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Mergers and Acquisitions in Canada


Thin Capitalization Rules

Under the “thin capitalization rules,” a portion of any interest that a corporation resident in Canada pays to a specified non-resident shareholder (or a person with whom the shareholder does not deal at arm’s length) on amounts owing by it to such persons, may not be deductible in computing the Canadian corporation’s income. A “specified non-resident shareholder” is generally defined to include a non-resident person along with certain non-arm’s length parties who own shares of the corporation having 25% or more of the votes or value of all of the issued shares of the corporation.

Generally, if the ratio of debt (owing to the specified shareholder or the shareholder’s non-arm’s length parties) to equity (paid-up capital, surplus and retained earnings) of the Canadian corporation does not exceed 1.5-to-1, no amount of interest expense will be disallowed. If the debt-to-equity ratio exceeds 1.5-to-1, the interest on the excess debt will not be deductible and the non deductible will be deemed up to a dividend subject to withheld tax. The calculation of the debt-to-equity ratio uses monthly debt and equity values.

The thin capitalization rules are relevant for determining taxable income only for corporations resident in Canada and thus do not apply to non-resident corporations which operate in Canada through a branch. However, the determination of Canadian branch profits of a non-resident corporation requires a reasonable allocation of expenses between the Canadian branch and other sources of income. Consequently, even if the use of borrowed funds by a non-resident corporation can be traced entirely to a Canadian branch, the deductible amount of interest might be limited to a reasonable allocation of such interest to the Canadian branch. In addition, interest-bearing indebtedness used to finance a Canadian branch operation of a non-resident corporation will generally reduce the corporation’s investment allowance for the purposes of calculating Canadian branch taxes (please see “Branch Taxes” above).

Where the Canadian operation is capitalized by debt financing, gross revenue will be subject to less Canadian tax, by virtue of the interest deduction, than if the parent corporation had financed the Canadian operation with equity. Although interest payments made to related non-resident parties generally are subject to a greater withholding tax rate than dividend payments, for U.S. corporations which benefit from the Treaty, withholding tax on most related party interest payments has been eliminated under the Treaty, as discussed above.

The 2014 Federal Budget recently amended the thin capitalization
rules to target back-to-back loan arrangements which involve bank or
other third-party intermediaries. These new rules limit interest
expense deductions and apply Canadian interest withholding tax in
certain situations.

Generally, subject to a certain exemptions,
the back-to-back loan rules apply when Canco owes an amount to a
relevant creditor and a “secondary obligation” exists between the
relevant creditor or a related person and a non-resident who is
considered to be a “worse” creditor of Canco (i.e. there is a
tax advantage to Canco owing money to the creditor as opposed to the
non-resident person). Notably, the secondary obligation does not
include security and guarantees provided by related non-residents.

Where
a foreign corporation (e.g. a parent corporation) guarantees the debt
of the Canadian payor, the Canadian payor can avoid the thin
capitalization rules by borrowing from a third party lender rather than
its U.S. parent. Thus, determining whether it is preferable to finance
with debt or equity requires a consideration of both Canadian and
foreign income tax consequences, since the interest income received by
the foreign corporation will usually be taxable in the foreign
jurisdiction.


Where a non-resident guarantees the debt of the Canadian payor and the Canadian payor pays a guarantee fee, the amount of such fee is deemed to be interest for purposes of the Act. If such deemed interest is paid to an arm’s length party, the deemed amount will not be subject to withholding tax under the Act. In addition, the Treaty provides that there will be no withholding tax on such payments if the recipient is a U.S. resident entitled to Treaty benefits. For all other non-arm’s length party guarantee fees paid to non-U.S. non-residents, withholding taxes may apply. It should be noted that there may be transfer pricing issues related to the value of the guarantee payment, as well as foreign tax issues. (please see “Transfer Pricing Rules” above).

Paid-up Capital

“Paid-up capital” in respect of a class of shares of a corporation, is an income tax term that is defined under the Act. However, Canadian corporate statutes do not use the term “paid-up capital,” per se, but refer to the equivalent corporate concept as “stated capital.” Accordingly, the starting point for the computation of paid-up capital of a class of shares of capital stock of a corporation, for income tax purposes, is the stated capital of that class, as determined under the applicable corporate statute. The Act provides many adjustments to paid-up capital which can apply in many situations.

Canadian corporate laws require a corporation to maintain a stated capital account and, except in specific circumstances, to add the full amount of any consideration that the corporation receives for any shares which the corporation issues for the public Canadian corporation. Generally, for non-public Canadian corporations, paid-up capital can be returned to a non-resident parent by a Canadian subsidiary without any Canadian withholding tax.

Unlike many jurisdictions including the U.S., there is no Canadian income tax requirement that a corporation pay out its profits before returning capital and, therefore, the foreign parent of a Canadian non-public subsidiary should consider a return of capital as a method to extract after-tax profits from the subsidiary on a tax effective basis. In addition, if a foreign corporation initially uses equity to capitalize its Canadian non-public subsidiary, it will generally be able to reduce the equity and increase the amount of debt financing without giving rise to any adverse Canadian income tax consequences, assuming that such actions do not give rise to interest deduction limitations under the thin capitalization rules discussed above.

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