- Thin Capitalization Rules
- Foreign Affiliate Dumping
- Transfer Pricing Secondary Adjustments
- Base Erosion Rules – Canadian Banks
- Overseas Employment Tax Credit
Current Thin Cap Rules
The thin capitalization rules (the “Thin Cap Rules”) contained in the Income Tax Act (the “Tax Act”) limit the deductibility of interest expense of a Canadian resident corporation in circumstances where the amount of debt owing to certain non-residents exceeds a 2-to-1 debt-to-equity ratio. The purpose of the Thin Cap Rules is to protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing to certain non-residents.
The Thin Cap Rules generally apply to debts owing to a specified non-resident shareholder – that is, a person who, either alone or together with persons with whom the specified non-resident shareholder is not dealing at arm’s length, owns shares of the particular corporation representing more than 25% of the votes or value of the corporation.
Currently, the Thin Cap Rules only apply to Canadian resident corporations.
Proposed Amendments to Thin Cap Rules
The Budget proposes to amend the Thin Cap Rules by:
- reducing the debt-to-equity ratio from 2-to-1 to 1.5-to-1;
- extending the scope of the Thin Cap Rules to debts of partnerships of which a Canadian resident corporation is a member;
- treating disallowed interest expense under the Thin Cap Rules as dividends subject to Part XIII withholding tax; and
- preventing double taxation in certain circumstances where a Canadian resident corporation borrows money from its controlled foreign affiliate.
Changes to Debt-to-Equity Ratio
The proposed changes to the debt-to-equity ratio are consistent with the conclusion reached by the Advisory Panel on Canada’s System of International Taxation (the “Advisory Panel”) to the effect that the permitted 2-to-1 debt-to-equity ratio is high compared to actual industry ratios in the Canadian economy, suggesting it allows inappropriately high levels of foreign related party debt.
The Government is of the view that the conclusion of the Advisory Panel continues to hold and that such a reduction of the ratio is required.
This measure will apply to corporate taxation years that begin after 2012.
Extension of Thin Cap Rules to Partnerships
The proposal to extend the Thin Cap Rules to partnerships is also consistent with the recommendation of the Advisory Panel that the scope of the Thin Cap Rules be extended to partnerships.
The Budget proposes to extend the Thin Cap Rules to debts owed by partnerships of which a Canadian-resident corporation is a member. In particular, for the purpose of determining the corporation’s debt-to-equity ratio under the Thin Cap Rules, debt obligations of a partnership will be allocated to its members based on their proportionate interest in the partnership.
In circumstances where a corporate partner’s permitted debt-to-equity ratio is exceeded, the partnership’s interest deduction will not be denied but an amount will be included in computing the income of the partner from a business or property, as appropriate. The source of this income inclusion will be determined by reference to the source against which the interest is deductible at the partnership level. This inclusion will equal the amount of the interest on the portion of the allocated partnership debt that exceeds the permitted debt-to-equity ratio.
The Budget includes the following example regarding the extension of the Thin Cap Rules 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.
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 is considered to have outstanding debts to a specified non-resident shareholder (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 ($10,000 – 1.5 x $4,000)/10,000 or 2/5 of $10,000).
This 2/5 ratio is then 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.
This proposed measure will apply in respect of debts of a partnership that are outstanding during corporate taxation years that begin on or after Budget Day.
Disallowed Interest Treated as a Dividend
The Budget proposes to recharacterize disallowed interest expense (including for this purpose any amount that is required to be included in computing the income of a corporation in respect of an amount deductible by a partnership of which the corporation is a member) as a dividend for purposes of Part XIII withholding taxes.
The calculations required for compliance with the Thin Cap Rules must be made after the end of a corporation’s taxation year. Under this proposal, disallowed interest expense of a corporation for a taxation year will be allocated to specified non-residents in proportion to the corporation’s debt owing in the taxation year to all specified non-residents (taking into account debts owing by partnerships of which the corporation is a member).
