Budget 2012: tightening of the "thin capitalization" rules unveiled 

publication 

March 2012

Tax Bulletin

Canada has enacted a detailed set of statutory provisions, commonly referred to as the "thin capitalization" rules, that restrict the deductibility of interest payments made to certain connected, non-resident lenders. In Budget 2012, the Government announced that the Canadian thin capitalization rules would be further tightened to protect the Canadian fiscal base and to more closely align the Canadian rules with those found in other jurisdictions.

Canadian thin capitalization rules – an overview

Canada's thin capitalization rules (the "Thin Cap Rules") are contained in subsections 18(4) to (6) of the Income Tax Act (Canada) (the "Tax Act"). The Thin Cap Rules generally prohibit a Canadian-resident corporation from deducting interest expenses in respect of the portion of its "outstanding debts to specified non-residents" that exceeds two times 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 fiscal 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.

The Thin Cap Rules generally only apply in situations where a Canadian-resident corporation 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

In 2000, the Government amended the Thin Cap Rules by reducing the applicable debt-to-equity ratio from 3:1 to 2:1. At the time of the amendments, the Government also indicated an intention to continue to consult with stakeholders on further refinements to the Thin Cap Rules.

In December 2008, the Advisory Panel on Canada's System of International Taxation, a panel of experts mandated by the Government to recommend ways to improve the competitiveness, efficiency and fairness of Canada's international tax system (the "Advisory Panel"), made a number of recommendations to the Government relating to the Thin Cap Rules. The Advisory Panel recommended, among other things, that (i) the operative debt-to-equity ratio under the Thin Cap Rules be reduced from 2:1 to 1.5:1, and (ii) the application of the Thin Cap Rules be expanded to capture debtors constituted as partnerships, trusts, and Canadian branches of non-resident corporations. The Advisory Panel also observed that even where an interest deduction was disallowed under the Thin Cap Rules, certain withholding tax advantages still accrued to the Canadian-resident corporate debtor by virtue of such payments continuing to be characterized as interest for non-resident withholding tax purposes. For instance, since the enactment of the Fifth Protocol to the Canada-United States Income Tax Convention , conventional interest payments made by a Canadian-resident debtor to a related U.S.-resident lender may typically be made free of Canadian withholding tax. By contrast, if such amounts were paid to the non-resident as a dividend, Canadian withholding tax would generally be levied at a rate of at least 5%.

budget 2012: thin capitalization proposals

Budget 2012 proposes a number of substantive amendments to the Thin Cap Rules, including: (i) the reduction of the operative debt-to-equity ratio from 2:1 to 1.5:1; (ii) extending the application of the Thin Cap Rules to debts of partnerships of which a Canadian-resident corporation is a member; (iii) deeming interest expenses disallowed under the Thin Cap Rules to be dividends for non-resident withholding tax purposes; and (iv) enacting certain relieving rules that will prevent double taxation from arising in certain circumstances where a Canadian-resident corporation borrows money from a "controlled foreign affiliate" of the corporation.

debt-to-equity ratio reduction

Studies conducted by the Advisory Panel, and thereafter confirmed by the Government, have suggested that (i) average debt-to-equity ratios in most industries in the Canadian economy are lower than the 2:1 debt-to-equity ratio inherent in the current Thin Cap Rules, and (ii) the debt-to-equity ratio upon which the Thin Cap Rules are based is high relative to comparable global standards. Accordingly, Budget 2012 proposes to reduce the operative debt-to-equity ratio under the Thin Cap Rules from 2:1 to 1.5:1.

The reduction in the applicable ratio will apply in respect of corporate taxation years that begin after 2012. As a consequence, Canadian corporations that have debt obligations that attract the application of the Thin Cap Rules should begin analyzing their affairs with a view to making any necessary capitalization adjustments in advance of taxation years that begin on or after January 1, 2013.

expansion of the thin cap rules to partnerships

The application of Thin Cap Rules to partnerships has long been a source of debate and uncertainty. Historically, the Canada Revenue Agency (the "CRA") had stated that the Thin Cap Rules did not apply to the computation of the income of a partnership and that the agency would not automatically look through a partnership to its corporate members when applying the Thin Cap Rules. However, some doubt was cast over the CRA's position by virtue of a provincial tax decision rendered in Ontario in the Wildenburg Holdings Limited case. In response to the Wildenburg decision, the CRA appeared to re-affirm its commitment to its past administrative position by stating that, "[i]f there is a bona fide partnership and the partners are jointly and severally liable for the partnership debts, the Department will view the partnership as the debtor." Nevertheless, the CRA's comments generated uncertainty with respect to the application of the Thin Cap Rules to certain partnerships, including limited partnerships (i.e., partnerships where partners are not jointly and severally liable for the debts of the partnership by virtue of the operative limited partnership statute). In fact, an advance income tax ruling released by the CRA in 2005 indicated that the CRA could seek to apply the general anti-avoidance rule in the Tax Act where a limited partnership was interposed in a corporate structure to preclude the application of the Thin Cap Rules.

Budget 2012 acknowledged that the Thin Cap Rules do not expressly reference interest expenses incurred by partnerships. As a consequence, Budget 2012 proposes to extend the application of Thin Cap Rules to capture debts owed by partnerships of which a Canadian-resident corporation is a member. Under the new proposals, for the purpose of determining a corporation's debt-to-equity ratio, debt obligations of a partnership of which a corporation is a member will generally be allocated to the corporate member based on its proportionate share of the partnership's total income or loss for the relevant fiscal period of the partnership. In instances in which a corporate partner's permitted debt-to-equity ratio under the Thin Cap Rules is exceeded, an amount equal to the interest on the portion of the partnership's debt to Specified Non-Residents that is allocated to the corporate partner and that exceeds the permitted debt-to-equity ratio will be required to be included in the corporation's income.

