Significant Changes To The Canadian Thin Capitalization Rules In The 2012 Budget

Background

The thin capitalization rules are designed to protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing by Canadian taxpayers to certain non-resident shareholders. The rules discourage non-resident shareholders from capitalizing a Canadian corporation with what is perceived to be too much debt and extracting pre-tax earnings of the corporation in the form of interest rather than after-tax dividends.

Existing Thin Capitalization Rules

The existing thin capitalization rules deny a Canadian corporation a deduction for interest paid to a "specified non-resident shareholder" to the extent that the ratio of debt to equity exceeds 2:1, i.e. only two-thirds of the capitalization can be in the form of debt. A "specified non-resident shareholder" is a foreign person that owns shares representing 25% or more of the vote or value of the Canadian corporation.