The corporation will be allowed to allocate the disallowed interest expense to the latest interest payments made to any particular specified non-resident in the taxation year. Where the disallowed interest expense has not been paid by the end of the taxation year of the corporation, the disallowed interest expense will be deemed to have been paid as a dividend by the corporation at the end of that taxation year.
Part XIII withholding tax will be due at the time that it would have been due if the deemed dividend had been paid at the time the disallowed interest expense was paid or deemed to have been paid. In circumstances where the amount withheld exceeds the withholding tax payable, the non-resident creditor will be able to obtain a refund of the excess.
For purposes of the Canada-US Tax Treaty (the “Treaty”), this will mean that interest which would have been exempt from Canadian withholding taxes under the Tax Treaty will now be subject to Canadian withholding taxes at the rate of 5% or 15%, since it will be treated as a deemed dividend.
This measure will apply to taxation years that end on or after Budget Day. For taxation years that include Budget Day, the measure will apply to an amount of disallowed interest expense that is based on a pro-ration for the number of days in the taxation year that are on or after Budget Day.
Interest on Certain Foreign Affiliate Loans Excluded from Thin Cap Rules Proposed Amendments
Under the existing definition of “outstanding debts to specified non-residents” in subsection 18(5) of the Tax Act, the Thin Cap Rules can, in certain circumstances, apply to loans made to a Canadian-resident corporation from a controlled foreign affiliate of the corporation.
The Canadian tax system also contains rules that protect the tax base by preventing taxpayers from shifting passive income to low-tax jurisdictions. Under these rules, foreign accrual property income (“FAPI”), which includes certain interest income earned by controlled foreign affiliates (“CFA”) of a taxpayer, is taxable in the hands of the Canadian resident taxpayer on an accrual basis.
The combination of these foreign affiliate rules can result in double taxation where, for example, a particular Canadian resident corporation that is owned by a widely held Canadian public company has borrowed money from its CFA. In these circumstances, the particular corporation may be prevented from deducting interest on the loan under the Thin Cap Rules while at the same time the interest is taxable in its hands as FAPI.
In order to prevent such double taxation, the Budget proposes to exclude from the application of the Thin Cap Rules interest expense of a Canadian resident corporation to the extent that the interest is taxable in the hands of the corporation as FAPI of a CFA of the corporation.
This measure will apply to taxation years of Canadian-resident corporations that end on or after Budget Day.
New Anti-Surplus Stripping Rule for Canadian Corporations Controlled by Non- Residents
Proposed foreign affiliate dumping amendments add a new anti-surplus stripping rule to the Tax Act as section 212.3. This provision will apply to a corporation resident in Canada (“CRIC”) which is controlled by a non-resident corporation (“NR Parentco”) where the CRIC engages in certain specified transactions with another non-resident corporation (“NR Subjectco”) that is or becomes a foreign affiliate of the CRIC. Where new section 212.3 applies, the CRIC is deemed to have paid a dividend to NR Parentco. That deemed dividend would, of course, be subject to withholding tax. There is a business purpose exception.
The new rule originates with a recommendation of the Advisory Panel on Canada’s System of International Taxation. A typical example of the mischief which prompted this new rule is a transaction where the CRIC acquires shares of a non-resident corporation in the same corporate group and incurs interest bearing debt to pay the purchase price. This debt results in deductible interest expense which reduces the Canadian tax base and removes corporate surplus from Canada in a way that the Department of Finance considers problematic from a tax policy perspective. Another example is a transaction where the CRIC acquires shares of a non-resident corporation in the same corporate group and pays the purchase price by issuing shares of the CRIC with paid-up capital equal to the purchase price. This paid-up capital allows for a future extraction of corporate surplus from Canada by way of a reduction and distribution of paid-up capital (which is not subject to withholding tax).
The scope of the proposed section 212.3 is not, however, limited to transactions between the CRIC and a non-resident corporation in the same corporate group. An acquisition by a CRIC in an arm’s length transaction of shares or debt of a non-resident corporation that becomes a foreign affiliate of the CRIC can also trigger the adverse application of this new anti-surplus stripping rule.
