Canada’s thin capitalization rules generally denies a
deduction for interest expense by a Canadian corporation (or trust) if the
interest expense is paid or payable on “outstanding debts to “specified
non-residents,” to the extent that the amount of the debt exceeds 1.5 times the
applicable “equity amount.” The denied interest expense not deductible is
deemed to be a payment of a dividend for purposes of withholding taxes at 25%
or less if a tax treaty lowers the withholding tax rate on the dividend.
In the absence of legislative restrictions, foreign
investors seeking to minimize taxes associated with an investment in Canada
would tend to invest a disproportionate amount of debt (as opposed to equity)
in Canada. The interest expense reduces income otherwise subject to tax in
Canada. By thinly capitalizing a Canadian business enterprise, a foreign
investor can receive a greater proportion of its return in the form of
deductible interest payments, rather than dividend payments out of after-tax
income. The purpose of thin capitalization rules is to prevent this type of
erosion of the domestic tax base in the country in which the business
enterprise is being carried on.
1. What is a “specified
non-resident” shareholder?
a.
A
“specified non-resident shareholder” is, generally, a non-resident person that
owns, either alone or together with non-arm’s length persons, shares of the
Canadian corporation with 25% or more of the votes or 25% or more of the FMV.
b.
Where
a partnership with non-resident partners has loaned money to a Canadian
corporation, for purposes of the thin capitalization rules, the CRA has stated
that the determination of whether there are any “specified shareholders” should
be made at the level of the partners (which are deemed to proportionately own
any shares held by the partnership), rather than the partnership, and any loans
made by the partnership should be attributed to its partners based on the
relative FMV of their respective interests
2. What is “equity amount”?
a.
“Equity
amount” is defined, generally, as the Canadian corporation’s retained earnings,
contributed surplus and paid-up capital on investments made by a specified
non-resident shareholder.
b.
The
equity amount is calculated as the retained earnings at the beginning of the
year, plus the average of each calendar month’s contributed surplus at the
beginning of the month, plus the average of each calendar month’s paid-up
capital at the beginning of the month
3. How is the “outstanding
debts” calculated?
a.
The
debt amount is calculated as the average of the highest amount of outstanding
debt in each month for the 12 months in the calendar year.
4. What are the implications of
the “Timing Mismatch” of Thin Capitalization calculation rules?
a.
If
a Canadian subsidiary is capitalized with both debt and equity at the 1.5-to-1
limit after the start of a month, because the debt will be counted for thin
capitalization purposes, but the equity will not, the entire interest expense
will be denied.
b.
Non-residents
that may be caught by the timing mismatch may choose to make the equity
investment before the beginning of any month in which a debt to the Canadian
subsidiary will be outstanding, so that the equity investment is counted for
that month for the purposes of the thin capitalization rule
c.
An
alternative may also be to choose to reduce the debt-to-equity ratio in respect
of a Canadian subsidiary to a ratio that is slightly below 1.5-to-1, such that
the thin capitalization rules do not apply even if the impact of any timing
mismatch is taken into account
