Lending to Your Canadian Subsidiary: The Thin Capitalization Rules

The debt-to-equity limit, and what happens to interest on the excess

Scott Tang, CPAUpdated 2026-11-032026 rules12 min read

A parent company can fund its Canadian subsidiary in two ways: by investing share capital or by lending money. Lending looks more flexible — the interest is deductible in Canada, and repaying the principal later is not taxed. But Canada has thin capitalization rules: if the subsidiary borrows too much from a significant foreign shareholder, the interest on the excess is not deductible and is also treated as a dividend subject to withholding tax.

1.5:1

Thin capitalization test: debts owed to specified non-resident shareholders ÷ equity as defined for tax purposes. This is not a cap on borrowing; it restricts the interest on the excess

25%

Only debts owed to non-resident shareholders holding 25% or more of the votes or share value (and to non-residents related to them) count

Deemed dividend

Interest on the excess is not deductible and is also subject to withholding tax as a dividend

How the test works

1Calculate the debt

Amounts borrowed from significant foreign shareholders

Shareholders holding 25% or more, and their related parties

Highest balance in each month

Averaged over the year

Numerator

2Calculate the equity

① Retained earnings at the start of the year

As defined in the rules

② Contributed surplus from specified non-resident shareholders

Averaged using the balance at the start of each month

③ Paid-up capital of specified non-resident shareholders' shares

Paid-up capital (PUC) for tax purposes, averaged using the balance at the start of each month

Denominator (statutory exclusions also apply)

3Compare

Debt ÷ equity

No more than 1.5 times

Interest on the excess

Not deductible; deemed a dividend

Even if the debt passes, the interest must still meet the general deduction conditions and EIFEL

A simple example

The parent invests C$1 million in share capital and also lends the subsidiary $3 million at 5% a year, so the annual interest is $150,000. (We assume the share capital equals paid-up capital for tax purposes, the loan balance stays the same all year and there are no retained earnings at the start of the year. This is only to show how the calculation works.)

	Amount
Debt allowed under the 1.5:1 test	$1 million × 1.5 = $1.5 million
Excess debt	$3 million − $1.5 million = $1.5 million
Deductible interest	$75,000, the interest on $1.5 million
Interest that is not deductible and is deemed a dividend	The other $75,000, subject to withholding tax as a dividend (usually 10% for a parent company in China)

The result: the subsidiary pays more corporate income tax because it loses the deduction for $75,000 of interest, and the parent also has withholding tax deducted. Work out the ratio of debt to share capital when you first fund the subsidiary.

Share capital or a loan?

Item	Share capital	Loan from the parent
Getting money back each year	Dividends: paid from after-tax profits; usually 10% withholding for a parent company in China	Interest: deductible in Canada if it passes thin capitalization and the other tests; usually 10% withholding for a parent company in China
Getting the principal back later	Capital reduction: the part returned up to paid-up capital (PUC) for tax purposes is generally not subject to withholding tax; any excess may be deemed a dividend	Repaying the principal of a genuine loan is generally not taxed
Thin capitalization	Not affected	Above 1.5 times, interest on the excess is not deductible
How banks and suppliers see it	More capital, a stronger-looking balance sheet	High liabilities

Many companies use both: part share capital and part loan, keeping the debt within the thin capitalization test and setting the interest rate under the arm's length principle.

No interest, no fixed term, just a "due to shareholder" balance: does that work?

Many subsidiaries' books have just one line: Due to shareholder. The parent sends money over with no interest, no repayment date and no loan terms, and the subsidiary pays it back whenever it has the cash.

The short answer: on the Canadian side this is usually not a big problem, as long as it really is a genuine loan. The side to focus on is the parent company in China — how the money is sent out of China determines how it should be recorded in Canada.

Not restricted

No interest, so the thin capitalization test does not reach it

0 withholding

Repaying the principal of a genuine loan is generally not subject to withholding tax

Commercially reasonable

China's new 2026 outbound lending rules: the interest rate and term must be commercially reasonable

In Canada: usually not a big problem

Issue	Canada The subsidiary
Nature of the debt	◐It must be a genuine loan: confirmed in writing, the parent really intends to get the money back, and it is not disguised share capital or a profit distribution
Thin capitalization (1.5:1)	✓No interest, so this test doesn't restrict it
Interest deduction	◐No interest to deduct; the full profit is subject to corporate income tax
Withholding tax	✓No interest is paid, so nothing has to be withheld
Transfer pricing	✓CRA generally won't "add" an interest charge for the subsidiary to deduct — Canadian transfer pricing adjustments mainly increase Canadian profit
Repaying later	✓Repaying the principal is generally not subject to withholding tax

Nature of the debt

🍁 Canada: ◐It must be a genuine loan: confirmed in writing, the parent really intends to get the money back, and it is not disguised share capital or a profit distribution

Thin capitalization (1.5:1)

🍁 Canada: ✓No interest, so this test doesn't restrict it

Interest deduction

🍁 Canada: ◐No interest to deduct; the full profit is subject to corporate income tax

Withholding tax

🍁 Canada: ✓No interest is paid, so nothing has to be withheld

Transfer pricing

🍁 Canada: ✓CRA generally won't "add" an interest charge for the subsidiary to deduct — Canadian transfer pricing adjustments mainly increase Canadian profit

Repaying later

🍁 Canada: ✓Repaying the principal is generally not subject to withholding tax

The advantage is flexibility. When the principal of a genuine loan is repaid later, there is generally no withholding tax. But be clear about what this is: it is repaying money that was borrowed, not a tax-free way to repatriate profits. For how to distribute profits and bring them home, see "Your Canadian Company Is Making Money: How to Repatriate Profits to the Parent Properly" in this series.

