“in many cases a portion of existing debt can be converted to equity.”
With interest being tax deductible when paid on a debt incurred for business purposes, there is an incentive for a non-resident to finance a Canadian corporation primarily with debt rather than equity. Without any restrictions on the amount of interest that is deductible, high levels of debt to non-residents would allow Canadian profits to be removed from Canada as interest expense, with only a non-resident withholding tax that is often reduced to a low rate by tax treaty.
Accordingly, where the ratio of non-arm’s length non-resident debt to equity of a Canadian corporation exceeds 2:1, the “thin capitalization” rules deny a deduction for interest paid or payable on the debt that exceeds this ratio. These rules generally apply only to debt owing to non-arm’s length non-residents who own (either alone or in combination with other non-arm’s length persons) 25% or more of the votes or value of the corporation.
The 2012 Federal Budget proposed a number of amendments to the thin capitalization rules, including:
- reducing the debt-to-equity ratio from 2:1 to 1.5:1; and
- treating the disallowed portion of the interest expense as a dividend subject to withholding tax
The proposed reduction to the debt-to-equity ratio applies to taxation years that begin after March 28, 2012. If the mix of debt and equity is not adjusted, corporations may find that interest that was previously deductible will no longer be deductible and that withholding tax will be assessed on the denied interest.
The proposal to subject the disallowed interest to withholding tax based on dividend rates applies for taxation years that end after March 28, 2012 (with prorating for years that straddle that date).
Legislation to implement these Budget proposals was released on August 14, 2012, and is expected to be enacted by December 2012. When it is, the new withholding tax will apply retroactively as indicated above.
There are no grandfathering provisions in the proposed amendments, to protect debt that was incurred before the Budget announcement. However, in many cases a portion of existing debt can be converted to equity so as to bring debt-to-equity ratios down to 1.5:1. Your Tax Specialist Group representative can discuss your options with you.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.