Volume 71, Number 5
by Nathan Boidman and Rhonda Rudick
Reprinted from Tax Notes Int’l, July 29, 2013, p. 459
(C) Tax Analysts 2013. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Canadian Thin Capitalization
Proposals Curtail Inbound Real
Estate Planning
July 29, 2013
by Nathan Boidman and Rhonda Rudick
Nathan Boidman and Rhonda Rudick are with Davies Ward Phillips & Vineberg LLP in Montreal. This article is the third in an occasional series focusing on tax considerations regarding foreign investment in
Canadian commercial real estate.
A
fall 2010 article by the authors1 discussed the tax
benefits for foreign investors in Canadian commercial real estate that are available from investment
structures that allow and facilitate internal financing
arrangements without engaging Canada’s thin capitalization rules.2 The structures would involve nonresident
corporations or trusts, whether resident or nonresident.
However, those articles also indicated that the government might move to extend thin capitalization to
those entities and that is exactly what was announced
in the federal budget on March 21.
This third article in the series briefly examines this
seminal development concerning tax planning for foreign investment in Canadian commercial real estate.
holders) to equity (share capital and retained earnings)
ratio. Interest on debt exceeding that limitation was
nondeductible under section 18(4) of the Income Tax
Act (Canada).
Those rules applied to internal debt financing of
corporations that are resident in Canada.3
Then over the years the equity base has been narrowed to include only the capital stock attributable to
25 percent or greater shareholders and the ratio has
been reduced to 1.5 to 1, as discussed in the second
article (note 2). The latter means that for every $40 of
eligible equity there can be $60 of eligible debt. There
is now the proposal to extend the rules to nonresident
corporations and to trusts.
Overview of Thin Cap Rules
Pre-Budget Structuring Strategies
Canada, in 1972, was the first country to adopt mechanical thin capitalization rules. They featured a 3-1
debt (owing to 25 percent or greater nonresident share-
Foreign investors in Canadian rental-income producing real estate, whether one or more individuals or entities, can invest directly or indirectly through one or
more entities (corporations or trusts).4 In the latter
1
Nathan Boidman and Rhonda Rudick, ‘‘Planning for Investment in Canadian Real Estate by Nonresidents,’’ Tax Notes Int’l,
Sept. 20, 2010, p. 967.
2
See section 18(4) of the Income Tax Act, R.S.C. 1985, c.1
(5th supp.), as amended. That was also dealt with in the second
article in this series; see Nathan Boidman and Rhonda Rudick
‘‘Recent Developments Affecting Foreign Developments in Canadian Real Estate,’’ Tax Notes Int’l, Apr. 30, 2012, p. 449.
3
As explained below, there has been uncertainty as to whether
the rules applied to nonresident corporations that elect net income tax treatment, as explained in the first article (see supra note
1), under section 216 of the ITA, regarding rental income from
Canadian real estate.
4
Note that a partnership is not an entity for these purposes in
that a partnership is not a taxpayer under Canadian law. Under
(Footnote continued on next page.)
TAX NOTES INTERNATIONAL
JULY 29, 2013 • 459
(C) Tax Analysts 2013. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Canadian Thin Capitalization Proposals Curtail
Inbound Real Estate Planning
PRACTITIONERS’ CORNER
For example, if property is being acquired for $50
million, with third-party financing of $35 million, the
$15 million of ‘‘equity’’ can (for an ‘‘indirect investment’’) be injected into the ‘‘acquisition vehicle or
entity’’ by a combination of loans to the entity and
equity investment in the entity. (That entity would then
borrow from the $35 million from the third party and
acquire the property.)
Under current law — before the March budget proposals — there could be a significant difference in the
overall result between the various options available.
For a nonresident corporation or nonresident trust
for which the investment is considered to entail the
carrying on of business in Canada as opposed to
merely the earning of income from property (under
case-made principles that distinguish the two — as discussed in the first article) through a permanent establishment (as defined under regulations for purposes of
the ITA), tax would be imposed on a basis comparable
to that applicable to a Canadian resident — that is, on
net income at rates generally applicable to Canadian
residents. And then the bulk of the $15 million could
be injected by way of interest-bearing loans without
being subject to the thin capitalization rules.
The same would apply to the use of a nonresident
trust that does not meet the latter circumstances but
that elects under section 216 (see note 3) to be taxed as
though the latter circumstances were met — that is, as
though a resident of Canada. But there is lack of certainty on whether an electing nonresident corporation
would engage the thin capitalization rules.5 Net income
taxation without being subject to thin capitalization
rules would also apply to investment through a Canadian resident trust.
That leaves investment through a Canadian resident
corporation. Here the thin capitalization rules would
apply.
In the foregoing illustration, what is the dollar impact of the thin capitalization rules applying or not
applying? Assume that when the thin capitalization
rules do not apply, the investor would likely choose to
either invest a nominal amount of the $15 million in
section 96 of the ITA, its income is allocated to its partners and
taxed in their hands. For further details, see the first two articles
in this series (supra notes 1 and 2).
