Loan from FA and Thin Cap – Budget Proposal

By: Melanie Huynh

Currently, interest paid by a Canco to a controlled foreign affiliate (CFA) could be subject to the thin capitalization rule in 18(4).  This may result in a denial of some or all of Canco’s interest expense, while the interest income earned by the CFA is taxed in Canada as FAPI, giving rise to double taxation.

Under the March 2012 budget proposal, Canco’s interest deduction is not denied, but only to the extent that the FAPI, net of related deduction under 91(4), is included in Canco’s income. Although the proposal is welcome, further fine tuning is needed to properly address the double taxation issue.

For example, under the proposal the net FAPI must be included in the income of the same Canco that has the interest expense.  This means the rule will only give the intended result if loans are made to the lowest tier Canco. To illustrate, assume Canco1 owns Canco2 which owns CFA, and CFA makes an interest bearing loan to Canco1. Because CFA’s FAPI is included in Canco2’s income and not Canco1, the proposal will not apply to Canco1 which will continue to be subject to the denial rule in 18(4). Presumably such a result is unintended.

Another concern with the budget proposal is that it does not provide relief for taxes paid (including any Canadian withholding tax) in respect of the FAPI. In the above example, assume the loan is made to Canco2 and say there is a 25% Canadian withholding tax paid and no further tax in CFA’s home country. Under this scenario Canco2’s FAPI will be completely offset by a 91(4) deduction. The proposal does not assist Canco2, however, because its net FAPI inclusion is nil. Canco2’s interest expense remains fully subject to the denial rule in 18(4). This is an unfair result considering that if the CFA were a Canadian company there would be no tax leakage for the group.

Given the above concerns, if Canco1 in the example is a public company it may be beneficial to make the loan from CFA to Canco1.  This is the current practice for most taxpayers anyway because, as a public company, the loan is unlikely to be caught by the rule in 18(4).

I am sure there are other tricks and traps with this proposal as we work through the rule – want to share yours?