Canada expands thin capitalisation rules

The Canadian federal government proposed amendments (the amendments) to the Income Tax Act (the Act) in its budget of March 21 2013 that will complete the overhaul of Canada's thin capitalisation rules that began in 2012. The amendments, contained in Bill C-4 which are before Parliament, expand the scope of the thin capitalisation rules to trusts and branches.

Canada, like many other jurisdictions, has thin capitalisation rules that restrict the extent to which corporations can deduct interest paid to significant non-resident shareholders or related persons. These rules restrict the degree to which the Canadian tax base can be eroded through the payment of deductible interest rather than distributions of after-tax profits in the form of dividends.

The thin capitalisation rules generally deny a deduction in respect of a portion of the total interest otherwise deductible in respect of applicable debts based on the portion, if any, of all applicable debts exceeding a specified multiple of equity. Before 2012, the rules specified a debt-to-equity ratio of 2:1.

The existing rules, applicable to a corporation resident in Canada (a CRIC), define the concept of a specified shareholder as the category of significant shareholders that are relevant. A specified shareholder is a person that either alone or together with all persons not dealing at arm's-length owned shares of the CRIC representing an interest of 25% or more in the CRIC, measured by either votes or value. The thin capitalisation rules in the Act apply to "outstanding debts to specified non-residents," being debts owed to either a non-resident that is a specified shareholder or that does not deal at arm's-length with any specified shareholder. Similarly, equity of a CRIC is measured as the aggregate of retained earnings of the CRIC, the CRIC's contributed surplus contributed by specified non-resident shareholders, and the paid-up capital of all shares owned by specified non-resident shareholders. The technical definitions of debt and equity for purposes of the thin-capitalisation rules are complex, and rely on a combination of monthly averages and annual amounts of the various elements referred to here.

The 2012 federal budget introduced three important changes to the thin capitalisation rules. Debts in place before the 2012 budget were not grandfathered from these changes.

The 2012 budget reduced the permitted debt-to-equity ratio from 2:1 to 1.5:1. This change is effective for any taxation year beginning after 2012. While most taxpayers will already be subject to this new rule, taxpayers with off-calendar years may still have time remaining in their first year being subject to the new limit to bring themselves back on side if not already compliant with the lower limit.

The second change introduced in 2012 is the imputation of debt owed by partnerships to corporate partners for thin capitalisation purposes. The imputation of partnership debts occurs under a new provision that deems a partner in a partnership to owe the specified portion of each debt owed by the partnership to the same person to whom the partnership owes such debt, and to have paid interest on that portion of debt to the extent that any interest paid or payable by the partnership is deductible in computing the income of the partner. The specified portion for a particular partner is based on the partner's share of partnership income or loss for the fiscal period of the partnership ending in the particular taxation year (and if the partnership has no income or loss, the partnership is treated as if it had income of $1 million for purposes of determining the specified portion). To avoid any effect on the income of other members of the partnership, the imputation rules do not deny a deduction to the partnership but instead treat the corporate partner as having itself derived an amount of income corresponding to interest on the portion of the debt in excess of the 1.5:1 limit.

The income inclusion for a partner under these rules is a proxy for a portion of the interest expense that would otherwise be denied and therefore can arguably be seen to represent additional partnership income. However, this special income inclusion does not increase the partner's adjusted cost base in the partnership interest, nor does it affect a limited partner's at-risk amount (which can restrict the deductibility of losses allocated from a partnership). As a result, mismatches can result, in the form of deemed capital gains or the restriction on the use of losses allocated to a partner that are attributable in whole or part to an interest expense that results in a special income inclusion under the new rules.

The final change introduced in the 2012 budget is the introduction of rules that treat the interest denied under the thin capitalisation rules as a deemed dividend. Specifically, any amount paid or credited as interest by a CRIC or a partnership is deemed to have been paid by the corporation as s dividend to the extent that such interest is not deductible under the normal thin capitalisation rule, or is included in computing the income of the corporation under the partnership imputation rules discussed above. A separate rule deems accrued interest that is not otherwise paid in the year to be paid immediately before the end of the year. This prevents the deferral of withholding tax associated with a deemed dividend.

The impact of the deemed dividend rule can depend on the jurisdiction of the relevant non-resident creditor. For US residents that are entitled to the benefits of the Canada-US Income Tax Convention, the effect of this rule can be to subject deemed dividends to a withholding tax of 5% or 15%, as compared with the 0% rate that may apply to interest (even related party interest). For residents of many other treaty jurisdictions, the reclassification of non-deductible interest as a dividend can result in a reduction in withholding tax, as significant direct corporate shareholders may be entitled to a lower (often 5%) withholding rate on dividends compared to the rate applicable to interest (often 10%).

The amendments introduced in 2013 are the last step in the recent overhaul of the thin capitalisation rules, and represent the most dramatic change. These changes generally are applicable for taxation years beginning after 2013, with no grandfathering for existing arrangements.

