Canada’s new thin capitalization (“thin cap”) rules will, in toto, become effective for tax year 2013, though some rules may have earlier effective dates.
The purpose of the Canadian thin capitalization rules is to prevent non-residents from placing a disproportionate amount of their investment in Canadian-resident corporations in the form of debt rather than shares.
Ultimately, the rules help to protect the Canadian tax base from erosion as a result of excessive interest deductions on debt owed to non-residents.
Under the current thin cap rules, the deduction of interest expense of a Canadian-resident corporation will be limited where the amount of debt owing to certain non-residents exceeds a 2-to-1 debt-to-equity ratio. Finally, the new rules will treat the disallowed portion of the interest deduction as a deemed dividend.
The proposed rules contained in the federal budget, will adjust the debt-to-equity ratio to 1:5 to 1. In addition, the new rules will be expanded to apply to specified non-residents partnerships of which a Canadian-resident corporation is a member. Further, going forward, interest expense on loans from a controlled foreign affiliate to a Canadian-resident corporation will be excluded from the think capitalization rules if it is taxable under the foreign accrual property income (“FAPI”).
Because of this change, it is recommended that all Canadian corporations with foreign ownership review their capital structure and existing debt levels to ensure that they remain in compliance with the rules.
For more information on how these rules may apply to you, read Mcmillan LLP’s March 2012 article entitled, “tightening of the ‘thin capitalization’ rules unveiled”, or KPMG’s June 2012 article entitled, “Time Running Thin for ‘Thin Cap’ Planning”.