This posting was authored by Crystal Taylor,
a Partner in the Saskatoon Office of Miller Thomson LLP
On March 21, 2013, the Minister of Finance, Jim Flaherty, tabled the 2013 Federal Budget (the “Budget”) entitled Jobs, Growth and Long-Term Prosperity – Economic Plan 2013. Among the tax measures contained in the Budget were changes to the interest deductibility rules applicable to non-resident owned entities known as the thin capitalization rules (“thin cap rules”).
Thin Capitalization Rules
The thin cap rules within the Income Tax Act (Canada) (the “Tax Act”) protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing to “specified non-residents” (as defined in the Tax Act).
In its 2008 report, the Advisory Panel on Canada’s System of International Taxation made a number of recommendations relating to the thin cap rules, including extending the rules to partnerships, trusts and Canadian branches of non-resident corporations.
Budget 2012 introduced certain amendments to the thin cap rules including, among other things, extending the scope of the thin cap rules to partnerships with one or more Canadian-resident corporate partners and the reduction of the debt-to-equity ratio from 2-to-1 to 1.5-to-1. See the January 11, 2013 posting on this Blog authored by Lyne M. Gaulin and John M. Campbell for a detailed discussion of the existing thin cap rules and the changes introduced in the 2012 Budget.
The current thin cap rules generally limit the deductibility of interest expense of a Canadian-resident corporation (or a partnership with one or more Canadian-resident corporate partners) in circumstances where the amount of debt owing to specified non-residents exceeds a 1.5-to-1 debt-to-equity ratio.
The current Budget proposes further amendments to the thin cap rules by extending the scope of their application to Canadian-resident trusts, and non-resident corporations and trusts that carry on business in Canada.
Canadian Resident Trusts
The Budget proposes that the existing thin cap rules will be extended to Canadian resident trusts and will be amended to accommodate the legal nature of trusts. A trust’s “equity” for the purposes of the thin cap rules will generally consist of contributions to the trust from specified non-resident beneficiaries plus the tax-paid earnings of the trust, less and capital distributions from the trust to specified non-residents. Trust beneficiaries will be used in place of shareholders in determining whether a person is a specified non-resident in respect of the trust.
Where interest expense of a trust is non-deductible as a result of the application of the thin cap rules, the trust will be entitled to designate the non-deductible interest as a payment of income of the trust to a non-resident beneficiary (i.e., the recipient of the non-deductible interest). In such a case, the trust will be able to deduct the designated payment in computing its income, but the designated payment will be subject to non-resident withholding tax under Part XIII of the Tax Act and potentially tax under Part XII.2, depending on the character of the income earned by the Trust.
This Budget proposal will also extend the thin cap rules to partnerships with one or more Canadian resident trusts as partners.
Similar to debt owed directly by the trust, where these rules result in an amount being included in computing the income of a trust, the trust will be entitled to designate the included amount as having been paid to a non-resident beneficiary as income of the trust.
Since some trusts may not have complete historical information, any trust that exists on Budget Day will be able to elect to determine the amount of its equity for thin cap purposes as at Budget Day based on the fair market value of its assets less the amount of its liabilities. Each beneficiary of the trust would then be considered to have made a contribution to the trust equal to the beneficiary’s share (determined by reference to the relative fair market value of their beneficial interest in the trust) of this deemed trust equity. Contributions to the trust, tax-paid earnings of the trust and distributions from the trust on or after Budget Day would then increase or decrease (as appropriate) trust equity for thin capitalization purposes.
The 1.5-to-1 debt-to-equity ratio will not change for Canadian resident trusts and partnerships with one or more Canadian resident trusts as partners.
Application Date
This measure will apply to taxation years that begin after 2013 and will apply with respect to existing as well as new borrowings.
Non-Resident Corporations and Trusts
The Budget also proposes to extend the thin cap rules to non-resident corporations and trusts that carry on business in Canada. The application and effect of the thin cap rules for a non-resident carrying on business in Canada will be similar to those in respect of a wholly-owned Canadian subsidiary of a non-resident.
However, since a Canadian branch is not a separate person from the non-resident corporation or trust, the branch does not have shareholders or equity for purposes of the thin cap rules. Therefore, the thin cap rules for non-resident corporations and trusts will differ from the rules for Canadian-resident corporations in certain respects.
A loan that is used in a Canadian branch of a non-resident corporation or trust will be an outstanding debt to a specified non-resident for thin capitalization purposes it if is a loan from a non-resident who does not deal at arm’s length with the non-resident corporation or trust.
In addition, a debt-to-asset ratio of 3-to-5 will be used, which parallels the 1.5-to-1 debt-to-equity ratio used for Canadian-resident corporations.
Where the non-resident is a corporation, the application of the thin cap rules would increase its liability for branch tax under Part XIV of the Tax Act.
A non-resident corporation or trust that earns rental income from certain Canadian properties may elect to be taxed on its net income under Part I of the Tax Act rather than being subject to non-resident withholding tax under Part XIII on its gross rental income. The election allows the non-resident to compute its taxable income as if it where a resident of Canada, with such modifications to the tax rules as the circumstances require. Where such an election is made, the thin cap rules for non-resident corporations and trusts, rather than those for Canadian residents, will apply in computing the non-resident’s Part I tax liability.
This proposal will also extend the thin cap rules to apply to partnerships with one or more non-resident corporations or trust as partners. Any income inclusion for a non-resident partner that arises as a consequence of the application of the thin cap rules will be deemed to have the same character as the income against which the partnership’s interest deduction is applied.
Application Date
This measure will apply to taxation years that begin after 2013 and will apply with respect to existing as well as new borrowings.
For a more detailed discussion of the 2013 Federal Budget, see the MT Federal Budget Review dated March 21, 2013 available on our website.
If you would like more information on this topic, please contact the author of this posting, Crystal Taylor at (306) 667.5613 or cltaylor@millerthomson.com.
