Canada amends its thin cap rules
By: Elinore J. Richardson
Introduction
The treatment for tax purposes of interest paid by a resident to a non-resident is one element
of a more general concern which appears to be occupying more than one tax administration
currently: - the sharing of tax revenues from cross-border investment activities by taxpayers between
"source" and "residence" jurisdictions. The merits of source and residence based taxation have long
been debated by tax administrations and economists alike. In Canada, legislators have attempted to
marry the conflicting demands of varying concepts of tax neutrality for Canadian business with those
of revenue protection, crucial to economic growth and job creation.
Thin Capitalization – the Rationale
Economists tend to distinguish between international investors that are foreign portfolio
investors (non-control) and those that are involved in foreign direct investment (control). As foreign
portfolio investors are at arm's length with issuers, the presumption is that debt obligations they
acquire reflect the true substance of the arrangements between them and their borrowers. Foreign
direct investors, however, are often parent multinationals, their goals being the exploitation of
international business opportunities and the efficient allocation of consolidated revenue and expense
among various jurisdictions. Given these objectives, intra-firm debt transactions can, inter alia, be
used to manipulate group expenses to maximise after-tax return. In such circumstances, a capital
importing country can find that the funding of a group subsidiary, resident in its jurisdiction, with
interest bearing debt will result in an erosion of its tax revenues. Most jurisdictions, therefore, have
some form of transfer pricing rules designed to ensure that the return on such debt is reasonable and
bears a similarity to some arm's length standard. The more difficult issue has been the way in which
jurisdictions determine what portion of intra-firm debt is disguised equity. Thin capitalization rules
are one means of addressing this issue.
As early as 1966, the Canadian Royal Commission on Taxation recognized that differences in
the tax treatment of interest and dividends under the Canadian tax system created an obvious
incentive for a non-resident to capitalize a Canadian subsidiary with debt rather than equity. The
problem was acknowledged by the Canadian government in its 1969 white paper entitled "Proposals
for Tax Reform":
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"under present law it is attractive for non-residents who control corporations in
Canada to place a disproportionate amount of their investment in the form of debt
rather than shares. The interest payments on this debt have the effect of reducing
business income otherwise taxed at 50% and attracting only the lower rate of
withholding tax on interest paid abroad."
Shortly thereafter, in 1972, Canada became one of the first countries to introduce statutory
"thin capitalization rules". These rules, with some minor tinkering, have remained essentially
unchanged for almost three decades.
The Current Canadian Rules
Canada's current rules are contained in subsection 18(4) to 18(8) of the Canadian federal
Income Tax Act1. Essentially, those rules disallow the deduction of interest, otherwise deductible, that
is paid by a corporation resident in Canada to a specified non-resident, to the extent that the ratio of
"outstanding debts to specified non-residents" to equity exceeds 3:1. Unlike the rules introduced, for
example, in 1987 by Australia, Canada's rules, to date, have applied only to the debt of corporations
resident in Canada. It has, therefore, not been unusual to see planning involving partnerships, trusts
or branches of foreign corporations which are outside the application of the Canadian rules.
Specified Shareholder
For purposes of these rules, the Act defines a "specified non-resident shareholder" to be a
"specified shareholder" who, at that time, was a non-resident. A "specified shareholder" is defined
to be a person who either alone or together with persons with whom that person is not dealing at
arm's length, owns shares of the capital stock of a corporation that: (a) give the holders the right to
cast 25% of the votes at an annual meeting of the shareholders or, (b) have a fair market value of
25% or more of the fair market value of all of the issued and outstanding shares of the corporation.
The Act also includes certain anti-avoidance rules which will attribute or re-distribute ownership
among persons with various rights or to an issuing corporation in specified circumstances.
Debts
"Outstanding debts to specified non-residents" of a corporation at any particular time in a
taxation year, means the total of all amounts, each of which is an obligation to pay an amount to a
specified non-resident shareholder of the corporation or to a non-resident person who was not
dealing at arm's length with a specified shareholder (the "specified non-resident"). Any loan made by
a specified non-resident (the "first lender") to another person, on condition that a loan (the "back to
back loan") be made to the corporation, will be deemed (to the extent of the amount of the lesser
loan) to be made by the first lender to the corporation.
RSC 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Act." Unless otherwise stated,
statutory references in this article are to the Act.
1
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Debts or obligations included for this purpose are loans and other similar indebtedness, such
as trade payables. Late payment charges on the purchase of goods and services from related nonresidents will also be included. Not included is non-interest bearing debt. Also, not included
currently, are deposit or guarantee arrangements entered into by a foreign parent or related
corporation in support of a borrowing by a resident Canadian corporation: see Examples A and B.
Example A
Foreign Bank
Foreign Co.
Deposit
Foreign Bank
Affiliate
Loan
Canadian
Co.
Example B
guarantee
Foreign Co.
Foreign Bank
loan
Canadian Co.
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It is to be noted that, under the current rules, Canadian Co. should be entitled to contract
unlimited borrowings from the foreign lenders. Assuming interest paid on the loans otherwise,
meets the tests of deductibility, subsection 18(4) of the Act should pose no limitations. Moreover,
the interest paid by Canadian Co. would, most likely, be exempt from Canadian non-resident
withholding tax.
Where the specified non-resident is itself a bank, which is considered to be an "authorized
foreign bank" as defined in the Act, debt outstanding from a resident Canadian corporation will be
excluded from debt outstanding for purposes of the thin capitalization rules, by reason of a proposal
contained in the February 1999 federal budget, so long as interest payments on that debt are included
in the foreign bank's income that is subject to income tax in Canada.
Equity
For purposes of determining whether the ratio has been met, a corporation resident in Canada
must compare the greatest aggregate amount that the corporation's outstanding debts to specified
non-residents were, at any time during the year, to equity. Equity for this purpose means:

