Canada's Thin Capitalization Rules

By Elinore J. Richardson and R. Ian Crosbie

The allocation of tax revenues from cross-border investment activities by taxpayers between "source" and "residence" jurisdictions appears to be occupying more than one tax administration currently. 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. The treatment of interest paid by a resident to a non-resident is central to these considerations.

In the February 2000 Federal Budget, the Department of Finance proposed significant changes to Canada's thin capitalisation regime. While the most troubling aspects of the proposals have been deferred, the remaining changes are significant and it is clear that further changes can be expected.

Thin Capitalization - The Rationale

A significant distinction can be drawn 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 (and tax efficient) allocation of consolidated revenue and expense among various jurisdictions. Intra-firm debt transactions can be used to manipulate group expenses to maximise after-tax return. A capital importing country that imposes a corporate tax 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, in undertaking a sweeping review of Canada's tax laws 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":

"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 only minor adjustments, 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. These 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 a modified equity calculation 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" as a "specified shareholder" who is 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 either: (a)†give the holder 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 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 is 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...