31 March 2001 Internal T.I. 2001-0076437 - Thin Capitalization Rules

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Overview of thin capitalization rules

Position: See overview

Reasons: See overview

March 31, 2001

Commonwealth Association of Tax Administrators

2001 Technical Conference

(draft response)

Thin Capitalization

Overview

Canada is considered a high tax jurisdiction. Other things being equal, a multi-national group that has invested in Canada would, in the interest of minimizing its global tax, generally wish to maximize its interest expense in Canada. Ignoring the impact of thin capitalization rules, it would be more attractive for non-residents who control corporations in Canada to place a disproportionate amount of their investment in the form of debt rather than shares. The interest payments on this debt have the effect of reducing business income otherwise taxed at a relatively high rate and attracting only the lower (often treaty-reduced) withholding rate on interest paid abroad. This would have a significant impact on the Canadian tax base. It is the objective of Canada's thin capitalization rules to curtail this practice and, had not such rules been introduced, thin capitalization would be a serious problem in Canada.

Canada has adopted what is referred to as a "fixed ratio approach" in determining whether a company is thinly capitalized. Generally, a portion of the interest otherwise deductible will be denied where the outstanding debts to certain specified non-residents exceeds 3 times the "equity" of the corporation. Generally, "equity" for these purposes means the aggregate of (1) the retained earnings of the corporation, (2) the contributed surplus of the corporation to the extent it was contributed by a "specified non-resident shareholder" and (3) the paid-up capital of the shares of the corporation that are held by a "specified non-resident shareholder".

It should be noted that Canada first introduced thin capitalization rules in 1972. The permitted 3:1 debt-equity ratio is now considered high when compared to actual industry ratios in the Canadian economy. As a result, the Department of Finance has released proposed legislation that will restrict the deduction of interest where a 2:1 debt-equity ratio is exceeded.

The current law also contains certain anti-avoidance provisions designed to deal with back-to-back loan arrangements. Where a specified non-resident makes a loan to a third party on condition that the third party make a loan to the Canadian corporation, the lesser amount of the two loans is deemed to be a loan to the corporation from the specified non-resident.

The Department of Finance recognizes that other changes to the thin capitalization rules need to be considered. The rules currently apply only to corporations and not to other business arrangements such as partnerships, trusts and branches. Taxpayers may therefore be able to use these structures in order to circumvent the rules. There is also concern that use of financing techniques that do not rely on traditional debt (such as leases from a non-resident parent) may weaken the effectiveness of the rules protecting the Canadian tax base.

Under Canada's tax treaties Canada generally preserves its right to limit the deduction of interest under its thin capitalization rules.

Prepared by:	Tim Kuss
		International Section
		Income Tax Rulings Directorate

File # 2001-007643
Date: March 2001