The March 29, 2012 Canadian federal budget (the “Budget”) proposes a number of changes to Canada’s thin capitalization rules that may have significant implications to cross‐border financing. Clients should review existing financing arrangements to assess the potential implication of these changes and must carefully consider proposed Canadian investments to ensure compliance with the new regime.
Current Thin Capitalization Rules
Canada’s thin capitalization rules (a.k.a. “thin cap”) are designed to prevent specified nonresidents of Canada (generally those who alone or together with other non‐arm’s length persons own greater than 25% of the shares of a Canadian corporation) from withdrawing the profits of a Canadian corporation in the form of excessive interest payments rather than in the form of after‐tax dividends. The repatriation of profits through interest payments as opposed to dividends may be desirable where:
- The interest is deductible in Canada and reduces the taxable income of the Canadian payer (contrast this with the payment of dividends, which are not deductible and are paid out of after‐tax profits).
- The interest would be subject to low – or no – Canadian withholding tax (contrast this with the payment of dividends, which are subject to a 25% withholding tax rate, which may generally be reduced to 5% or 15% under Canada’s tax treaties).
- The non‐resident lender is taxed on the interest income at a lower rate than the rate applicable to the Canadian payer.
The thin cap rules currently deny the ability of the Canadian corporation to deduct interest on the portion of debt owing to specified non‐residents that exceeds two times the equity of the corporation that has been contributed by specified non‐residents. Accordingly, specified non‐residents generally capitalize Canadian subsidiaries with no more than a 2:1 debt to equity mix to stay onside the thin cap requirements. The thin cap rules currently do not extend to guarantees provided by Canadian corporations, to debt incurred by partnerships (even if the partnerships have Canadian‐resident corporate partners) or to trusts and Canadian branches of non‐resident corporations.
The Budget materials suggest that Canada’s thin capitalization rules are generally effective, transparent and relatively simple to administer and comply with; however, certain significant changes are required in order to strengthen the rules to protect Canada’s tax base.
- Reduction of the Debt to Equity Ratio
The Budget materials indicate that the current 2 to 1 debt to equity ratio is too high compared to actual industry ratios in the Canadian economy as well as general global standards. The Budget therefore proposes to reduce the ratio from 2:1 to 1.5:1 effective for taxation years that begin after 2012
- Thin Cap Now Applies to Partnerships
The thin cap rules will now apply to debts of partnerships of which a Canadian‐resident corporation is a member (interestingly, the rules will not be extended at this time to guarantees, or to trusts or branches of non‐resident corporations). Each corporate member will be allocated its proportion of debt owing to specified non‐residents in determining the quantum of interest that is denied deductibility based on the corporate member’s share of the partnership’s income for the year. This proposed change is of immediate concern since it will apply for taxation years that begin on or after March 29, 2012
- Withholding Tax – Watch out for Deemed Dividends
The Budget proposals indicate that the portion of interest that is denied deductibility will be recharacterized as a dividend for Canadian withholding tax purposes. This is a significant change that may catch many Canadian corporations – and their non‐resident lenders – by surprise. Generally, there is no Canadian withholding tax on interest paid to a non‐resident lender unless either: (i) the interest is paid to a related party; or (ii) the interest is “participating interest” (e.g., interest that is based on the profitability of the borrower). Moreover, there is an exemption from Canadian withholding tax for interest (other than participating interest) paid to related parties resident in the United States and who are entitled to the benefits of the Canada‐US Tax Treaty (the “US Treaty”).In contrast to interest, dividends are subject to Canadian withholding tax in all cases.
The recharacterization of interest payments as dividends will have different consequences to lenders situated in different jurisdictions. For example, US lenders will generally incur an increased Canadian withholding tax cost (assuming the interest would otherwise have been exempt from Canadian withholding tax under Canadian domestic law or the US Treaty but the deemed dividends would be subject to either a 5% or 15% withholding tax rate under the US Treaty). However, most of Canada’s tax treaties – aside from the US Treaty – impose a 10% withholding tax on interest paid to non‐arm’s length parties and therefore lenders in other jurisdictions may benefit from the new rule to the extent deemed dividends would be subject to a lower 5% dividend withholding tax. This proposed change is of immediate concern since it will apply for taxation years that end on or after March 29, 2012.
Canadian corporations that have received loans from non‐resident shareholders should review their ability to comply with the revised thin cap rules as soon as possible and consider possible alternatives for bringing their debt to equity ratios within the new 1.5 to 1 limits as may be necessary. Contributing additional equity, repaying debt or converting existing debt into equity may be required, although each of these actions carry potential commercial and tax consequences that must be carefully considered.
Corporate partners of partnerships that have received loans from certain non‐residents must immediately review their compliance with the thin cap rules, which will in many cases be an entirely new concept to such partners and may in some cases require a significant amount of debt reorganization.
All Canadian corporations (and corporate partners of partnerships) will need to be mindful of these proposed changes to the thin cap rules when structuring new investments or before taking certain actions that may change the applicable debt to equity ratio.