Where a portion of the interest payable by Canadian subsidiary (Canco) on loans from its US Parent and a UK sister company is denied under the thin capitalization rules and deemed to be a dividend, can Canco allocate the deemed dividend first to US-Co (subject to 5% dividend withholding) rather than to UK-Co (a 15% rate)?
Response
S. 214(16)(b) allows the corporation resident in Canada to designate all or a portion of each specific interest payment to a particular non-resident as a dividend, to the extent of the total amount of the interest payments to that non-resident that were otherwise deemed to be a dividend under s. 214(16)(a), thereby effectively allowing the corporation to determine the timing of the deemed dividends for Part XIII purposes. However, the paragraph does not allow the corporation to transfer a deemed dividend from one payee to another, to alter amounts paid to a specified non-resident, or to affect the timing of amounts paid.
Example
Assume that throughout the year, Canco in the above example has $1,000 in paid-up capital and no other equity, and owes $1,000 to US-Co (its parent) bearing interest at 7% (paid as to $35 at the end of each of Q2 and Q4), and owes $1,000 to UK-Co (a sister) bearing interest at 5% ($25 at the end of Q2 and Q4).
$500 (or 25%) of this debt exceeds the thin capitalization limit of 1.5-to-1. Accordingly, 25% of each of the above interest payments would be deemed to be a dividend absent a designation under s. 214(16)(b). If Canco instead designates $17.50 of its fourth quarter US-Co interest payment to be a dividend (i.e., 25% of total US-Co interest of $70), and $12.50 of its fourth quarter UK-Co interest payment to be a dividend (25% of $50), the imposition of Part XIII tax will be deferred to the end of Q4.