June 15, 2012
Canadian corporations that owe debt to certain non-residents need to carefully review the impact of the major modifications to Canada’s “thin capitalization” regime announced in the 2012 federal budget. These modifications include a reduction in the debt-to-equity ratio, an extension of the regime to partnership debt, and the introduction of a new deemed dividend rule for excess interest expense.
Although the reduction of the debt-to-equity level to 1:5 to 1 (from 2:1) will generally not apply until 2013, important changes are already in effect. As such, it is important to understand the new rules and to assess the impact on the current financing structure of Canadian corporations. There may still be time to implement tax planning strategies to mitigate any adverse tax consequences that may result from the proposed new rules.
Certain aspects of the new thin capitalization regime are already in effect. 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. In addition, the new regime no longer limits the thin capitalization rules to just corporate debt for taxation years beginning after March 28, 2012. Under the proposals, these rules will be extended to apply to debts owed by partnerships of which a Canadian-resident corporation is a member.
This TaxNewsFlash-Canada summarizes some of the key changes in the new thin capitalization regime and offers strategies to help you assess possible opportunities that may be available to your business under these rules.
Thin Capitalization Rules
The thin capitalization rules in the Income Tax Act are intended to prevent non-residents from placing a disproportionate amount of their investment in Canadian-resident corporations (Cancos) in the form of debt rather than shares.
The current rules limit the deductibility of interest expense of a Canco in circumstances where the amount of debt owing to certain non-residents exceeds a 2-to-1 debt-to-equity ratio. The thin capitalization rules are thus designed to protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing to these non-residents.
More precisely, these rules apply to debts owing to a specified shareholder that is not resident in Canada and any other non-resident who does not deal at arm’s length with a specified shareholder. A specified shareholder is a person or related group owning shares representing more than 25% of the votes or value of the corporation.
As the budget’s proposal to reduce the debt-to-equity ratio to 1:5 to 1 will not apply until 2013 (i.e., for taxation years that begin after 2012), there may be time to consider appropriate tax planning opportunities to help ease the transition into the new limits.
Take Action Now
To help mitigate these changes, you should:
- Review the capital structure and existing debt levels of all Canadian corporations with foreign ownership to determine whether they will be affected by this decrease in allowable debt capacity. If so, you should take the time to carefully plan for any required restructuring. Arrangements in place on budget day (i.e., March 29, 2012) are not grandfathered
- Consider restructuring existing debt, either by way of repayment, removal of the interest feature, or conversion into equity.
When considering restructuring or settling debt, keep the following factors in mind:
- The foreign exchange implications to both the Canadian and foreign entities
- Whether the debt forgiveness rules could apply
- Foreign income tax implications
- Whether the existing terms of the debt permit a restructuring (e.g., notification terms required, impact on debt covenants of Canadian and/or foreign entities, penalties for change in terms, and impact on any existing commercial obligations)
- Non-resident parent’s access to the resources needed to invest more capital into the Canadian entity.
The new regime extends the thin capitalization rules to debts owing to specified non-residents by partnerships of which a Canadian-resident corporation is a member. 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 such debts owed by the partnership. In general, the specified proportion is calculated as the corporation’s proportionate share of the partnership’s total income or loss (as opposed to the proportionate capital contribution to the partnership). These debts will then be included in the particular corporation’s debt-to-equity ratio.
When the corporate partner’s debt-to-equity ratio is exceeded, the partnership’s tax deduction for interest will not be denied but an amount equal to the percentage of excess debt times the partner’s allocated interest expense from the partnership will be included in the partner’s income. The income inclusion will be either business or property income to the corporate partner, determined by reference to the source against which the interest is deductible at the partnership level. This income inclusion is considered a deemed dividend paid by the corporate partner to the specified non-resident. The corporate partner must then remit applicable withholding tax on the deemed dividend.
This rule applies to corporate taxation years beginning after March 28, 2012.
The proposed rules could result in a corporation exceeding the prescribed debt-to-equity ratio even where a corporate partner holds an interest in a partnership but has no influence over the partnership’s borrowings.
Take Action Now
To help mitigate these changes, you should:
- Re-examine the capital structure and existing debt levels of all your Canadian corporations with foreign ownership that in turn have interests in partnerships to evaluate the effects of this measure and consider restructuring if required.
- Carefully monitor partnership debt during a year where the new rules apply to ensure that it will not negatively affect a corporate partner’s thin capitalization limit. Doing so may require the partnership to have a different level of reporting to the corporate partner than in previous years, which may increase compliance costs.
- Remember that the urgency for restructuring partnership debt depends on the corporate year-end, not the partnership year-end, because the application of the thin capitalization rules to partnership debt applies to the corporate partner’s taxation years ending after March 28, 2012.
For example, for a corporation with a taxation year-end of April 30, the new rules to include partnership debt in the calculation of the corporation’s debt-to-equity ratio would apply to the year ended April 30, 2013. However, the partnership debt inclusion for the year ended April 30, 2013 will remain at the existing 2:1 debt-to-equity ratio. The new thin capitalization ratio of 1.5:1 only applies to taxation years beginning after 2012, and will not apply until the corporate partner’s April 30, 2014 taxation year. If, on the other hand, the corporation has a December 31 tax year-end, it will be subject to both the new 1.5 to 1 debt to equity ratio and the new partnership debt inclusion for its December 31, 2013 year-end.