New section 212.3 will apply, subject to the business purpose exception, where the CRIC:
- acquires shares of NR Subjectco;
- contributes capital to NR Subjectco;
- NR Subjectco becomes indebted to the CRIC, except in the ordinary course of business where the indebtedness is repaid within a commercially reasonable period;
- acquires indebtedness of NR Subjectco from another person, except for an acquisition in the ordinary course of business from a person with whom the CRIC deals at arm’s length;
- acquires an option in respect of, or an interest in, shares or debt of the NR Subjectco; or
- engages in a transaction of similar effect.
If new section 212.3 applies, then the CRIC is deemed to have paid a dividend to NR Parentco at the time of the relevant transaction.
The amount of the deemed dividend is the fair market value of property transferred by the CRIC in the relevant transaction and/or the fair market value of any obligation incurred or assumed by the CRIC in the relevant transaction.
Where the CRIC has issued shares in the relevant transaction, the CRIC is not deemed to have paid a dividend in respect of the issue of such shares. Instead, the paid- up capital of the shares issued is reduced by the amount the paid-up capital would otherwise have been increased.
The Business Purpose Exception
New subsection 212.3 will not apply if the CRIC’s transaction can reasonably be considered to have been undertaken by the CRIC (instead of by NR Parentco or another non-resident that does not deal at arm’s length with NR Parentco) primarily for bona fide purposes other than to obtain a tax benefit (a reduction, avoidance or deferral of tax or increase of refund).
New subsection 212.3 specifies a number of factors to be considered in deciding if the business purpose exception is available, including whether:
- the business activities of NR Subjectco are more closely connected to the business activities of: (i) the CRIC (or a Canadian resident parent or subsidiary of the CRIC), or (ii) any non-resident corporation with which the CRIC does not deal at arm’s length (other than NR Subjectco and corporations in which NR Subjecto has a direct or indirect equity interest);
- shares in NR Subjectco owned by the CRIC do not participate fully in profits or appreciation of NR Subjectco, e.g., fixed value preferred shares;
- the transaction was undertaken by the CRIC at the direction of a non-resident corporation with which the CRIC does not deal at arm’s length;
- negotiations for the transaction were initiated by senior officers of the CRIC who are resident in and who work principally in Canada;
- if the vendor initiated the transaction, the principal negotiation contact on the other side is an officer of the CRIC who is resident in and who works principally in Canada;
- principal decision making authority for the CRIC in respect of the transaction is exercised by senior officers of the CRIC who are resident in and who work principally in Canada;
- the performance evaluation or compensation of senior officers of the CRIC who are resident in and who work principally in Canada is more closely connected to the operational results of NR Subjectco than the performance evaluation or compensation of senior officers of any non-resident corporation with which the CRIC does not deal at arm’s length (other than NR Subjectco or a corporation controlled by NR Subjecto); and
- senior officers of NR Subjectcoreport to and are functionally accountable to senior officers of the CRIC who are resident in and who work principally in Canada to a greater extent than to senior officers of any non-resident corporation with which the CRIC does not deal at arm’s length (other than NR Subjectco).
It could be very difficult to determine if the business purpose exception applies before a CRIC undertakes a transaction to which new section 212.3 could apply. It could be equally difficult to satisfy the Canada Revenue Agency (the “CRA”) that the business purpose exception applies in the event of a CRA audit or reassessment. The wording of the exception suggests that a taxpayer may have to prove why a non-resident corporation in the corporate group did not undertake the transaction instead of the CRIC. This is tantamount to requiring the taxpayer to prove a negative. Also, a number of the specified factors used in determining if the business purpose exception is available will be very difficult to resolve in practice.
The Government invites stakeholders to submit comments concerning the details of the proposed “business purpose” test, as set out in the Notice of Ways and Means Motion for this measure, before June 1, 2012.
Other Consequential Amendments
The Budget proposes a number of related amendments to other rules. Some of these are noted below.