the retained earnings of the corporation at the commencement of the year on an
unconsolidated basis determined in accordance with generally accepted accounting
principles, subject to certain exceptions, among them those relating to recent
characterizations of equity or debt for financial reporting purposes,

the corporation's contributed surplus at the commencement of the year, to the extent
that it was contributed by specified non-resident shareholders, and

the greater of the corporation's paid-up capital at the beginning or the end of the year in
respect of shares held by specified non-resident shareholders.
Tiering
The current rules have three twists, two of which have not been affected by the proposed
changes. First, subsection 18(4) does not recharacterize interest on debt which exceeds the limits
prescribed by the rules as dividends. It simply denies a deduction by the corporation paying it. The
effect of the denial is, economically, to treat the amount of excessive interest as a dividend in that it
is subject to Canadian income tax at the corporate level. However, for all tax purposes, i.e. for
Canadian non-resident withholding tax purposes, it remains interest. That means that Canada will
charge its domestic non-resident withholding rate of 25%, reduced, as applicable, by relevant treaties.
Interest will normally be taxed at a treaty rate of 10%, while dividends will be taxed at either a general
rate of 15% or at 5%, in the case of a foreign corporate recipient with a substantial interest.
Second, the Canadian thin capitalization rules are, for the most part, straight forward and
relatively easy to apply. Situations do arise, however, due to the fact that the rules do not look to
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"ultimate ownership" but only to "direct ownership", which can give rise to costly oversights. The
following example illustrates the type of situation which can arise.
Example C
Foreign Co.
100% equity
100%
equity
Canadian Co.
Foreign Co. A
Loan
100%
equity
Canadian
Opco.
In this example, Canadian Opco. requires funds. Foreign Co. A is Foreign Co.'s. financing
subsidiary. It lends the money. The thin capitalization rules will apply to disqualify all interest
payable by Canadian Opco. as it will have no paid-up capital or contributed surplus from specified
non-resident shareholders, unless its retained earnings alone are sufficient to provide the coverage.
Finally, the elements of the formula may give rise, in certain cases, to anomalous results where
a Canadian corporation is involved in the acquisition of a target corporation or another transaction
which requires that for a short period it increases substantially its intra-firm debt. Assume, for
example, that Foreign Co. creates Canco A and Canco A acquires Canco B. Assume further that
Canco A is capitalized with a significant amount of debt from Foreign Co. to make the acquisition.
That debt is almost immediately repaid. In measuring debt to equity, Canco A must, for its first
taxation year, match the highest debt at any time in the year against the greater of its paid-up capital
from Foreign Co. at the commencement of the year (a nominal amount on incorporation prior to
making the bid) and that at the end of the year (the amount after repayment of the debt). A portion
of Canco A's interest will be non deductible. Had Canco A's shareholders realized the situation, they
could have put Canco A back on side with an additional subscription of capital immediately before
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the year end under the current rules. This may no longer be possible under the budget proposals
described below.
The Technical Committee on Business Taxation
The Technical Committee on Business Taxation, established by the Minister of Finance for
Canada in March 1996, to recommend ways to improve the business tax system, issued its report (the
"Mintz Report") in December 1997.
The Mintz Report, inter alia, reviewed the federal-provincial general corporate rates of tax in
Canada, noted the increasing role of Canada as a capital exporter and highlighted, in the area of
international taxation, the need for a series of changes to reduce erosion of the Canadian tax base.
Among the reasons for this, the Mintz Report cited Canadian corporate tax rates which the
Committee described as "internationally non-competitive", discouraging the location of business
operations in Canada and resulting, as well, in an erosion of the Canadian tax base.
The Mintz Report noted that the Canadian economy "is increasingly integrated with the global
economy". Canada, historically a capital importer, exports almost as much capital as it imports, the
Mintz Report acknowledged. "Foreign direct investment into Canada totaled approximately $170
billion in 1995" compared with outbound foreign direct investment of approximately $140 billion in
the same year. As relatively little domestic tax revenue is traditionally raised by tax administrations
from outbound foreign direct investment, the change in Canada's role was considered as perhaps
necessitating a re-evaluation of past policies.
The Mintz Report also commented on the thin capitalization rules as follows:
"In general, the Committee is of the view that the thin capitalization rules are working
well, and are not a major impediment with respect to the day-to-day operations of
Canadian businesses. The rules are simple and effective, and the paucity of
jurisprudence with respect to the rules suggests that disputes with the Canadian
revenue authorities have been rare…"
Nonetheless, the members of the Committee could not resist the temptation to tinker. The
Mintz Report contained the following recommendations:
"the existing ratio of 3 to 1 should be reduced to 2 to 1, as a closer proxy for
financing that would generally be available in an arm's length context."
"the rules should be extended in their application to Canadian branches of foreign
corporations, and to partnerships and trusts."
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"the provisions on back to back loans should be extended to all indebtedness
(including funds on deposit)."
On balance, the Mintz Report recommended that "guaranteed debt not be included in the thin
capitalization provisions at this time" as it "might […] disrupt normal commercial financing
arrangements".
The Budget Proposals
In the government's first federal budget of the millenium, the Minister of Finance has flirted
with a few of the Business Taxation Committee's proposals in the international area but has refused
to dance. Hard issues have been left for later. Nonetheless, the government has decided to embark
on a reform of the thin capitalization rules which will impact foreign direct investment in Canada.
The government initially indicated in the budget proposals that it would

