Existing Canadian Thin Cap Regime
The existing Canadian thin cap regime protects the Canadian tax base from excessive interest deductions by limiting the amount of interest expense that can be deducted by a corporation resident in Canada16 (“Canco”) on cross-border loans from “specified non-resident shareholders” and non-residents not dealing at arm’s length with such shareholders (collectively referred to herein as “specified non-residents”). Generally, specified non-resident shareholders are non-residents who, either alone or together with non-arm’s length persons, own or have a right to acquire shares of Canco representing 25% or more of the votes or value of all Canco shares.
In the absence of the Canadian thin cap rules, specified non-residents could erode the Canadian tax base by financing Canco with significant debt and nominal equity. The Canadian thin cap rules prevent specified non-residents from doing so by disallowing any deduction for interest expense in computing the income of Canco in respect of debt owing to specified non-residents in excess of the permitted 2-to-1 debt-to-equity ratio.
Proposed Amendments to the Canadian Thin Cap Regime
Bill C-45 contains significant amendments to the existing Canadian thin cap regime. These amendments consist of the following:
- reduce the permitted debt-to-equity ratio from 2-to-1 to 1.5-to-1,
- extend the scope of the Canadian thin cap regime to loans from specified non-residents to partnerships with one or more direct or indirect Canco partners,
- treat Canco’s disallowed interest expense and interest required to be included in Canco’s income in respect of loans to partnerships as dividends deemed paid by Canco to specified non-residents, and
- provide for an exception in circumstances where a Canco borrows from its controlled foreign affiliate.
Reduction of Debt-to-Equity Ratio
The proposed reduction of the permitted debt-to-equity ratio from 2-to-1 to 1.5-to-1 applies to taxation years beginning after 2012. The computation of the debt component of the ratio will continue to be based on a monthly average of the greatest amount owing by Canco to specified non-residents in the month except that Canco will be required to include its “specified proportion” or proportion, as applicable, of a partnership’s debt owing to specified non-residents in relation to Canco as discussed in more detail below.
The equity component of the ratio is generally equal to the total of the following amounts:
- Canco’s retained earnings at the beginning of the taxation year,
- average of Canco’s contributed surplus at the beginning of each month in the taxation year to the extent contributed by a specified non-resident shareholder, and
- average of the PUC of Canco shares at the beginning of each month in the taxation year owned by a specified non-resident shareholder.
The computation of the equity component of the ratio is subject to three changes under Bill C-45:
- The PUC of the Canco shares is reduced for thin cap purposes by any PUC reduction under the foreign affiliate dumping rules to the extent Canco shares are owned by specified non-resident shareholders.
- Any portion of the contributed surplus of Canco that arises on or after March 29, 2012 in connection with an Investment to which the foreign affiliate dumping rules apply is not taken into account.
- The computation of the equity component also takes into account any reduction in the amount of the PUC of shares of a non-resident corporation that immigrates to Canada and becomes a Canco under rules in Bill C-45 meant to deter the use of corporate immigration to circumvent the foreign affiliate dumping rules.
Extension of Canadian Thin Cap Regime to Loans from Specified Non-Residents to Partnerships
The amendments extend the Canadian thin cap regime to loans made by a specified non-resident in relation to Canco to a partnership in which Canco has a direct interest or indirect interest through tiers of partnerships for taxation years beginning after March 28, 2012. Canco is required to include in computing the debt component of its debt-to-equity ratio a portion of any debt owing by such a partnership to a specified non-resident.
The portion of the partnership’s debt attributed to Canco is the “specified proportion”, if determinable. Canco’s “specified proportion” generally means its share of the income (or loss) of the partnership for the fiscal period of the partnership ending at or before the end of Canco’s taxation year. Where the partnership income (or loss) for a particular fiscal year is nil, Canco’s “specified proportion” is computed as if the partnership had income for that period of $1,000,000. If Canco’s “specified proportion” cannot be determined, then Canco’s proportion of the debt of the partnership is computed based on the proportion that the fair market value of its interest in the partnership at that time is of the fair market value of all interests in the partnership at that time.