The new regime recharacterizes denied interest expense as a deemed dividend. Because the deemed dividend is in respect of a non-resident, it will be subject to non-resident withholding tax. For this purpose, the new rules provide that any amount that is required to be included in computing the income of a corporation in respect of a partnership’s denied interest expense is also treated as a deemed dividend paid by the corporation to the specified non-resident.
This rule will apply to corporate taxation years ending after March 28, 2012. For taxation years that include the budget day of March 29, 2012, the amount of denied interest expense will be prorated for the period in the taxation year that is after March 28, 2012. We understand that Finance chose proration as a coming-into-force measure because it was the simplest methodology to achieve the desired result.
Withholding taxes on such deemed dividends will be due when the applicable withholding taxes on the interest payments would otherwise be due.
A corporation can designate which interest payments are to be recharacterized as a dividend. This designation must be made on or before the corporation’s filing due date for the applicable taxation year (i.e., in most cases within six months after the end of the corporation’s taxation year). Where interest expense has not been paid by the end of the taxation year, the portion that is denied will nonetheless be deemed to have been paid as a dividend immediately before the end of the taxation year.
This aspect of the new regime appears to address a recommendation in a 2008 report by the Advisory Panel on Canada’s System of International Taxation. Among other things, the Panel recommended that Finance “ensure non-resident investors are prevented from inappropriately reducing their Canadian withholding tax obligations”.
Depending on withholding tax rates on interest and dividends, the deemed dividend change could have an immediate effect. This change will be punitive to U.S. corporations that have made interest-bearing loans to related Canadian group companies that previously were not subject to any withholding tax on denied interest under the Canada-U.S. tax treaty. The Canada-U.S. treaty’s interest withholding rate is generally 0% but dividend withholding tax may be 5% or higher. As a result, a withholding tax requirement will now be introduced.
In certain situations, if the non-resident lender is not a direct shareholder of the Canadian company, the withholding tax could be 15%, which will make the impact of the proposals even more significant.
Payment of Withholding Tax
Under the new regime, withholding tax on interest that is deemed to be a dividend will be required to be paid by the 15th day of the month following the time that such interest is paid or deemed paid. To comply with this rule, Canadian corporations must carefully monitor interest payments to ensure that withholdings are made on a timely basis, particularly when partnerships are involved. Otherwise, interest and penalties may apply. On the other hand, the deemed dividend rule may be advantageous to multinational groups where the withholding tax on interest is greater than the withholding tax on dividends. These situations may result in a refund of excess withholding tax.
In any case, the designation of interest to be recharacterized as a deemed dividend must be made on or before the corporation’s filing due date for the taxation year (say, by June 30, 2013 in the case of a corporation with a 2012 calendar year-end).
Take Action Now — Time Frame for Application of Deemed Dividend Rules
The treatment of denied interest as a deemed dividend applies immediately, but is based on a 2:1 debt-to-equity ratio. It is important to remember that:
- Offside corporations must get back to the 2:1 ratio for the balance of their 2012 tax year to avoid deemed dividend recharacterization on any denied interest, and must also reorganize to meet the 1.5:1 debt-to-equity ratio for their first taxation year that begins after 2012.
- It may be difficult to meet the thin capitalization rules in a short time period because of the components of the thin capitalization formula and the complexity of the calculations. For example, the amount of debt used in the formula is the average of the greatest total amount of debt in each month owing to specified non-residents. Therefore, any reduction to the amount of debt will need to be sufficient enough to ensure that the average amount of the debt used in the formula will eventually meet the desired ratio. This may mean that the amount of debt may need to be decreased even more than the 2:1 ratio, to ensure that on an annual basis, the appropriate ratio results from the formula. Similar complexities exist in the calculation of equity for purposes of the thin capitalization rules.
- Because of the potential added cost related to withholding tax on interest recharacterized as a deemed dividend, it will now be necessary for corporations to set up a system to carefully monitor their estimated thin capitalization status during the year.
The new regime contains a relieving provision that will exclude interest expense on loans from a controlled foreign affiliate to a Canadian-resident corporation from the thin capitalization rules to the extent that a portion of that interest is taxable to the Canadian corporation as Foreign Accrual Property Income (“FAPI”). This rule applies to corporate taxation years ending after March 28, 2012.
Currently, the combination of the thin capitalization and the FAPI rules can result in double tax, as shown below:
Under the current thin capitalization rules in this example, CanSub has received a loan from a non-resident (U.S.Co) that is related to a “specified shareholder” (Canco). Therefore, the thin capitalization rules apply to CanSub and can result in a denial of CanSub’s interest expense even though FAPI is included in its income.
Under the new regime, interest expense will generally not be subject to the thin capitalization rules to the extent it is also included in FAPI. However, the relief appears limited only to situations where the borrower itself (i.e., CanSub) has directly been subject to tax on FAPI. In many circumstances, the interest expense and FAPI may be reported by two different related Canadian corporations.
Your KPMG adviser can assist you in determining how the new thin capitalization regime may apply to your particular facts and circumstances and help assess any potential implications. We can also help you identify, evaluate and implement potential tax planning strategies to mitigate any adverse tax consequences that may arise from these changes. For details, contact your KPMG adviser.
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Information is current to June 12, 2012. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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