Canadian Thin Capitalization Rules

Doing what is legally best for your business and its advancement into Canada, given Canada's strict tax-related rules.

Contact Neufeld Legal PC at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Canada's thin capitalization rules are designed to prevent the erosion of the Canadian tax base by limiting the amount of interest expense a Canadian corporation can deduct on debt owed to certain non-resident parties. These rules are particularly relevant for Canadian subsidiary corporations with foreign parent corporations, as they regulate the debt-to-equity ratio of such entities.

Purpose of the Thin Capitalization Rules

The primary objective of the thin capitalization rules is to curb "base erosion and profit shifting" (BEPS). By using excessive debt from a related foreign parent, a Canadian subsidiary could make large, tax-deductible interest payments, thereby reducing its taxable income in Canada and shifting profits to a lower-tax jurisdiction. The rules are intended to ensure a fair portion of a Canadian subsidiary's taxable income remains in Canada.

The Debt-to-Equity Ratio

The core of the thin capitalization rules is a prescribed debt-to-equity ratio.

• The Ratio: The current ratio is 1.5:1. This means that for every $1 of equity, a Canadian subsidiary can have up to $1.50 in debt from "specified non-residents."

• Specified Non-Residents: This generally refers to a non-resident shareholder who, alone or together with non-arm's length persons, owns 25% or more of the shares of the Canadian corporation (by vote or value). The rules also apply to certain non-resident persons who do not deal at arm's length with a specified shareholder.

• Calculation: The debt portion of the ratio is calculated as the average of the greatest amount of the Canadian corporation's outstanding debts to specified non-residents at any time in each month of the year. The equity portion is calculated based on the corporation's unconsolidated retained earnings at the beginning of the year, contributed surplus from specified non-residents, and paid-up capital related to shares owned by specified non-residents.

Consequences of Exceeding the Ratio

If a Canadian subsidiary's debt-to-equity ratio exceeds the 1.5:1 limit, the interest deduction is proportionally disallowed.

• Interest Denial: The interest paid on the portion of the debt that exceeds the 1.5:1 ratio is not deductible for Canadian tax purposes.

• Recharacterization: Any interest that is denied deductibility under these rules is treated as a dividend for Canadian withholding tax purposes. This means that even if the payment is a contractual interest payment, it can be subject to Canadian withholding tax at a rate of 25%, which may be reduced by an applicable tax treaty.

Additional Considerations

• Back-to-Back Loans: Specific anti-avoidance provisions exist to address "back-to-back" loan arrangements, where a non-resident parent provides a loan to a third party, and that third party, in turn, lends money to the Canadian subsidiary.

• Partnerships: The thin capitalization rules also extend to partnerships that have a Canadian corporation as a member.

• Earnings Stripping Rules (EIFEL): It is important to note that, in addition to the thin capitalization rules, Canada has introduced new "earnings stripping" rules, known as the Excessive Interest and Financing Expenses Limitation (EIFEL) rules. These rules are intended to further limit interest deductibility based on a percentage of the taxpayer's taxable income before interest, tax, depreciation, and amortization (tax EBITDA). The EIFEL rules apply after the thin capitalization rules [more on earnings stripping rules].

With this realization as to the potential impact of Canada's thin capitalization rules, when a foreign parent corporation is planning to finance its Canadian subsidiary, it is crucial to consider Canada's thin capitalization rules. Maintaining a debt-to-equity ratio within the 1.5:1 limit is essential to ensure that interest payments on the inter-company debt are fully deductible for tax purposes in Canada.

To learn more about how our law firm stands apart when it comes to expanding your business into Canada, in what we do differently from most larger law firms and how this can properly protect and advance your Canadian commercial venture, contact our law firm today for a confidential initial consultation at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.  

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