CHAPTER 08 Tax Considerations
In very general terms, the Canadian business is denied an interest deduction to the extent that its “relevant debt” exceeds 1.5 times its “relevant equity.” Interest subject to the thin capitalization rules may be treated as a deemed dividend or trust distribution subject to withholding tax. These rules may also apply to loans made to a Canadian business by an arm’s-length intermediary under back-to-back lending arrangements such as a back-to-back loan or certain guarantees given by a related non-resident person. Conversely, where a Canadian resident corporation has made a loan to a non-resident, and such loan does not bear a reasonable rate of interest and has been or remains outstanding for more than a year, the Tax Act imputes interest income calculated at a prescribed rate on the principal amount outstanding to the Canadian lender. The amount of imputed interest is reduced by any amount of interest received by the Canadian resident corporation. Moreover, if the loan is made to a non-resident shareholder of the Canadian resident corporation or a person connected with a shareholder (other than a foreign affiliate of the corporation) and is not repaid within one year of the end of the taxation year during which it was made, the principal amount of the loan may be deemed to be a dividend for Canadian withholding tax purposes. Foreign Affiliate Dumping Rules The Tax Act contains rules targeting so-called foreign affiliate dumping transactions. Although there are many variations, an example of foreign affiliate dumping is a non-Canadian parent transferring shares of a non- Canadian subsidiary to a wholly owned Canadian corporation for intercompany debt and shares of the Canadian corporation. The issuance of shares by the Canadian corporation is generally to comply with the debt-to-equity thin capitalization limit. The interest on
the intercompany debt is deductible by the Canadian corporation, but the income from the foreign subsidiary is generally exempt from Canadian taxation under Canada’s foreign affiliate system. This allows the Canadian corporation to use the interest expense on the intercompany debt to shelter income from its existing Canadian operations. The debt-dumping provisions generally apply where a Canadian corporation is controlled by a non-resident
parent or group of non-residents; the Canadian corporation makes an investment in a foreign
corporation that is, immediately after the investment, a “foreign affiliate” of the Canadian corporation or becomes a foreign affiliate as part of the series; and the investment is not excluded from the application of the foreign affiliate dumping rules under statutory exceptions. Examples of such statutory exceptions are corporate reorganizations and strategic acquisitions of a business that is more closely connected to the business of the Canadian corporation than to the business of any non-resident member of the multinational group. For these purposes, the term “investment” is defined broadly. Accordingly, care must be exercised in any situation involving foreign affiliates of a Canadian corporation controlled by a non-resident parent.
The Tax Act contains rules targeting so-called foreign affiliate dumping transactions.
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