Contributed surplus of a CRIC that arose in a transaction to which new section 212.3 applies cannot be converted into paid-up capital without triggering a deemed dividend.
Contributed surplus of a CRIC that arose in a transaction to which new section 212.3 applies is not counted as equity for the purposes of the thin capitalization rule.
Where corporate immigration into Canada or emigration out of Canada results in a CRIC controlled by an NR Parentco and the CRIC has a foreign affiliate, paid-up capital reductions and deemed dividends can result.
The new rule applies to transactions undertaken on or after Budget Day subject to grandfathering for certain arms’ length transactions subject to a written agreement entered into before Budget Day if the transaction is completed before 2013.
Where a transaction between a Canadian resident and a non-resident with whom the Canadian resident does not deal at arm’s length is not consistent with a similar arm’s length transaction, Canada’s transfer pricing rules allow the CRA to adjust the transaction prices and other relevant amounts to the arm’s length amounts for Canadian income tax purposes.
For example, if a Canadian resident pays a non-arm’s length non-resident a price of $1,000 for the purchase of goods, other property or services and an arm’s length party in similar circumstances would only have paid $700, then the Canadian resident is deemed to have paid the lower arm’s length price, i.e., $700. The $300 excess over the lower arm’s length price will be disallowed as a deduction where the Canadian resident has deducted the cost of the goods, other property or services in computing its income. Management fees, royalties and interest paid by a Canadian resident to a non-arm’s length non-resident are commonly subject to review and adjustment on this basis. Where the price paid is treated as cost of inventory or capital property, the lower arm’s length price will become the Canadian resident’s cost for tax purposes.
This type of transfer pricing adjustment is called a “primary adjustment”.
Where the Canadian resident subject to a primary transfer pricing adjustment is a corporation, the CRA generally treats the amount of the primary adjustment, i.e., the disallowed portion of the price paid to the non-arm’s length non-resident, as a shareholder benefit under subsection 15(1) of the Tax Act which is deemed to be a dividend subject to withholding tax under paragraph 214(3)(a) of the Tax Act. This treats the portion of the price paid to the non-resident in excess of the arm’s length price as being tantamount to a distribution of corporate surplus. This is referred as a “secondary adjustment.” In the above example, the $300 excess over the arm’s length price would be a deemed dividend subject to withholding tax.
The CRA’s policy with respect to assessing withholding tax for such secondary adjustments is set out in paragraph 211 of CRA Information Circular 87 – 2R on International Transfer Pricing.
The Budget proposes to amend section 247 of the Tax Act to provide specifically for withholding tax assessments for secondary adjustments. The proposed amendments also codify, to some extent, existing CRA administrative policy for relief from the secondary adjustment withholding tax if the non-resident repays or “repatriates” the excess amount to the Canadian corporation.
The proposed amendments are welcome because they provide specific rules for an area that was previously only dealt with under CRA administrative practice. The proposed amendments also specify an exception and a taxpayer favourable adjustment in relation to secondary adjustment withholding tax assessments.
The proposed amendments provide:
Amount: The amount subject to withholding tax is the sum of the Canadian corporation’s income and capital transfer pricing adjustments under section 247, but with the capital adjustments determined on a gross basis. And, this amount is determined as if the Canadian corporation had undertaken no transactions other than those transactions in which the particular non-arm’s length non-resident participated.
Reduction: The amount subject to withholding tax is reduced by transfer pricing adjustments in the Canadian taxpayer’s favour.
Deemed Dividend: The excess amount is treated as a deemed dividend for withholding tax purposes. Therefore, the withholding tax rate under any applicable tax treaty will be the rate for dividends. Nothing is said about when such deemed dividends will qualify for the lower dividend withholding tax rate available under many treaties where the shareholding meets a specified minimum threshold.
Timing: The deemed dividend is deemed to be paid at the end of the taxation year in which the relevant transactions occurred.
