June 15, 2012
Time Running Thin for “Thin Cap” Planning
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.
Reduction of Debt-to-Equity Ratio
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.
Thin Capitalization and Partnership Debts
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.
Denied Interest Treated as a Dividend
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).
Foreign Affiliate Loans to be Excluded
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.
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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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