reduce the threshold ratio of debt to equity from 3:1 to 2:1,

alter the manner in which the ratio was to be calculated,

extend the definition of debts outstanding to debt owing to a third party that is
guaranteed or secured by a specified non-resident, and

repeal a current exemption from the rules applicable to developers and manufacturers of
aircraft and aircraft components.
These amendments were proposed to take effect for taxation years that begin after 2000. In
addition, the government indicated that it intends to initiate consultations to extend the application
of the thin capitalization rules to other arrangements and business structures. Specifically mentioned
were partnerships with non-resident members, trusts with non-resident beneficiaries and Canadian
branches of non-resident companies carrying on business in Canada. Also noted were debt
substitutes, such as certain types of leases.
Threshold Debt-Equity Ratio
The reduction of the threshold ratio from 3:1 to 2:1 was warranted, said the government in
the Supplementary Information which accompanied the budget, as it provides a "better measurement
of excessive reliance on related-party debt financing in the context of actual Canadian industry debt
equity ratios". No separate consideration was given to appropriate debt equity ratios for financial
institutions, although it is understood that some accommodation may be under review. No
economic data was supplied by the government in support of its assertions.
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If one accepts that a fixed debt to equity ratio standard, though inflexible and arbitrary, is
preferable to a multi-factor arm's length standard such as that advanced by the OECD, in the interest
of increased certainty and reduced administration and compliance costs, the only question which
then remains is how stringent tax policy makers wish to be with respect to intra-firm debt.
Increasingly, other jurisdictions have introduced lower thresholds, or reduced those,
previously at 3:1. The US "earnings stripping rule", introduced in 1989, adopts a safe harbour of 1.5
to 1.0 but disqualified interest (non-deductible to the extent a US group has excess interest expense)
may be carried forward indefinitely. Australia recently expanded the debt base to which its thin
capitalization rules apply, but reintroduced the three to one standard after having lowered it for a
short period to 2:1.
A 2:1 single factor standard, if adopted by Canada, will certainly do nothing to encourage
foreign investors to increase investment activity in Canada.
Calculation of Equity on an Averaged Basis
The change proposed will require that a Canadian corporation with debt outstanding to
specified non-residents compute retained earnings at the beginning of the year and compute
contributed surplus and paid-up capital attributable to specified non-residents at the beginning of
each month in a year. The corporation will then measure the amount it has calculated against the
greatest total amount of debt owing to non-residents at any time in each month of the year and
determine the average annual ratio of debt to equity.
The proposal is justified by the government in that it will "give less weight than the current
rules to debt levels that are temporarily high". While this may be true, it is also true that it will make
it more difficult to rectify oversights which occur during the course of a year. It will also clearly put
an end to any planning based on artificial inflation of paid-up capital over a corporation's year end.
If, as the government suggests, the modification is to deal with temporarily high levels of debt
which can have a disproportionate effect, perhaps, at the very least, given the increased
administrative cost to taxpayers of instituting yet another information gathering system and of
maintaining adequate records to support the calculations, the legislation might be drafted to permit
taxpayers to decide annually whether or not to use the monthly calculation. As another option, a
weighted calculation of debt only could have been proposed.
Broadening of the Conditional Loan Rule
The expressed intention is to extend the ambit of the rules by including, as debt outstanding,
loans to a Canadian corporation from a third party that are guaranteed or secured by a specified nonresident. It is understood that, while the budget resolution is not qualified, the government may be
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giving some consideration, at the least, to "appropriate" carve outs. This review process may result
in a deferral of the application of the rules.
If one accepts, as apparently the Australian legislators do, the impossibility of determining
what constitutes "good" and "bad" debt for this purpose, the solution, one must conclude, must be
either to include all debt with a consequent increase in the ratio or to establish bright-line tests which