The amendments expand the thin capitalisation rule to apply to all trusts. To accommodate this expansion, the following new concepts (among others) are introduced:

• Tax paid earnings, representing the after-tax income of the trust that is retained by it; often, this may be nil, as many trusts distribute all of their income through deductible distributions;

• Specified beneficiary, meaning any beneficiary of the trust that either alone or together with all persons not dealing at arm's-length has an interest as a beneficiary representing at least 25% of the beneficial interests in the trust (analogous to a specified shareholder of a CRIC); and

• Equity amount, being the measure of equity for any taxpayer for purposes of the 1.5:1 limit, and defined for a trust resident in Canada (for CRICs, the equity amount is defined in the manner described above in respect of the existing rules) generally to include the aggregate of (x) contributions to the trust made by a non-resident person that was either a specified beneficiary or not dealing at arm's-length with a specified beneficiary and (y) the trust's tax paid earnings, less (z) any capital distributions of the trust to persons other than non-residents that are (or do not deal at arm's-length with) specified beneficiaries.

The relevant amount of debt for trusts resident in Canada under the new thin capitalisation rules is the aggregate of all debts owed to non-residents who are (or do not deal at arm's-length with) specified beneficiaries.

Because trusts will likely not have been tracking the foregoing amounts, the amendments permit a trust to elect on or before the filing due date of its tax return for its first year that begins after 2013 to have its equity amount as of March 21 2013 be deemed to be an amount equal to the fair market value of its property at that time less it total liabilities at that time, multiplied by a fraction representing the portion of beneficial interests in the trust held at that time by non-residents who are (or do not deal at arm's-length with) specified beneficiaries.

The new rules restrict deductibility of such debt to the extent it exceeds 1.5 times the trust's equity amount. Instead of paying trust-level income tax on the denied interest, the trust has the option to treat the denied interest as income paid to the non-resident creditor by making a designation in its tax return; this would then generally result in withholding tax being payable by the non-resident instead of creating a tax liability that impacts all beneficiaries (though, in some cases, the trust could still be subject to a special tax imposed under Part XII.2 of the Act).

It is important to note in applying the new rules applicable to trusts resident in Canada that the equity amount relies on contributions made by certain non-residents. This measurement of equity is analogous to contributed surplus of a CRIC that is contributed by certain non-resident shareholders. Unlike paid-up capital of a CRIC, an attribute that attaches to shares, trust contributions appear not to count towards the equity amount of a trust if the beneficiary that made the contribution transfers its interest as beneficiary.

For corporations and trusts not resident in Canada, the thin capitalisation rules are now intended to apply to the extent that such entities carry on business or earn certain property income in Canada. The traditional measures of equity do not apply, as the Canadian branch of a non-resident entity is not a separate legal entity. Instead, to preserve the 60/40 ratio represented by the thin-capitalisation limit, the equity amount for these entities is defined as 40% of the total average cost of all property used or held in carrying on a business in Canada or that is an interest in real property in Canada (where the non-resident has elected to pay ordinary net income tax on rental income rather than withholding tax), less the total debts of the entity relating to its Canadian activity and not included in its outstanding debts to specified non-residents.

Outstanding debts to specified non-residents, being the debt to which the thin capitalisation rules apply, includes for this purpose all debts owed by a corporation to a non-resident person that is a specified shareholder or not dealing at arm's length with a specified shareholder or the corporation, and all debts owed by a trust to a non-resident that is a specified beneficiary or not dealing at arm's-length with a specified beneficiary or the trust itself. The relevant debt for this purpose is not limited in any way to debt that is connected with the non-resident's Canadian operations; it is not clear why debt unconnected to Canadian activities should be compared for thin capitalisation purposes against a measure of equity that is limited in this way.

The Amendments, especially taken together with the 2012 changes, significantly expand the scope of the Canadian thin capitalisation rules. They will have a material impact on existing trusts and non-residents operating through branches in Canada. These rules will not only impact how investments are made into Canada in the future, but may have important consequences to existing investments that were structured under the pre-existing rules and for which no grandfathering is provided.

Biography
		Jeffrey Shafer Associate, Toronto Blake, Cassels & Graydon Tel: +1 416-863-3187 Fax: +1 416-863-2653 Email: jeffrey.shafer@blakes.com Jeffrey practises in all areas of Canadian domestic and cross-border income tax law, with a particular focus on mergers and acquisitions, international transfer pricing, private equity investment, domestic and international corporate and trust reorganisations, and the taxation of various investment vehicles. His practice also includes acting for taxpayers at all levels in the tax appeals process. Jeffrey is an adjunct professor at the University of Toronto Faculty of Law, and he speaks and writes regularly about Canadian domestic and cross-border income tax issues. Jeffrey is a member of the International Fiscal Association, the Canadian Tax Foundation, the Canadian Bar Association and the Ontario Bar Association.