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 from foreign companies, the Thin Capitalization Rules may limit or disallow the deduction of interest paid on these loans.
Discussion:
Under Thin Capitalization Rules, interest bearing debt from non-resident companies are 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.
Recommendation:
If your company is being financed by non-resident companies, please contact Gilmour Knotts Chartered Accountants to discuss Thin Capitalization Rules and how to monitor and minimize the tax impact on your Canadian resident corporation.