5
Section 216 provides for taxation of an electing nonresident
as though the person were a resident, but it does not per se deem
the nonresident to be a resident. Section 18(4) is written as being
applicable to a corporation that is resident in Canada. It is that
distinction that provides the basis for the view that section 18(4)
does not apply to an electing nonresident corporation. But the
Canada Revenue Agency views the matter differently.
equity or up to no more than 10 percent (that is, $1.5
million) and therefore between $13.5 million and $15
million would be loaned to the acquisition vehicle. Assume that an arm’s-length lending rate is 12 percent.
That would produce deductible interest of up to $1.8
million annually.
But when the thin capitalization rules apply (for example, when a Canadian resident corporation is used),
the loan amount would be restricted to $9 million (60
percent of the $15 million) so that the deductible interest would be limited to $1.08 million, or $720,000 (40
percent) less than the $1.8 million that is available
when the thin capitalization rules do not apply.6
Effect of the Budget
As already noted, the March 21 budget7 proposes to
extend the scope of the thin capitalization rules to
nonresident corporations and to resident and nonresident trusts, including electors under section 216.
In other words, this creates a level playing field, in
which any acquisition vehicle chosen by a foreign investor — whether resident or nonresident corporation
or resident or nonresident trust — will attract thin
capitalization rules that will restrict, in the context of
the illustration above, the amount of internal loans on
which interest can be deducted to $9 million — as opposed to up to $15 million in three of the four options
under pre-budget thin capitalization law.
For a Canadian resident trust, proposed additions to
section 18(5) and in particular the definition of the
term ‘‘equity amount’’ effectively substitute various aspects of beneficiary interests (for share investment for
of Canadian resident corporations), in determining
equity for the basic 1.5-1 ratio.
Similarly, for a nonresident corporation or nonresident trust, proposed additions to section 18(5) regarding the definition of equity amount effectively substitute an amount equal to 40 percent of the cost of
property being used in Canada over third-party debt for
that property (for share investment, for Canadian resident corporations).8
6
The full implications of this difference would depend on differences in applicable tax rates, as between these various types/
residence of acquisition vehicles and the applicability, if any, of
Canadian withholding taxes on the internal interest payments.
The latter could range from nil (when domestic law exemptions
or the Canada-U.S. tax treaty exemption is engaged) to 25 percent (when the full ITA statutory withholding rate applies). See
also infra note 9 respecting Canadian withholding tax.
7
For prior coverage, see Amanda Heale, Drew Morier, Patrick
Marley, and Mark Brender, ‘‘International Highlights in Canada’s 2013 Budget,’’ Tax Notes Int’l, Apr. 1, 2013, p. 11.
8
For example, in the illustration used above, the proposed
rule in paragraph (c) of the definition of the term ‘‘equity
amount’’ requires a calculation of 40 percent of the excess of the
$50 million cost contemplated in new subparagraph (c)(i) over
the third-party loan of $35 million contemplated in subparagraph
(Footnote continued on next page.)
460 • JULY 29, 2013
TAX NOTES INTERNATIONAL
(C) Tax Analysts 2013. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
case, there is an opportunity to inject the ‘‘equity’’ portion of the investment (that is, that portion not provided by third-party lenders) by way of internal debt
that results in tax-deductible internal interest payments.
PRACTITIONERS’ CORNER
Summary Comment
(c)(ii) — that is, 40 percent of $15 million or $6 million. That $6
million is the equity amount that is then used in the basic 1.5-1
formula in section 18(4). The latter seeks to determine whether
the assumed internal loan of $9 million exceeds 1.5 times the
equity amount of $6 million. Here the answer would be negative.
TAX NOTES INTERNATIONAL
9
Those circumstances entail two interrelated rules. First, section 212(1)(b) of the ITA generally imposes a 25 percent withholding tax on outbound interest payments made by a Canadian
resident to a non-arm’s-length nonresident. Second, section
212(13.2) of the ITA may deem a nonresident person to be a
Canadian resident for interest payments it makes. As discussed
in the first article (see supra note 1), there is a wider potential for
a nonresident corporation than a nonresident trust to engage the
latter deeming rule. Note, however, that the Canada-U.S. tax
treaty uniquely exempts a U.S. person from Canadian withholding tax on interest paid by an affiliated Canadian resident.
JULY 29, 2013 • 461
(C) Tax Analysts 2013. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
As a result of the extension of thin capitalization
rules to trusts, one of the three principal benefits of
utilizing nonresident trusts for foreign investment in
Canadian real estate will no longer be available, beginning in 2014. One of the other two important benefits,
avoidance of corporate tax on capital, has been eliminated by the abolition in recent years of both federal
and provincial taxes on capital. The third may still be
relevant in that there are circumstances in which (as
explained in detail in the first article) a nonresident
trust may be superior to a nonresident corporation in
avoiding Canadian withholding tax on internal interest
payments.9 As a result of the latter factor, it cannot be
categorically stated that the higher Canadian tax rates
applicable to trusts as compared to corporations means
that the use of nonresident trusts for investment in Canadian real estate will generally provide inferior overall
tax results compared to the use of nonresident corporations, which also will now be subject to Canada’s thin
capitalization rules.
◆