The inclusion of Canco’s “specified proportion” or proportion, as applicable, of a partnership’s debt has the effect of increasing the debt component of the debt-to-equity ratio of Canco in determining the amount of any debt owing or deemed to be owed by Canco to specified non-residents in excess of the permitted debt-to-equity ratio. Interest expense will be denied in computing Canco’s income in respect of each debt owing by Canco to a specified non-resident based on Canco’s excess debt ratio.
For Canadian tax purposes, it is not possible to deny an interest deduction at the partner level in respect of interest on partnership debt because the income (or loss) of a partnership is computed at the partnership level and allocated on a net basis (i.e., after deducting interest on partnership debt) to the partners. As a result, Canco’s portion of any interest expense deducted by the partnership in respect of Canco’s “specified proportion” or proportion, as applicable, of each debt of a partnership owing to a specified non-resident in relation to Canco is included in computing Canco’s income based on Canco’s excess debt ratio rather than being disallowed. The net result of this income inclusion for Canco should be the same as a disallowance of interest deduction because the inclusion in income should generally offset a corresponding interest expense deducted in computing the portion of the partnership’s income allocated to Canco.
The impact of these new rules on Canco is illustrated in the following example. In this example, ForeignCo is a specified non-resident in relation to Canco and has made an interest bearing loan of $2,000,000 to Canco. Canco’s equity for thin cap purposes is $1,500,000, comprised of PUC of the shares of Canco owned by a specified non-resident shareholder in the amount of $500,000 and retained earnings of $1,000,000.
Canco has an interest in a partnership. The partnership agreement provides that 40% of the income (or loss) of the partnership is allocated to Canco. ForeignCo has made an interest bearing loan of $1,000,000 to the partnership. Canco’s “specified proportion” of the partnership loan would be $400,000 (40% of $1,000,000).
The structure is illustrated in Diagram 1.
In this example, Canco’s aggregate excess debt amount (both direct and indirect) is computed as follows:
$2,000,000 (direct debt) plus $400,000 (indirect partnership debt) minus [1.5 x Canco’s equity of $1,500,000] = $150,000
Canco’s aggregate excess debt ratio is 5/80 ($150,000/$2,400,000). The result is that 5/80 (or 6.25%) of the interest expense on Canco’s direct debt is not deductible in computing Canco’s income and 5/80 (or 6.25%) of the interest expense on the indirect partnership debt is included in computing Canco’s income.
Deemed Dividend Treatment for Canco’s Non-Deductible Interest and Interest on Partnership Debt Included in Canco’s Income
Under the existing Canadian withholding tax regime, both the denied and allowable portion of any interest on loans from specified non-resident lenders to Canco are treated as interest in the hands of specified non-resident lenders. Interest (other than participating debt interest) paid or credited by Canco to a specified non-resident lender dealing at arm’s length with Canco is not subject to Canadian withholding tax. Where a specified non-resident lender is not dealing at arm’s length with Canco, any interest paid or credited by Canco to such specified non-resident lender is subject to Canadian withholding tax at a rate of 25% or a reduced rate under an applicable income tax treaty.
Under the proposed amendments, any portion of the interest on a loan from a specified non-resident lender to Canco, or to a partnership in which Canco has an interest, that is denied or included in computing Canco’s income, as applicable, is deemed to be a dividend (rather than interest) paid or credited by Canco to the specified non-resident lender and is subject to Canadian withholding tax. If the denied or included interest is treated as a dividend rather than interest, the applicable rate of Canadian withholding tax may be different depending on whether the specified non-resident lender is dealing at arm’s length with Canco or entitled to a reduced withholding tax rate under a tax treaty.
An arm’s length specified non-resident lender will generally be adversely impacted if any denied or included interest (other than participating debt interest) is treated as a dividend since none of Canada’s tax treaties have a full exemption for Canadian withholding tax on dividends.