Budget 2012 presented the following example to illustrate how the Thin Cap Rules are intended to apply to partnerships:

Canco 1 and Canco 2 are Canadian-resident corporations and are equal partners in a partnership that earns income from a business. Canco 1 is wholly owned by Forco, a non-resident corporation. The Canco 1 shares owned by Forco have paid-up capital of $4,000 but Canco 1 has no other capital for the purposes of the thin capitalization rules. Forco lends $3,000 to the partnership and lends $8,500 directly to Canco 1.

Canco 1 has a 50 per cent interest in the partnership and will therefore be allocated 50 per cent of the partnership loan ($1,500) for thin capitalization purposes. Canco 1 has capital of $4,000 and is considered to have outstanding debts to a specified non-resident (Forco) of $10,000 ($8,500 debt owed by Canco 1 to Forco plus $1,500 in debt allocated from the partnership).

With a permitted debt-to-equity ratio of 1.5-to-1, Canco 1 has $4,000 of total excess debt – that is, ($10,000 – 1.5 x $4,000)/10,000, or 2/5, of $10,000. This 2/5 ratio is applied to interest on the debt owed directly to Forco by Canco 1 as well as the debt allocated from the partnership to determine how much interest is denied, or added back to income, respectively. Accordingly, 2/5 of the interest deduction in respect of the $8,500 direct loan from Forco will be denied and an amount equal to 2/5 of the deductible interest expense in respect of the $1,500 debt allocated from the partnership will be required to be included in computing the income of Canco 1 from the partnership's business.

The expansion of the Thin Cap Rules to capture partnerships will apply in respect of debts of a partnership that are outstanding at any time during the taxation year of a corporation that begins on or after March 29, 2012. Accordingly, Canadian-resident corporations that are members of partnerships should examine the thin capitalization implications of such holdings in advance of the start of their next taxation year.

disallowed interest expenses treated as dividends

Consistent with the recommendations of the Advisory Panel, Budget 2012 proposes to deem interest expenses disallowed under the Thin Cap Rules to be dividends for the purposes of the non-resident withholding tax levied under Part XIII of the Tax Act.2 Under the proposals, disallowed interest expenses of a corporation for a taxation year will be allocated among Specified Non-Resident lenders in proportion to the corporation's debt owing in the taxation year to all Specified Non-Residents.

While straightforward at a high level, the application of the new deeming rule will be operationally complex. Specifically, the calculations associated with the application of the Thin Cap Rules are required to be made after the end of the relevant corporation's taxation year. However, Budget 2012 proposes that specific interest payments made during a particular taxation year may be recharacterized as dividends under the new proposals. (As a relieving measure, it is proposed that a corporation be permitted to designate, on or before the corporation's filing-due date for the taxation year, which interest payments made to a particular Specified Non-Resident in the taxation year will be recharacterized as dividends.) 

Where a particular interest expense, deduction of which has been disallowed under the Thin Cap Rules, has not been paid by the end of the relevant taxation year, the disallowed interest expense will be deemed to have been paid as a dividend by the corporation at the end of the particular taxation year.

Generally, withholding tax in respect of a dividend paid to a non-resident (including a deemed dividend) is required to be remitted to the CRA within 15 days following the month in which the dividend is paid or deemed to have been paid. As a result, it is conceivable that certain taxpayers may not become aware that certain interest payments have been recharacterized as dividends, subject to non-resident withholding tax, until well after the applicable remittance deadline.

A special apportionment rule will apply in respect of interest expenses, which are recharacterized as dividends, that arise during taxation years that include the day of the Budget (i.e., March 29, 2012).

The proposed deemed dividend rules will apply to taxation years that end on or after March 29, 2012. Accordingly, on the assumption that the Budget 2012 proposals will be enacted as proposed, the deemed dividend rule is currently operative. Canadian corporate taxpayers should therefore consider taking immediate steps to (i) establish procedures for determining whether particular interest payments may subsequently be recharacterized as dividends, subject to non-resident withholding tax, and (ii) establish procedures to determine, within 15 days following the end of each taxation year, whether any accrued interest expense will be deemed to have been paid as a dividend as of the end of the taxation year for Canadian withholding tax purposes.

foreign affiliate loans

The Thin Cap Rules can, under certain circumstances, apply in respect of loans received by a Canadian-resident corporation from a "controlled foreign affiliate". However, special taxation rules apply in respect of the passive income earned by "controlled foreign affiliates", which can give rise to required inclusions in the income of Canadian-resident shareholders for tax purposes. The combined application of such rules with the Thin Cap Rules can trigger double taxation in certain circumstances.

Budget 2012 proposes ameliorative amendments to the Tax Act that would reduce the incidence of such double taxation. These measures will apply to taxation years of Canadian-resident corporations that end on or after March 29, 2012. 

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Budget 2012 proposes material amendments to the existing thin capitalization regime in Canada. Canadian corporate taxpayers should immediately review their capitalization structures, partnership holdings, and withholding tax management protocols to reduce the possibility that such statutory changes will give rise to unanticipated tax, penalty and interest liabilities. 


by Peter Botz, Michael Friedman and Carl Irvine

1 A "specified non-resident shareholder" of a corporation is defined to include a "specified shareholder" of the corporation who is, at that time, a non-resident person. A "specified shareholder" of a corporation generally captures a person who either alone, or together with persons with whom the person does not deal at arm's length, owns shares representing 25% or more of the votes attached to, or the fair market value of, the issued and outstanding shares of the corporation.

2 Disallowed interest expenses that may be recharacterized as dividends will include any amounts required to be included in the income of a Canadian corporation by virtue of the Thin Cap Rules applying to a partnership of which the corporation is a member.

a cautionary note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2012