How do the thin capitalization rules work for a Canadian subsidiary of a foreign parent?
For 2026, Canada's thin capitalization rule denies interest on debt owed to specified nonresidents to the extent that debt tops 1.5 times the borrower's equity. A specified nonresident holds 25% or more of the votes or value, or doesn't deal at arm's length with such a holder. Denied interest is deemed a dividend for Part XIII withholding.
How the 1.5 to 1 test is calculated
For 2026, ITA 18(4) lets a corporation or trust deduct interest on debts owed to specified nonresidents only up to 1.5 times its equity amount, the ratio in the Act as of October 2026 laws-lois.justice.gc.ca. Interest on the excess is denied in proportion: the excess debt divided by the total debt to specified nonresidents. Each piece of the formula is measured at a different time, and that timing is where most files go wrong.
| Piece | What counts | When it is measured |
|---|---|---|
| Debt to specified nonresidents | Debts owed to a specified nonresident shareholder, or to a nonresident not at arm's length with any specified shareholder, where the interest would be deductible | Greatest amount at any time in each calendar month ending in the year, then averaged |
| Retained earnings | The corporation's own, excluding retained earnings of any other corporation | Beginning of the year only |
| Contributed surplus | Only what a specified nonresident shareholder contributed | Beginning of each calendar month, averaged |
| PUC (paid up capital) | Only shares owned by specified nonresident shareholders | Beginning of each calendar month, averaged |
| Permitted debt | 1.5 times the equity amount | For the year |
| Share of interest denied | (Average debt minus permitted debt) ÷ average debt | Applied to interest on that debt |
Two consequences follow from the timing. Profit earned this year doesn't raise the equity amount until the next year, because retained earnings are frozen at the opening balance. And repaying a loan on the second day of a month doesn't help that month, since the test takes the greatest balance at any time in the month laws-lois.justice.gc.ca.
Who counts as a specified nonresident?
A specified shareholder owns, alone or together with persons it doesn't deal with at arm's length, shares carrying 25% or more of the votes or 25% or more of the fair market value of all issued shares, and rights to acquire shares count as owned. A specified nonresident shareholder is a specified shareholder who is a nonresident (or a nonresident owned investment corporation) laws-lois.justice.gc.ca.
The debt side reaches further than the shareholder. A loan from a foreign sister company counts when that lender doesn't deal at arm's length with the specified nonresident shareholder, even though the sister owns no shares of your client laws-lois.justice.gc.ca. A lender that would otherwise be a specified shareholder only because of an agreement made to safeguard its rights under the debt is deemed not to be one, under 18(5.1).
Holding your client through a Canadian holding company doesn't switch the rule off. Because a shareholder's shares are counted together with those of persons it doesn't deal with at arm's length, a foreign grandparent that controls the Canadian holding company can itself be a specified nonresident shareholder of your client laws-lois.justice.gc.ca. Map the whole ownership chain before you conclude the rule doesn't apply.
Worked example: a Canadian subsidiary of a US parent
Canco is wholly owned by USco. USco lent Canco $6,000,000 at 5%, and the balance never changed during the year. Canco had $2,000,000 of retained earnings at the start of the year, USco's shares carry $1,000,000 of PUC all year, and USco contributed no surplus.
| Step | Amount |
|---|---|
| Average monthly peak debt owed to USco | $6,000,000 |
| Retained earnings at the beginning of the year | $2,000,000 |
| PUC of USco's shares, monthly average | $1,000,000 |
| Equity amount | $3,000,000 |
| Permitted debt (1.5 × $3,000,000) | $4,500,000 |
| Excess debt | $1,500,000 |
| Share of interest denied ($1,500,000 ÷ $6,000,000) | 25% |
| Interest charged (5% × $6,000,000) | $300,000 |
| Interest denied | $75,000 |
| Interest deducted | $225,000 |
The $75,000 goes back into income on the T2, and it does not disappear for withholding purposes either (next section). Converting $1,000,000 of the loan into shares on the first day of the year would fix it: debt falls to $5,000,000, equity rises to $4,000,000, and permitted debt becomes $6,000,000. Do the same conversion partway through the year and only the months after it count, because PUC is averaged month by month.
What happens to the denied interest?
ITA 214(16) deems interest that a corporation resident in Canada (or a partnership) pays or credits to a nonresident, to the extent it is not deductible because of 18(4), to have been paid as a dividend and not interest for Part XIII. Interest that is payable but unpaid at year end is deemed paid immediately before the end of the year under 214(17), so the withholding obligation arises even if no cash moved laws-lois.justice.gc.ca.
