Thin Capitalization Rules
Rules called “thin capitalization rules” limit the ability of trusts to deduct the interest they paid on debts owing to specified non-resident beneficiaries (see the definition of “specified beneficiary” below). The following trusts are subject to the rules if they earned business or property income in a taxation year and they are required to file an income tax return:
- a trust resident in Canada;
- a trust having activities in Canada, but that is not resident there;
- one of the above-mentioned trusts that is a member of a partnership.
Such trusts cannot deduct the interest they paid on the portion of the debts owing to specified non-resident beneficiaries that exceed the authorized 1.5-to-1 debt-to-equity ratio.
If a portion of the debts owing to specified non-residents is allocated to the trust by a partnership and the interest paid by the partnership on this portion of debts owing is deductible in the calculation of the partnership's business or property income, the trust must add to its share of such an income an amount equal to the portion of the interest that exceeds its authorized debt-to-equity ratio.
More specifically, to determine the amount of interest that the trust cannot deduct (for the debts it contracted) or the amount that it must add to its share of a partnership's business or property income (for the debts contracted by the partnership), the trust must use the excess debt ratio, calculated as follows:
- A × 1.5 = B, where
- A is the equity, and
- B is the amount of authorized debt
- C − B = D, where
- C is the debts owing to specified non-resident beneficiaries, and
- D is excess debts
- D ÷ C = E, where
- E is the excess debt ratio
A specified beneficiary is a person who holds an interest as a beneficiary of the trust, either alone or with other persons not dealing at arm's length with that person. The fair market value (FMV) of the interest must be equal to at least 25% of the FMV of the interests of all of the trust's beneficiaries.
A person is deemed to hold an interest as a beneficiary of the trust if that person or a person not dealing at arm's length with the person has a right, whether immediate or future, and whether absolute or contingent, to obtain or acquire an interest as a beneficiary of the trust.