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Thin Capitalization Rules - Time For Planning is Running Out - by Jodi Kelleher and Heather O'Hagan 

Canadian Tax Adviser

 

August 21, 2012

 

Jodi Kelleher
Vancouver, International Corporate Tax

 

Heather O'Hagan
Toronto, International Corporate Tax

 

The Department of Finance released draft legislation that reflects its 2012 federal budget proposals to modify the thin capitalization rules to reduce the debt-to-equity ratio to 1.5:1 (from 2:1), extend the rules to partnership debt, and introduce a new deemed dividend rule for excess interest expense on August 14, 2012. The proposed legislation largely mirrors the description of the proposals released in the March 29, 2012 budget with some clarifications.

However, consistent with the 2012 budget proposals certain aspects of the new thin capitalization rules are already in effect (see TaxNewsFlash-Canada 2012-27 "Time Running Thin for “Thin Cap” Planning"). The treatment of denied interest expense as a deemed dividend and the related Part XIII non-resident withholding tax obligations on current debt-to-equity levels in excess of 2:1 apply to taxation years that end after March 28, 2012. There is no grandfathering of existing loans. Furthermore, the extension of the thin capitalization rules to apply to debts owed by partnerships of which a Canadian-resident corporation is a member apply to corporate taxation years beginning after March 28, 2012.

 

Background

The 2012 federal budget proposed changes to the thin capitalization rules to :

 

  • Reduce the debt-to-equity ratio to 1.5:1 (from 2:1)
  • Include partnership debt in the debt-to-equity ratio
  • Treat disallowed interest as dividends
  • Exclude interest on foreign affiliate loans that is treated as foreign accrual property income (FAPI) for tax purposes.

 

Thin Capitalization Clarifications

Finance made the following clarifications to the thin capitalization rules in the proposed legislation released on August 14, 2012.

 

Inclusion of partnership debt in the debt-to-equity ratio
The 2012 federal budget proposed that, for purposes of calculating a corporation's debt-to-equity ratio, each member of a partnership is deemed to owe that member's "specified proportion" of the debts owed by the partnership (within the meaning of proposed subsection 248(1)). In general, the "specified proportion" is calculated as the corporate partner's proportionate share of the partnership's total income or loss (as opposed to its proportionate capital contribution to the partnership). Under the new rules in proposed subsection 18(7), these debts would then be included in the corporation's debt-to-equity ratio. In the situation where a member does not have a "specified proportion" in the partnership (for example, the member is not entitled to an allocation of income each year), proposed subparagraph 18(7)(a)(ii) provides that the amount deemed to be owed by the partner would be based on the proportion of the fair market value of the partner's interest in the partnership.

 

Relevant fiscal period for partnership debt inclusion
A partner's "specified proportion" of a partnership's debt is to be determined using the last fiscal period of the partnership ending before the partner's taxation year end under proposed subparagraph 18(7)(a). Where this is not determinable (e.g., the first fiscal period of the partnership ends after the partner's year end), the partner's share of the debts of a partnership is determined by reference to the relative fair market value of its interest in the partnership under subparagraph 18(7)(a)(ii).

 

Partnership debt included if related interest is deductible
The draft legislation specifies that debt of a partnership will be included in the thin capitalization calculation if the interest that is paid or payable on the debt is deductible by the partnership in computing the partnership's income under proposed paragraph 18(7)(c). This new provision ensures that interest that has been capitalized pursuant to subsection 18(2), subsection 18(3.1) or section 21 is not subject to the thin capitalization calculations.

 

FAPI exemption no longer net of expenses
The 2012 budget proposed to exclude interest expense of a Canadian resident corporation from the application of the thin capitalization rules to the extent that it is taxable to the Canadian resident corporation as FAPI. However, in the budget proposals, the portion of the interest expense eligible for the exemption was calculated based on the net FAPI of the Canadian corporation - that is gross FAPI net of an amount of foreign accrual tax deducted under subsection 91(4). The draft legislation does not limit the calculation to net FAPI, as proposed subsection 18(8) only refers to the portion of interest included in income pursuant to subsection 91(1) (gross FAPI) and no reference is made to subsection 91(4) of the Act.

 

However, in cases where the controlled foreign affiliate receiving the interest has split ownership, the proposed rules will only exempt a portion of the interest expense from the thin capitalization rules. If two Canadian corporations hold shares in the controlled foreign affiliate, its FAPI is included in the taxable income of both shareholders based on their relative participating percentages in the controlled foreign affiliate. The Canadian corporation paying the interest expense will therefore only be picking up its proportionate share of any FAPI, and thus will only be able to exempt a portion of its interest expense from the application of the thin capitalization rules.

 

Compound interest excluded
The 2012 budget proposed that, for the purposes of disallowed interest that is treated as a dividend, interest that is payable but has not been paid or credited in the relevant taxation year is deemed to have been paid immediately before the end of that taxation year and not at any other time. The draft legislation has excluded "interest payable pursuant to a legal obligation to pay interest on an amount of interest" (e.g., compound interest) from this deeming rule pursuant to proposed subsection 214(17).

 

Penalties on late withholding removed
The draft legislation proposes that no penalty will apply in respect of the late withholding applicable to a deemed dividend arising under subsection 214(16) unless the taxpayer would otherwise be liable for a penalty for failing to withhold on the payment of the interest that is deemed to be a dividend under proposed paragraph 227(8.5)(a). While there is no legislated relieving provision for any interest that would otherwise be due on the late withholding resulting from the deemed dividend, proposed subsection 214(16)(b) provides some relief in that it allows a corporation to designate it its tax return which payments of interest to recharacterize as dividends, in order to mitigate the interest applicable on the late withholding.

 

For more information, contact your KPMG adviser.

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