can be applied with certainty. It will be interesting to see what the government comes up with faced
with a Canadian business community constituted in large part of a number of strong and profitable
Canadian subsidiaries of US and other foreign multinationals, very few of which would, in all
probability, be rated, all of whom keep competitive information extremely private and most of whom
have been permitted to do so over long time periods by using parent or group results as the basis for
external borrowing! In such an environment, how will it be possible to design a bright-line test
which will separate tax-motivated transactions. From those entered into primarily for commercial
purposes? Moreover, what possible advantage can Canada think to obtain by forcing Canadian
borrowers across the board into financial arrangements which have as their end to increase the cost
of borrowing!
Similar to the case of guarantees is that of security. While there have clearly been situations
where corporations related to Canadian borrowers have put funds on deposit with a foreign bank to
"facilitate" borrowings by a Canadian corporation, how will corporate groups, under the new
proposals, deal with lenders who will seek the greatest amount of security possible even if it is not an
absolute requirement of a transaction?
Repeal of Aircraft Developers and Manufacturers Exemption
There is nothing really which can be said. The government seemingly made no comment
when the exemption was introduced and has been similarly silent in face of its demise.
Non-Corporate Borrowers
It remains to be seen what will come of the government's request for comment and its review.
Australia has tackled the problem and it is to be expected that the Australian legislation will be the
subject of review. While it is clear that the application of the thin capitalization rules only to
corporate entities does leave the opportunity for base erosion, the offensiveness of that erosion will
have to be weighed carefully against the legislative complexity which will result from any attempt to
reduce it.
Grand Fathering
The government's proposals are intended to have application to taxation years beginning after
2000. So long as the proposed rules will have application only to intra-firm debt the lead time of
almost a year in most cases to put ratios on side, should be sufficient. However, if the government
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intends to proceed with the more far reaching changes affecting guaranteed debt, the period seems
hardly enough. Many international borrowings by Canadian issuers have no call provisions during a
specified period; others have call provisions but exercisable only at a significant economic cost to the
borrower. It is to be hoped that the legislators will take these concerns, as well, into consideration as
they review the proposals.
Conclusion
It is clear that a number of factors have conspired to encourage foreign multinationals to
increase the debt of their Canadian subsidiaries over the past several years. Many of these factors
have been within the control of the Canadian government. The first and most significant has been
Canada's insistence on maintaining a considerably higher federal-provincial general corporate rate of
tax in face of reductions by several of its major treaty partners. Also, important has been Canada's
generous rules, which permit deduction of interest expense on borrowings to finance foreign
investment. Third, tax changes in foreign jurisdictions, notably the US, which have restricted
deduction domestically of interest costs relating to foreign investment, have also encouraged shifting
of such costs to other jurisdictions.
It is also clear that "shifting", or more exactly, "doubling" has been facilitated since the
introduction by the US of its "check-the-box" regulations in 1996 and, also, by differing jurisdictional
interpretations as to the character of debt and equity. The result has been that certain multinationals
have been able to structure their affairs so as to obtain additional deductions of interest in one or
two foreign jurisdictions, without ever giving up their interest deduction domestically.
Add to these considerations that Canada's role has been slowly changing over the last decade
and a half from that of a country dependent on foreign capital to that of one which has made
significant strides toward becoming a substantial exporter of capital. Moreover, many of Canada's
important treaty partners have been reviewing and refining their positions as the jockeying
internationally for tax revenues continues.
Amidst these developments which have raised serious concerns from Canada's perspective as
to where its tax revenues will come from in the future, though one might well take issue with an
approach which might have benefited from a more comprehensive review and considered action, it is
not difficult to see from whence the tax man cometh!