An often overlooked change proposed in the Canadian federal budget of March, 2012, may have a significant impact on how Canadian subsidiaries of foreign corporations are financed. The thin capitalization rules will be changing effective January 1, 2013. Existing Canadian tax law limits the ability of a corporation resident in Canada to incur deductible interest expense on cross-border debt owing to non-residents who are, or are related to, significant shareholders.
Many Canadian subsidiaries, particularly finance companies are capitalized with heavy debt leverage. Current rules permit a debt to equity ratio of 2:1 in order to obtain tax efficiency. The change proposed in the budget will change this ratio to 1.5 to 1. The impact will be that Canadian subsidiaries will require more equity in order to obtain tax efficiency. The proposed changes in the budget will treat these non-deductible interest payments (the portion that exceeds the ratio) as dividends paid by the corporation for withholding tax purposes, resulting in the imposition of a 5%, 15% or 25% withholding tax, depending on the circumstances.
The budget also extends the application of the thin capitalization rules to partnerships where a corporation resident in Canada is a partner.
One area that was not changed is if the leverage to the Canadian subsidiary was provided by arm’s-length third parties. A common structure utilized is to have the non-Canadian parent of a Canadian subsidiary provide a guarantee of its Canadian subsidiary to either its main creditor or a Canadian national bank and then have that financial institution provide debt to the Canadian subsidiary. The debt provided by the financial institution is not factored into the calculation of the debt/equity ratio for thin capitalization purposes. The interest payable by the subsidiary to the third party finance company would remain deductible. The new rules should have no impact on this structure.