Tax Question:
What is Thin Capitalization and what are the implications? Is it a domestic or international tax issue?
Facts:
Thin Capitalization Rules are an international tax issue. They are the tax rules which limit the deductibility of interest paid by Canadian resident companies on interest-bearing debt from non-resident (foreign) companies which are related to a person who owns either 25% or more of; the voting shares or, fair market value of issued and outstanding shares of the Canadian resident corporation. Thin Capitalization Rules are to discourage non-residents from forcing a Canadian subsidiary into a loss or zero profit situation and thus not paying Canadian taxes on profits earned in Canada. If your Canadian company is too heavily financed by foreign companies, the Thin Capitalization Rules may limit or disallow the deduction of interest paid on these loans.
Under Thin Capitalization Rules, interest-bearing debt from non-resident companies is subject to a 1.5:1 debt to equity ratio. For example, if the interest-bearing foreign debt is 1.5 million compared to 1 million non-interest bearing share capital you are onside, but if the debt is 2 million compared to 1 million share capital you are offside. If you are offside, some or all of the interest paid on the foreign debt would be non-deductible for tax purposes in Canada. Instead, the non-deductible amount of interest paid would be treated as a dividend paid to the non-resident from after-tax profits. These converted dividends would also be subject to withholding taxes (subject to the withholding tax rate of the applicable tax treaty, generally 0%-25%. 5% for US residents). If the withholding taxes are not paid on time by the Canadian corporation they may be subject to penalties and interest. The withholding tax would also be unrecoverable by the non-resident company, resulting in double taxation. The non-resident company would have to include the entire dividend (before withholdings) in income.
If you would like more information on this topic, please contact a member of the Empire CPA team by filling out the contact form below.
Canadian and foreign tax laws are complex and have a tendency to change on a frequent basis. As such, the content published above is believed to be accurate as of the date of this post. Before implementing any tax planning, please seek professional advice from a qualified tax professional. Empire, Chartered Professional Accountants will not accept any liability for any tax ramifications that may result from acting based on the information contained above.
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