The CRA's T2 guide says to remit Part XIII on these amounts at the rate for dividends, and the corporation may designate, on or before its filing due date, which interest payments to a particular specified nonresident are the deemed dividends. The designation can go in the notes to the financial statements, and the payments to nonresidents themselves are reported on Schedule 29 canada.ca.
The statutory Part XIII rate is 25% for both nonresident interest and dividends laws-lois.justice.gc.ca. Treaties usually separate the two. Under the Canada US treaty, interest beneficially owned by a US resident is generally taxable only in the US, while dividends to a company owning at least 10% of the voting stock are capped at 5%
canada.ca. In the example, the $225,000 of deductible interest attracts no Canadian withholding, but the $75,000 deemed dividend attracts $3,750 at 5% (it would be $18,750 at 25% with no treaty). The CRA must receive the tax by the 15th of the month after the amount is paid or credited
canada.ca, and it goes on the NR4 slips covered in the NR4 deadline page.
Thin cap runs before EIFEL
For taxation years beginning on or after October 1, 2023, 18(4) applies only to interest that would be deductible in the absence of both 18(4) and section 18.2, and Finance's explanatory notes say this ensures the thin capitalization rules apply in priority to the EIFEL restriction fin.canada.ca. The order matters because EIFEL then works on what's left.
EIFEL's interest and financing expenses only pick up amounts that would be deductible in the absence of section 18.2, so interest 18(4) has already denied is not counted again. For taxation years beginning on or after January 1, 2024, the EIFEL ratio is 30% of adjusted taxable income laws-lois.justice.gc.ca. So your client tests the foreign related debt against 1.5 to 1 first, adds back the denied part, and then runs the remaining net interest through the EIFEL rules, unless it's an excluded entity.
| Order | Rule | Limit | Denied amount |
|---|---|---|---|
| 1 | Thin capitalization, ITA 18(4) | Debt to specified nonresidents up to 1.5 times equity | Deemed a dividend for Part XIII |
| 2 | EIFEL, ITA 18.2 | Net interest and financing expenses up to 30% of adjusted taxable income | Handled under the EIFEL rules |
Edge cases: partnerships, branches, trusts and back to back loans
Partnerships: 18(4) applies to corporations and trusts, but 18(7) treats each member as owing its share of the partnership's debts, owning its share of the partnership's property and paying its share of the interest, so a corporate partner tests its share of partnership borrowing from specified nonresidents laws-lois.justice.gc.ca.
Branches: a nonresident corporation carrying on business in Canada is covered too. Its equity amount is 40% of the amount by which the average cost of the property it uses in its Canadian business exceeds the average debts relating to that business, a different formula from the one for a Canadian corporation laws-lois.justice.gc.ca.
Trusts: a Canadian resident trust measures equity using contributions from specified nonresident beneficiaries and its tax paid earnings, less amounts paid or payable to beneficiaries, so the corporate PUC and retained earnings figures don't apply laws-lois.justice.gc.ca.
Back to back loans: when a specified nonresident funds or secures a loan that an intermediary makes to your client, 18(6) and 18(6.1) can treat that part of the debt as owed directly to the specified nonresident, and the nondeductible part of the related interest is deemed paid to the nonresident for Part XIII laws-lois.justice.gc.ca. A loan from a third party is not automatically safe.
Sources
Does this year's profit increase the equity amount?
No. Retained earnings enter the equity amount only at their balance at the beginning of the year, so current year profit helps from the following year on laws-lois.justice.gc.ca. New share capital or contributed surplus from the specified nonresident shareholder counts sooner, from the start of the next calendar month.
Does a loan from a foreign sister company count if the sister owns no shares?
Yes, if the sister doesn't deal at arm's length with a specified nonresident shareholder of your client. The debt definition covers those lenders as well as the shareholder itself laws-lois.justice.gc.ca.
Who withholds on the deemed dividend, and when is it due?
The Canadian corporation withholds at the dividend rate, 25% unless a treaty lowers it, and the CRA must receive it by the 15th of the month after the amount is paid or credited canada.ca. Unpaid interest is deemed paid immediately before year end under 214(17), which starts the clock
laws-lois.justice.gc.ca.
Does thin cap apply to a Canadian corporation with no foreign shareholders?
Not through its own shareholders, because the test needs a nonresident holding 25% or more of the votes or value laws-lois.justice.gc.ca. Its interest can still be limited by the EIFEL rules, which don't depend on foreign ownership.
General information for the tax year shown, not advice for a specific client. Confirm the facts before you file or remit.