13 May 2002 IFA Roundtable Q. 7, 2002-0135330 - 2002 IFA - Thin Capitalization

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: a) Will equity provided to a corporation at any time during the first day of a month included in equity for the month for thin capitalization purposes?

b) Will debt that is initially non-interest bearing, but which later converts to interest bearing, be an outstanding debt to a non-resident from the time it is issued?

c) Will the conversion of the debt from non-interest to interest bearing result in a shareholder benefit?

Position: a) No
b) Likely, unless interest is waived for the entire tax year
c) No response given

Reasons: a) Only equity in place at "the beginning of the calendar month", meaning the first moment of the month, qualifies as equity for the month for thin capitalization purposes.

b) The debt will be an outstanding debt to a non-resident because there will be an amount in respect of interest paid or payable in the tax year.

c) No response needed in light of answer to (b)

Question 7 - Subsection 18(4)

The thin capitalization rules in subsections 18(4) to 18(6) of the Income Tax Act (the "Act") deny an interest deduction to a corporation resident in Canada to the extent that its debt to equity ratio with regard to specified non-residents exceeds 2 to 1. For purposes of calculating the debt portion of the ratio, the greatest amount of outstanding debts to specified non-residents during each calendar month is used, while in calculating equity, the contributed surplus and paid-up capital of specified non-resident shareholders at the beginning of each calendar month is used. As a result, if amounts are advanced in the required ratio at a time other than the beginning of a month, the debt to equity ratio of the debtor corporation in respect of the advance will exceed 2 to 1 until the next month. In the opinion of the CCRA, would an advance made on the first day of a calendar month form part of the equity of the Canadian corporation at the "beginning" of that month?

In order to deal with a mid-month requirement for funding, a taxpayer might issue indebtedness that is non-interest bearing for the rest of the month in which it is issued, but which becomes interest bearing at the beginning of the next month. What are the views of the CCRA on whether:

? The new debt only becomes an outstanding debt for purposes of the thin capitalization rules in the subsequent month (i.e. when it becomes interest bearing)?

? A shareholder benefit is conferred by reason of the conversion of the non-interest-bearing debt to interest-bearing debt?

CCRA's Response
Beginning of a Calendar Month

? We are of the view that the phrase "the beginning of a calendar month" in subparagraph 18(4)(a)(ii) is a reference to the earliest moment of the particular calendar month. Therefore, an advance of equity on the first day of the month can be included in calculating a corporation's debt to equity ratio as long as the advance is made at the earliest moment on that day; however, an advance made at any other time on the first day would not be included in the corporation's debt to equity ratio until the next month. As a corollary, we note that it is not necessary for an advance of equity to have been made prior to the end of the previous month in order to be effective for thin capitalization purposes.

Outstanding Debt

? We are of the view that a debt structured so as to be initially non-interest bearing, but which later in the same tax year bears interest, would be an outstanding debt for purposes of the thin capitalization rules from the time it is issued. One of the requirements for "outstanding debts to specified non-residents" is that they are debts or obligations on which an amount in respect of interest is or would be, but for subsection 18(4), "deductible in computing the corporation's income for the year". Even though no interest accrues during the non-interest bearing period, there would still be an interest amount that would be deductible for computing the corporation's income for the year in respect of the particular debt by virtue of the later interest bearing period.

We have previously stated "outstanding debts to specified non-residents" would not normally include a debt where interest payable for the tax year in question has been formally waived by the creditor (see the 1993 Congress of the Association de Planification Fiscale et Financiere, Question 37). These two positions are consistent because in the case of an interest waiver for an entire tax year, there is no interest amount paid or payable in respect of the debt that would otherwise be deductible in computing the corporation's income for the year.

Shareholder Benefit

? Since the use of an initial non-interest bearing period would not be effective in preventing a debt from qualifying as an outstanding debt to specified non-residents at the time the debt is issued, it is not necessary to comment on whether a shareholder benefit is conferred by reason of the conversion of a non-interest bearing debt to interest bearing debt in the context of the above question.

Presenter: Jim Wilson
Prepared by: Ted Cook
Phone number: 946-4165
Division: Income Tax Rulings Directorate
IFA Conference - CCRA Roundtable
Responses Prepared by ITR Directorate
May 13, 2002