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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.
Proposed Changes
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.
Effective Date
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.
Recommendations
If you think that you have clients that may be affected by these
proposed amendments to the thin capitalization rules, we recommend
that you contact a member of the tax group so that their existing
structures can be reviewed and amended as necessary.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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