CFA Exception: There is an exception for a transaction with a non-resident that is a controlled foreign affiliate (“CFA”) under subsection 17(15) of the Tax Act. A primary transfer pricing adjustment in relation to a transaction with this type of CFA will not give rise to a deemed dividend subject to withholding tax. Excess payments by the Canadian corporation to such a CFA are considered to be equivalent to downstream capital contributions to the foreign affiliate rather than upstream distributions of surplus to foreign shareholders. Therefore, a withholding tax assessment is not appropriate. A subsection 17(15) CFA is generally a CFA controlled by the taxpayer and/or Canadian residents with whom the Canadian corporation does not deal at arm’s length. The non-resident must qualify as this type of CFA throughout the period during which the subject transaction or series of transactions occurred. The broad scope of the term “series of transactions” (see the recent GAAR decision of the Supreme Court of Canada in Copthorne Holdings Ltd.) may come to be a problem for this exception.
Paragraphs 212 and 213 of CRA Information Circular 87 – 2R on International Transfer Pricing and CRA Transfer Pricing Memorandum TPM – 02 set out the CRA’s administrative policy for relief from secondary adjustment withholding tax assessments where the non-resident repays the excess amount to the Canadian resident.
The proposed amendments codify this CRA administrative policy to a limited extent by providing:
Reduction for Repayment: The deemed dividend subject to withholding tax may be reduced where the non-resident has paid the Canadian corporation an amount with the concurrence of the CRA. The reduction would generally be the amount of the repayment, although the proposed amendment is not this specific.
CRA Discretion: The amount of the reduction is the amount that the CRA considers to be appropriate having regard to all the circumstances. This discretion will presumably allow the CRA to continue elements of its current administrative practice, such as denying repatriation relief for abusive transactions, allowing repayment by way of offset of other amounts owing by the Canadian corporation to the non-resident, or creation or adjustment of a shareholder’s loan account, and requiring the taxpayer to accept the primary transfer pricing adjustment and waive objection and appeal rights.
Arrears Interest: The withholding tax that was or could have been assessed prior to reduction for repayment will still be subject to arrears interest for the period from the date of the deemed dividend to the date of repayment. The CRA may agree to reduction of the arrears interest where the CRA considers such a reduction to be appropriate in the circumstances (including whether the other country provides reciprocal treatment).
The proposed amendments on repatriation relief are welcome; however, they fall short on the detailed mechanics. Determining all the tax consequences of a repatriation, in all affected taxation years, can be quite complex in some circumstances. This is particularly the case where repayment is effected by way of adjustments to an existing shareholder loan account and/or where a foreign currency is involved. Also, nothing is proposed to address the inequitable CRA position that withholding tax refunds are not entitled to refund interest.
The changes described above will apply to transactions that occur on or after Budget Day.
The Budget proposes that amendments be made to the “base erosion” rules in the Tax Act regarding the FAPI regime.
In particular, it is proposed that amendments will be developed to: (i) alleviate the tax cost to Canadian banks of using excess liquidity of their foreign affiliates in their Canadian operations; and (ii) ensure that certain securities transactions undertaken in the course of a bank’s business of facilitating trades for arm’s length customers are not inappropriately caught by the base erosion rules.
The Government has indicated that these amendments will be developed in conjunction with industry representatives and will include appropriate safeguards to ensure the Canadian tax base is adequately protected.
Canadian resident employees who qualify for the Overseas Employment Tax Credit (“OETC”) are entitled to a tax credit equal to the federal income tax otherwise payable (calculated using the employee’s average tax rate) on 80% of their qualifying foreign employment income, up to a maximum of $100,000. The OETC is deductible in determining the employee’s tax payable.
The Budget proposes to phase out the OETC over four taxation years, beginning in 2013. During the phase-out period, the factor (currently 80%) applied to an employee’s qualifying foreign employment income in determining the credit will be reduced to:
- 60% for the 2013 taxation year;
- 40% for the 2014 taxation year; and
- 20% for the 2015 taxation year.
The OETC will be eliminated beginning in 2016.
The phase-out will not apply to qualifying foreign employment income related to a project or activity committed to in writing before Budget Day.