The not-so-thin
“thin-capitalization” rules
April 2012
The Income Tax Act (Canada) (ITA) contains rules which
limit the deductibility of interest expense that is incurred by a
Canadian-resident corporation where the amount of interestbearing debt owed to certain non-residents exceeds a 2-to-1
debt-to-equity ratio. The intent of these rules is to allow
Canadian corporations to be financed by their non-resident
shareholders using a reasonable level of debt while protecting
the Canadian tax base against interest deductions from
excessive amounts of such debt.
Proposals introduced in the 2012 federal budget will tighten these rules by reducing the
debt–to-equity threshold, extending the rules to apply to partnerships, and changing the
tax treatment of interest expense that is disallowed under these rules.
Current rules
The ITA includes a specific formula in calculating the 2-to-1 debt-to-equity ratio, applying
a number of defined terms in the process. For example, the rules only apply to Canadianresident corporations with “outstanding debts to specified non-residents.” This term is
defined in the ITA as a non-resident who owns, or is related to a person who owns either
25% or more of the voting shares of the Canadian-resident corporation, or 25% or more
of the fair market value of all of the issued and outstanding shares of the capital stock of
the corporation. 1 A common example, therefore, would include interest-bearing debt
owed by a Canadian corporation to its non-resident parent company that exceeds the 2-to1 ratio. Any interest expense that is disallowed under these rules must be added back to
the corporation’s income and reported as such on the corporation’s income tax return.
1
The rules contain specific definitions of equity and debt for the purpose of the thin-capitalization rules. For
example, equity includes the corporation’s opening balance of retained earnings, the monthly average paidup capital at the beginning of each month, and the monthly average contributed surplus at the beginning of
each month owned/contributed by specified non-resident shareholder(s). For purposes of computing the
outstanding debts to specified non-residents, the formula uses the average amount of each month's largest
outstanding balance of interest-bearing debt.
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This disallowed interest (whether paid or payable) is still subject to withholding tax under
the ITA as interest paid to a non-resident. 2
Proposed rules
The proposed rules were introduced in response to a number of recommendations made
by the Advisory Panel on Canada’s System of International Taxation (the "Advisory
Panel"). 3
Reduction to ratio
The budget proposes to tighten the rules by reducing the debt-to-equity ratio from 2-to-1
to 1.5-to-1, applicable to corporate taxation years that begin after 2012. 4
Application to partnership debts
In applying the thin-capitalization rules to corporations, the budget proposals will extend
the rules to include debts owed by partnerships of which the Canadian-resident
corporation is a member. Accordingly, in calculating the corporate members’ debt-toequity ratio, debt obligations of the partnership will be allocated to its members based on
their proportionate interest in the partnership. Thus, partnership debts owed to a specified
non-resident shareholder of the corporate partner, will be included proportionately in the
corporate partner's debt-equity equation. Where a corporate partner exceeds its permitted
debt-to-equity ratio, rather than adjusting the income of the partnership, an amount will
be included in the partner’s income determined by applying the partner's excess debt-toequity ratio to the partnership interest deduction on the portion of the partnership debt
allocated to the corporate partner.
This new measure will apply to partnership debts that are outstanding during corporate
tax years that begin on or after March 29, 2012.
Dividend treatment of excess interest
Finally, for withholding tax purposes there is a proposal to recharacterize interest expense
disallowed by the thin-capitalization rules as dividends, instead of as interest under the
current rules.
2
Under the ITA, certain passive income (i.e., certain dividends, and royalties) paid to non-residents is
subject to withholding tax at a rate of 25%. However, if the non-resident is resident of a country which has a
tax treaty in force with Canada, the rate in most cases would be lower, as specified under the relevant tax
treaty (e.g., under the Canada-US Tax Convention, the withholding tax on interest is eliminated in most
cases). The ITA has eliminated withholding tax on interest payments made to arm’s-length non-residents,
with certain exceptions.
3
Included in the Advisory Panel’s December 2008 report.
4
The Advisory Panel concluded that the current 2-to-1 ratio is high compared to actual industry ratios in the
Canadian economy, suggesting this ratio allows inappropriately high levels of foreign related party debt.
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In many cases, this proposal may result in higher withholding tax rates, particularly where
the non-resident related lender is not a shareholder. While most tax treaties provide for
withholding tax rates on dividends ranging from 5% to 15%, non-resident tax does not
apply to interest paid to arm’s-length non-resident parties. Under the Canada-US tax
treaty, the tax has been eliminated on eligible interest payments made to non-arm’s-length
parties.
Payments of current year's interest made in that year are recharacterized and deemed to be
a dividend at the time of the interest payment, unless otherwise designated. Where the
disallowed interest expense has not been paid by the end of the tax year, it will be deemed
to have been paid as, and treated as, a dividend paid at the end of the tax year.
If the deemed dividend results in a higher withholding tax, it appears that the additional
withholding tax would be payable by the fifteenth of the month following the month in
which the non-deductible interest was paid. While the new rules will allow a corporation
to designate the timing of when the non-deductible—and thus the deem dividends—are
paid, unless there are relieving provisions forthcoming, it appears that the shortfall of
non-resident tax withheld/remitted could be subject to penalties for failure to
withhold/remit as well as interest charges. In order to minimize the exposure to penalties
and interest, and timely remit the appropriate non-resident tax, it would be advisable for
taxpayers to carefully monitor its thin-cap calculations on a month-to-month basis
throughout the year. Where the corporation is a member of a partnership, these
calculations should also include, where possible, its share of the partnership’s debts and
interest deduction that would potentially be disallowed under the proposed rules.
This measure will apply to taxation years ending on or after March 29, 2012. Therefore
this rule will be apply to most 2012 taxation years, assuming the proposal becomes law as
currently proposed.
Example of impact of proposed rules
Canco is a Canadian-resident corporation wholly-owned by USco, a US resident
corporation. Canco has borrowed C$30 million from USco, subject to interest at 3% per
year, to help finance its manufacturing operations. At December 31, 2013, Canco’s yearend, all of this debt was still outstanding. Canco has no other outstanding debts to
specified non-residents. Canco’s equity, as defined under the thin-capitalization rules, is
$10 million.
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Under the current rules, $300,000 of interest would be disallowed and added back into
Canco’s income for tax purposes. 5 Under the proposed rules, the disallowed amount
would increase to $450,000 with the decrease in the debt-to-equity ratio from 2-to-1 to
1.5-to-1. 6 Under the current rules, the withholding tax rate on the disallowed interest
when paid or credited would be zero, pursuant to the Canada-US income tax treaty
(assuming that USco is eligible for treaty benefits). Under the proposed rules, the
disallowed interest would be treated as a dividend for withholding tax purposes, subject to
a rate of 5% under the Canada-US tax treaty, or $22,500. If no interest was paid during the
year, the non-resident tax would be due January 15, 2014. 7
Some of these changes are effective for 2012 taxation years, while others will not be
effective until 2013. Corporations with debts owing to specified non-residents should
review their situation to determine what steps should be taken to minimize the impact of
the proposals.
Contact one of our Grant Thornton LLP tax specialists to obtain more details about these
rules and how they will impact your particular situation. We are also happy to discuss any
of the other measures introduced in the 2012 federal budget.
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5
Calculated as: $30 million minus 2 x equity of $10 million x $900,000 of interest
$30 million
6
Calculated as: $30 million minus 1.5 x equity of $10 million x $900,000 of interest
$30 million
7
Assume that the interest will be paid in time to avoid the application of subsection 78(1)
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