A non-arm’s length specified non-resident lender will also be negatively impacted if the interest (other than participating debt interest) is treated as a deemed dividend in the following circumstances. If a specified non-resident lender is not dealing at arm’s length with Canco for purposes of the Act and is entitled to the benefits of the Canada-United States Tax Convention (the “Canada-U.S. Tax Treaty”), there is no Canadian withholding tax on interest (other than participating debt interest). On the other hand, the Canadian withholding tax rate under the Canada-U.S. Tax Treaty for dividends is either 5% if the beneficial owner of the dividend is a company that owns at least 10% of the voting stock of the company paying the dividend or 15% in all other cases. The Canada-U.S. Tax Treaty is currently Canada’s only tax treaty that has a full exemption for Canadian withholding tax in respect of interest (other than participating debt interest) on non-arm’s length debt.
The proposed amendments also provide that any interest (other than compound interest) payable by Canco, or a partnership in which Canco has an interest, in respect of Canco’s particular taxation year that remains unpaid at the end of such taxation year is deemed to have been paid or credited immediately before the end of such taxation year. This proposal is a departure from certain Canadian tax provisions dealing with deemed payments which provide for a period after a taxation year during which certain amounts may be paid before triggering a deemed payment.
Canco will be entitled to designate in its return of income for a particular taxation year which payments of interest in the year are to be treated as dividends. Bill C-45 and related Explanatory Notes do not provide any guidance on the manner in which Canco can allocate deemed dividends among debts owing to specified non-residents.
However, we understand that the intention is that the treatment of any denied or included interest as a deemed dividend will apply proportionately and separately to each debt owed to a specified non-resident. For example, if Canco’s excess debt ratio is 10%, then 10% of interest paid or payable in respect of each debt owing to specified non-residents in a taxation year will be treated as a deemed dividend. Therefore, it would appear that Canco cannot allocate deemed dividends among specified non-residents in a disproportionate manner so as to benefit from a lower withholding tax rate under a tax treaty to which a particular specified non-resident may be entitled.
By making a designation, Canco may be able to address certain timing issues with respect to the triggering of the Canadian withholding tax on deemed dividends. If Canco does not make this designation, then each interest payment is considered to be a blended payment including both an interest and deemed dividend component.
No penalty will be imposed for any failure to deduct or withhold Canadian tax in respect of denied or included interest that is deemed to be a dividend if such interest would not have been subject to Canadian withholding tax had it been treated as interest. This generally means that no penalty would be imposed in respect of deemed dividends to arm’s length specified non-resident lenders since no Canadian withholding tax is applicable on interest (other than participating debt interest) paid on arm’s length debt. There would also be no penalty imposed with respect to deemed dividends to non-arm’s length specified non-resident lenders who qualify for the exemption from Canadian withholding taxes on interest (other than participating debt interest) under the Canada-U.S. Tax Treaty.
These proposed amendments apply to taxation years ending after March 28, 2012 subject to certain transitional rules for dividends deemed paid in a taxation year that includes March 29, 2012.
Exception for Loans from a Controlled Foreign Affiliate to Canco
Loans owing by Canco to its controlled foreign affiliate may be subject to the Canadian thin cap regime which could result on the one hand, on interest being denied or included in income under the Canadian thin cap rules, and on the other hand, on the same interest being treated as foreign accrual property income (“FAPI”) and included in Canco’s income. In order to prevent this form of double taxation, it is proposed that the deduction of such interest would not be denied or that an amount equal to such interest would be deducted in computing any interest included in Canco’s income, as applicable, under the Canadian thin cap rules to the extent that a FAPI amount included in Canco’s income in respect of the particular taxation year or subsequent taxation year, or included in the partnership’s income for a fiscal period, may reasonably be considered to be in respect of such interest.
This proposed amendment applies to taxation years ending after 2004.
