Canada, like many developed countries, restricts the amount of interest a corporation resident in Canada (CRIC) may deduct on loans made by non-residents who are the CRIC’s significant shareholders or their affiliates. The aim of these rules is to protect the Canadian tax base from erosion by limiting the extent to which foreign investors may take profits out of their Canadian subsidiaries in the form of tax-deductible interest, rather than after-tax dividends. These rules are commonly referred to as "thin capitalization" rules.
The thin capitalization rules generally deny the deduction by a CRIC of interest payable to specified non-residents (a non-resident owning shares representing more than 25% of the votes or value of the CRIC and any other non-resident who does not deal at arm’s length with such shareholder) to the extent that a debt-to-equity ratio is exceeded. Historically, the rules in the Income Tax Act (Canada) (ITA) did not take into account debt owed by partnerships of which a CRIC is a member or by trusts, or debt of Canadian branches of non-resident corporations. Further, the disallowed interest expense retained its character as interest for Canadian withholding tax purposes (25% withholding rate generally reduced to 10% under most tax treaties, or 0% under the Canada-U.S. treaty).
The Advisory Panel on Canada’s System of Taxation (Advisory Panel) released its report in December 2008, recommending reducing the maximum debt-to-equity ratio under the thin capitalization rules from 2:1 to 1.5:1 to be more in accord with world standards and extending the scope of the rules to partnerships, trusts and Canadian branches of non-resident corporations as a matter of fairness and to maintain the integrity of the rules.
The Advisory Panel’s recommendations were adopted in part in Canada’s 2012 federal budget (Budget 2012) and in part in Canada’s 2013 federal budget (Budget 2013) released on March 21, 2013.
Budget 2012- Partnerships
Specifically, Budget 2012 broadened the application of the thin capitalization rules by:
- reducing the permitted debt-to-equity ratio from 2.0:1 to 1.5:1;
- extending the rules to include debts owed by partnerships of which a CRIC is a member;
- including in a CRIC’s income, where the debt-to-equity ratio of the CRIC in a partnership of which it is a member is exceeded, the portion of the deductible interest of the partnership that exceeds such ratio; and
- deeming interest that is disallowed under the rules to be a dividend that is subject to Canadian withholding tax of 25% (generally reduced under most tax treaties to 15%, or 5% in some circumstances).
The rules computing a CRIC’s share of debts of partnerships in which it is a member take into account multiple tiers of partnerships and determine a partner’s share of the debts of a partnership by reference to its "specified proportion", as defined in subsection 248(1) of the ITA, generally to mean the partner’s share of the income of the partnership. Where the specified proportion is not determinable (e.g., because the fiscal period of the partnership ends after the partner’s year-end), the partner’s share of the debts of a partnership is determined by reference to the relative fair market value of its interest in the partnership. Further, Budget 2012 added a new anti-avoidance rule to the ITA to ensure that the deemed dividend rules cannot be avoided by transferring a debt obligation.
Budget 2013 – Trusts Resident in Canada and Canadian Branches
Budget 2013 proposes to extend the application of the thin capitalization rules to (i) trusts that are resident in Canada and (ii) non-resident corporations and trusts that carry on business in Canada. These new measures will apply to taxation years that begin after 2013, and will apply with respect to both existing and new indebtedness.
Canadian resident trusts
Budget 2013 proposes to broaden the rules so that they also apply to Canadian resident trusts. Essentially, trust beneficiaries will be considered in determining whether a person is a specified non-resident in respect of the trust. Subsection 18(5) of the ITA will be amended to add new definitions of "specified non-resident beneficiary" and "specified beneficiary" of a trust, which are similar in concept to the definitions of "specified non-resident shareholder" and "specified shareholder" in respect of a corporation. A difference is that a shareholder can be a specified shareholder if it owns shares that represent 25% of votes or value; in the case of "specified beneficiary", it is a 25% value test only. The trust’s "equity amount" for purposes of the thin capitalization rules will generally consist of contributions to the trust from specified non-residents plus the "tax-paid earnings" of the trust, less any capital distributions from the trust to specified non-residents of the trust. The same 1.5:1 debt-to-equity ratio will apply to trusts.
A trust will be entitled to designate any disallowed interest expense as a payment of trust income to the relevant non-resident beneficiary. Such a designated payment will be deductible in computing the income of the trust, but it will be subject to Canadian withholding tax under Part XIII of the ITA (and the trust may be subject to Part XII.2 tax).
The rules will also apply to partnerships in which a Canadian resident trust is a partner.
Non-resident corporations and trusts
Budget 2013 proposes to broaden the rules so that they apply to non-resident corporations and trusts that carry on business in Canada so the rules would apply in a manner similar to that applicable to a wholly-owned Canadian subsidiary of a non-resident corporation, with necessary adjustments to take into account the fact that a Canadian branch is not a separate person and has neither shareholders nor equity.
Indebtedness attributed to a Canadian branch will generally be considered to be an outstanding debt to a specified non-resident for purposes of the thin capitalization rules if it is owed to a specified non-resident shareholder, a specified non-resident beneficiary or a non-resident who does not deal at arm’s-length with a specified shareholder or specified beneficiary. A non-resident corporation is deemed to be a specified shareholder of itself and a non-resident trust is deemed to be a specified beneficiary of itself for such purposes.
The "equity amount" of a non-resident corporation or trust will be determined by reference to the branch assets in a manner that is intended to be consistent with the treatment of Canadian subsidiaries and the 1.5:1 debt-to-equity ratio.
Where a non-resident corporation or trust elects to be taxed on its net rental property income from Canadian real property (in lieu of withholding tax on gross rental income) pursuant to a section 216 election, the thin capitalization proposals will apply.
The thin capitalization rules will also apply to a partnership in which a non-resident corporation or trust is a member.