Published: April 10, 2020
Last Updated: October 21, 2022
Thin Capitalization Rules – A Canadian Tax Lawyer Guide
When non-Canadian residents decide to start a corporation in Canada to operate a business, an important typical question is how to fund that business. Businesses can get funding in a variety of ways, from external funding sources such as selling equity, raising debt from third parties, or even crowdfunding through organizations like Kickerstarter or Indiegogo, to internal financing through contributed capital or taking on debt from shareholders. When it comes to internal financing, debt is often an attractive option because the interest payments on debt can be deducted as business expenses, reducing the business’ tax liability. Furthermore, when considering how to extract retained earnings in the Canadian corporation to a non-Canadian resident shareholder, interest payments can also be attractive as some tax treaties offer a reduced withholding tax rate on interest compared to dividends.
However, if these internal debt financing arrangements are between a Canadian corporation and what is called a specified non-resident shareholder, thin capitalization rules apply and limit the amount of interest that can be deducted from the Canadian corporation’s income and the interest exceeding the allowable amounts will be deemed to be dividends for Canadian withholding tax purposes. Call our top Canadian tax firmand learn how tax planning can improve your tax efficiency.
Thin Capitalization Limit – 1.5:1 Debt-Equity Ratio
When a specified non-resident shareholder finances a Canadian corporation through debt, the thin capitalization rules found in ss.18(4) through ss.18(8) come into play and restrict the deductibility of interest to a 1.5:1 debt-equity ratio.
A specified non-resident shareholder is one or a group of several non-resident shareholders of the Canadian corporation who owns 25% of the Canadian corporation in terms of voting power or fair market value. Where this 25% threshold is met, the thin capitalization rules will apply. The 1.5:1 debt-equity ratio which applies is the debt which is the average of the greatest amount of the Canadian corporation’s outstanding debt to specified non-resident shareholders in each month of the year. The equity is calculated as the Canadian corporation’s unconsolidated retained earnings at the beginning of the year, not including the retained earnings of another corporation; the average of the Canadian corporation’s contributed surplus from specified non-resident shareholders at the beginning of each month of the year; and the average of the Canadian corporation’s paid-up capital of shares owned by specified non-resident shareholders at the beginning of each month of the year. Where the 1.5:1 debt-equity ratio is surpassed, the amount of interest that is deductible is limited proportionally to how much the 1.5:1 ratio is exceeded – i.e. if the corporation has a 3:1 debt-equity ratio, then only 50% of the interest expense is deductible. Furthermore, the interest stemming from the debt that exceeds the ratio will be deemed to be a dividend for Canadian income tax purposes.
Anti Avoidance Provisions – Thin Capitalization Back-to-Back Loans
Furthermore, ss.18(6) prevents the use of back-to-back loans to avoid the thin capitalization rules. Essentially, where a specified non-resident shareholder lends a sum of money to another entity and that other entity then lends a sum of money to the Canadian corporation, that loan is considered to be made by the non-resident shareholder up to a maximum of the amount the non-resident shareholder lent to the other entity. Notably, where there are several tiers of Canadian corporations, it is not advisable for the specified non-resident shareholder to directly finance a lower-tier Canadian subsidiary because that lower-tier subsidiary is unlikely to have the available equity. However, the specified non-resident shareholder can directly finance the upper-tier Canadian subsidiary which in turn can finance the lower-tier Canadian subsidiary to the extent that the upper-tier Canadian subsidiary has sufficient equity. The upper-tier Canadian subsidiary can finance the lower-tier Canadian subsidiary without any problems because they are both Canadian corporations and thus the thin capitalization rules do not apply. Of course, the back-to-back loan provisions may technically apply to these types of internal financing arrangements; however, CRA’s administrative position is that they do not apply the ss.18(6) back-to-back loan provisions to these internal financing structures.
Tax Tip – Thin Capitalization
While the utilization of debt financing inbound Canadian investments can provide both tax and liability advantages, the thin capitalization rules can be very complex and the actual calculation of the relevant debt and equity is not entirely straight forward. As such, it can be easy to fall afoul of the thin capitalization rules and the consequences can be severe as the interest deduction is proportionately denied and an equal proportion of the interest paid is deemed to be a dividend for Canadian withholding tax purposes. As such, it is imperative to get professional tax planning advice before setting up an investment or business structure in Canada with a foreign entity. Speak to one of our experienced Canadian tax lawyers and make sure you avoid any potentially costly pitfalls.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."