Reviewing Loan Arrangements with Specified Non-Resident Lenders
It is important for taxpayers to review their cross-border loan arrangements with specified non-resident lenders and to consult with their tax advisors to determine what, if anything, can be done to minimize the adverse Canadian tax consequences of these changes to the Canadian thin cap rules. Taxpayers should consider, among other things, whether loans receivable by a specified non-resident lender from a Canco should be transferred to another specified non-resident lender that is entitled to a lower Canadian withholding tax rate on dividends, whether Canco should repay loans owing to specified non-resident lenders in excess of permitted debt-to-equity ratio, and whether loans owing to specified non-resident lenders denominated in foreign currency should be converted into another currency to reduce the impact of foreign currency fluctuations.
If you have any questions or require further analysis on the international tax measures discussed herein, please contact the authors.
1 Bill C-45 contains various amendments to the Draft Legislation released by the Department of Finance (Canada) on August 14, 2012.
2 Or becomes controlled by a non-resident corporation as part of the relevant series of transactions or events.
3 Or becomes a foreign affiliate of the Canadian resident corporation as part of the relevant series of transactions or events.
4 If a CRIC forgives debt owing to the CRIC by an NR Subjectco, this will be an Investment which triggers section 212.3 because the forgiveness confers a benefit on the NR Subjectco.
5 Caution will be required in monitoring intercompany accounts to ensure that ordinary course trade payables are paid within 180 days.
6 Domestic tax law in NR Parentco’s jurisdiction, and possibly the tax treaty, if any, between Canada and that jurisdiction will determine if NR Parentco is entitled to a foreign tax credit for the Canadian withholding tax.
7 The period for filing the Dividend Substitution Election is extended if the Dividend Substitution Election is due within 120 days after the legislation enacting these changes becomes law. In this case, the Dividend Substitution Election will be deemed to be timely filed if made within 365 days after the legislation enacting these changes becomes law.
8 PUC reinstatement is also available to allow a CRIC or QSC to distribute shares of the capital stock of a foreign affiliate of NR Subjectco that were substituted for the NR Subjectco shares or sale proceeds from or amounts received as dividend or PUC distributions on such shares to the extent of the portion of the fair market value of such shares or the portion of the proceeds of disposition or dividend or PUC distribution that may reasonably be considered to relate to the NR Subjectco shares.
9 The Explanatory Notes state that business activities will be “connected” if they are similar or parallel or if they are upstream or downstream components of a larger integrated business.
10 A Connected Affiliate is a controlled foreign affiliate of the CRIC for the purposes of section 17 of the Act if the business of that controlled foreign affiliate is at least as closely connected to the business activities of NR Subjectco and other corporations in which NR Subjectco has a direct or indirect equity interest on a collective basis, as the Canadian business activities of the CRIC and non-arm’s length Canadian resident corporations are on a collective basis.
11 The period for filing this election is extended if the election is due within 120 days after the legislation enacting these changes becomes law. In this case, the election will be deemed to be timely filed if made within 365 days after the legislation enacting these changes becomes law.
12 Including loans, unpaid purchase price, trade payables and all other types of indebtedness.
13 This rule also applies to indebtedness owing to a partnership of which a Canco is a member and to indebtedness owing by non-resident persons who are partners or beneficiaries of a partnership or trust, as the case may be, which is a shareholder of Canco.
14 The period for filing the PLOl Election is extended if the PLOI Election is due within 120 days after the legislation enacting these changes becomes law. In this case, the PLOI Election will be deemed to be timely filed if made within 365 days after the legislation enacting these changes becomes law.
15 Average annual yield of three-month Canadian government treasury bills plus 4%, except that, for purposes of computing the section 17.1 inclusion, there is no rounding off to highest whole percentage in determining such annual yield.
16 The Canadian thin cap regime applies to Canadian resident corporations whether or not controlled by a non-resident corporation. Therefore, a Canadian resident corporation subject to the thin cap regime may or may not be a CRIC subject to the foreign affiliate dumping rules.