 1.5:1 debt to equity ratio applicable in the context of resident corporations and trusts).
Finally, for non-resident taxpayers earning rental income in Canada and who have made an election under section 216 of the Tax Act to be taxed on a net income basis with respect to that income (as opposed to having gross rental payments subjected to withholding tax under Part XIII of the Tax Act), the Thin-Cap Rules for non-resident corporations and trusts, rather than those for Canadian residents, will apply in computing the non-resident's Canadian income tax liability.
As is the case with respect to partnerships having Canadian-resident trust members, the new Budget 2013 measures will also be extended to partnerships in which a non-resident corporation or trust is a member.