19 May 2010 Roundtable, 2010-0366541C6 - Thin Capitalization

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.

Principal Issues: Under what conditions will CRA not apply subsection 18(6)

Position: See document

Reasons: See document

International Fiscal Association Annual Conference

May 19, 2010

Application of Subsection 18(6)

Subsection 18(6) of the Income Tax Act (Canada) (the "Act") provides as follows:

Where any loan (in this subsection referred to as the "first loan") has been made

(a) by a specified non-resident shareholder of a corporation, or

(b) by a non-resident person, or a non-resident-owned investment corporation, who was not dealing at arm's length with a specified shareholder of a corporation,

to another person on condition that a loan (in this subsection referred to as the "second loan") be made by any person to a particular corporation resident in Canada, for the purposes of subsections (4) and (5), the lesser of

(c) the amount of the first loan, and

(d) the amount of the second loan

shall be deemed to be a debt incurred by the particular corporation to the person who made the first loan.

Subsection 18(6 ) is intended to address indirect loans that are arranged to circumvent the direct relationships envisaged in subsections 18(4) and (5). It applies whenever a loan (referred to as the "first loan") is made by a specified non-resident shareholder, or by a non-resident or a non-resident-owned investment corporation not dealing at arm's length with a specified shareholder, to another person on condition that any person make a loan (referred to as the "second loan") to a Canadian resident corporation. In these circumstances, the lesser of the first loan and the second loan is deemed to be a debt incurred by the corporation to the person who made the first loan.

Assume, for example, that a non-resident corporation ("Foreignco") is a specified non-resident shareholder of a corporation resident in Canada ("Canco1") and that Canco1 owns all the shares of another corporation resident in Canada ("Canco2"). Foreignco makes a loan to Canco1 ("first loan") on condition that Canco1 make a loan to Canco2 (second loan"). In this example, Canco1 has significant paid-up capital and retained earnings such that subsection 18(4) does not apply to limit the deductibility of the interest on the first loan. However, Canco2 has only a nominal amount of paid-up capital and retained earnings such that the deductibility of any interest paid or payable to specified non-residents would be limited by subsection 18(4).

The CRA has taken the position that, generally, subsection 18(6) of the Act will be applied only in those situations where the application of subsections 18(4) and (5) is otherwise frustrated or circumvented (see paragraph 3 of Interpretation Bulletin IT-59R3). In Income Tax Technical News 15 (Archived) dated December 18, 1998 the CRA listed the conditions to be met to qualify for the treatment described in paragraph 3 of IT-59R3. The conditions are:

• the "first loan" and the "second loan" must be in the same amount;
• the interest earned on the "second loan" would have to exceed the interest paid on the "first loan"; and
• the specified non-resident shareholder of Canco1 has de jure control over both Canco1 and Canco2.

Question

The conditions for relief from subsection 18(6) may be difficult to satisfy and no relief may be available in circumstances where subsection 18(4) does not appear to be frustrated or circumvented. For example, if Foreignco does not have de jure control over Canco1 or where the second loan is not in the same amount as the first loan, subsection 18(6) would apply to treat the second loan as owing to Foreignco with the result that the interest paid or payable on the second loan would not be deductible in computing its income. Has the CRA reconsidered its position as set out in ITTN 15?

CRA Response

Yes - the CRA will no longer require that the first loan and the second loan be in the same amount or that the interest on the second loan exceeds the interest on the first loan. In this latter respect, the deductibility of interest on the first loan under paragraph 20(1)(c) is a separate issue that taxpayers will have to take into consideration in structuring their loan arrangements. We are also removing the de jure control requirement and replacing it with the requirement that the secondary borrower be related to the primary borrower (other than as a result of the application of paragraph 251(5)(b) of the Act).

Our revised position, which applies to all current and future assessing actions, is as follows:

Subsection 18(6) of the Act will not be applied if:

• The first loan is subject to subsection 18(4) (i.e., the lender is a specified non-resident in respect of Canco 1); and
• Canco1 and Canco2 are related (other than as a result of the application of paragraph 251(5)(b) of the Act).