The thin capitalization rules are designed to protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing by Canadian taxpayers to certain non-resident shareholders. The rules discourage non-resident shareholders from capitalizing a Canadian corporation with what is perceived to be too much debt and extracting pre-tax earnings of the corporation in the form of interest rather than after-tax dividends.
Existing Thin Capitalization Rules
The existing thin capitalization rules deny a Canadian corporation a deduction for interest paid to a “specified non-resident shareholder” to the extent that the ratio of debt to equity exceeds 2:1, i.e. only two-thirds of the capitalization can be in the form of debt. A “specified non-resident shareholder” is a foreign person that owns shares representing 25% or more of the vote or value of the Canadian corporation.
A summary of the proposed changes is as follows:
- The 2012 federal budget proposes to reduce the permissible debt-to-equity ratio from 2:1 to 1.5:1. The effect is that the maximum amount of debt a non-resident shareholder can use to capitalize a Canadian corporation decreases from 66.6% to 60%.
- For purposes of determining whether the debt-to-equity ratio exceeds 1.5:1, each corporate member of a partnership will be deemed to owe a proportionate share of the partnership debt.
- Interest on debt that exceeds the 1.5:1 ratio will be a recharacterized as a dividend for Canadian withholding tax purposes. Where, for example, the amount paid would be exempt from withholding tax as interest under the Canada-U.S. Tax Treaty, the disallowed interest will be subject to withholding at the 5% deemed dividend rate.
- Interest paid by a Canadian corporation in respect of debt owed to a controlled foreign affiliate will be excluded from the application of the thin capitalization rules to the extent that the interest is taxable in the hands of the Canadian corporation as foreign accrual property income (FAPI). The purpose of this carve-out is to provide relief from double taxation.
The 1.5:1 debt-to-equity ratio will apply to taxation years that begin on or after March 29, 2012. As there are no grandfathering provisions in the proposed rules, re-capitalization of the Canadian corporation may be necessary to the extent that non-residents have contributed capital on a 2:1 debt-to-equity ratio.