Five things to get right in Canada

Keep a one-page written confirmation
Amount, currency, interest-free, repayable on demand, plus a board resolution. You can leave the terms open, but you do need a document — CRA, banks and auditors will all ask for it.
File the T106
Loans to and from the parent count as related-party transactions. If they and your other related-party transactions total more than C$1 million in a year, file the T106 with the T2.
Don't let the balance flip
If the subsidiary pays expenses for the parent or lends money to it, and the total exceeds the due-to-shareholder balance, the position becomes "the parent owes the subsidiary". CRA will require interest to be charged to the parent, and may also treat the amount as a dividend and require withholding tax.
Not planning to repay? Do the numbers first
Simply forgiving the debt usually triggers the debt forgiveness rules — reducing tax attributes such as losses and tax depreciation, or even creating income. Converting it into shares issued to the parent (a debt-to-equity conversion) may also have similar results, depending on the fair market value of the shares and the nature of the debt. Run the numbers and plan before you act.
Use the currency in the agreement
Record the loan in the currency the agreement specifies. If it is in RMB or US$, calculate the foreign exchange gain or loss on repayment.

Also, a loan repayable on demand is a current liability on the financial statements, which makes the current ratio look worse. When the subsidiary borrows from a bank, the bank often asks the parent to sign a postponement agreement.

On the Chinese parent's side: what to focus on

Foreign exchange: the 2026 outbound lending rules
The Measures for the Administration of Outbound Lending by Domestic Enterprises (Yin Fa [2026] No. 63), in force from April 20, 2026, replace earlier documents such as Circular 306. The lender must have been established for at least 1 year, have an equity relationship with the borrower and use its own funds. The interest rate and term must be commercially reasonable, and the term is in principle 6 months to 5 years. The balance cap = the parent's owners' equity in its most recent audited financial statements × the macro-prudential adjustment coefficient (published and adjusted by the People's Bank of China and SAFE). For foreign-currency loans, the balance is also calculated using the prescribed currency conversion factor. The new measures don't expressly say "the interest rate must be above zero", but whether "interest-free, no fixed term" counts as commercially reasonable is for advisers and banks in China to judge.
Investment contributed as debt falls under ODI
Where outbound direct investment (ODI) approval or filing has been completed and the investment is contributed as debt, it is managed as outbound direct investment. To convert an existing outbound loan into equity, complete the ODI procedures first, then amend or cancel the outbound loan registration.
Enterprise income tax: interest may be deemed received
For interest-free loans between related parties, China's tax authorities can make a special tax adjustment under the arm's length principle, treating the parent as having received interest and assessing additional enterprise income tax.

Three approaches: how to choose

Item	Interest-free due to shareholder	Share capital through ODI	Outbound loan with interest on commercial terms
Foreign exchange in China	Must be registered as outbound lending; whether interest-free with no fixed term is "commercially reasonable" is for advisers in China to judge	Remitted after the outbound investment filing	Remitted after registration
Tax in China	Interest may be deemed received and additional tax assessed	No interest income	Interest income is taxed in China; whether, and how much of, the Canadian withholding tax can be credited depends on Chinese rules
Tax in Canada	No interest deduction	No interest deduction	Interest that passes thin capitalization, EIFEL and the other tests is deductible
Getting money back later	Repay the principal; the most flexible	Capital reduction: returned up to paid-up capital (PUC) for tax purposes, with more paperwork	Repay the principal

How to decide:

Equity contributed through ODI → if the subsidiary actually issued shares, record it in Canada as share capital. Investment lawfully contributed as debt, or funds sent as an outbound loan → record it in Canada as a loan, on the actual terms of the loan agreement. How it is recorded in Canada depends on the actual legal rights and obligations, not just on what the remittance purpose says, and it should match the registration documents in China.
You want the flexibility of a loan → go through outbound lending registration, with the interest rate and term set on arm's length, commercial terms. Don't set an arbitrary low rate just for the foreign exchange registration, and don't assume that rate is an arm's length rate.
Whether to charge interest: calculate the group's actual total tax → factor in corporate income tax in both countries, Canadian withholding tax, China's tax credits and their limits, interest deduction limits and losses on both sides. Don't just compare the two tax rates of 26.5% and 25%.
A common combination → part ODI share capital + part outbound loan bearing interest on commercial terms, with the debt kept within the thin capitalization test.
Parent company in Hong Kong → there are no foreign exchange controls, so an interest-free due to shareholder balance is workable in practice. But Hong Kong has also had transfer pricing rules since 2018, so if money lent from Hong Kong bears no interest, the Hong Kong Inland Revenue Department may also make an adjustment.

Chinese foreign exchange and tax requirements are governed by the rules in force at the time and how they are applied locally. Please confirm the specific remittance plan with the parent company's accountant or lawyer in China.

Other points to watch

A reasonable interest rate
The interest rate on a loan from the parent must be set under the arm's length principle; if it is set too high, CRA will adjust it (see the transfer pricing article in this series).
The EIFEL interest limit
Canada also has a separate limit on excessive interest and financing expenses (EIFEL), applied after the thin capitalization rules. A subsidiary whose net interest expense for the year is modest (no more than C$1 million for the group in total) is generally not affected.
The general deduction conditions
Passing the thin capitalization test doesn't mean the interest is automatically deductible: the money must also be borrowed to earn business income, the rate must be reasonable, and the other deduction conditions must be met.

How Sheng Qian CPA can help

Plan before you fund
How much share capital, how much debt and at what interest rate, planned together with the thin capitalization test and future dividends and capital reductions.
Complete loan documents
Loan agreement and board resolutions, with transactions with the parent matching in both the Minute Book and the books.
Sort out interest-free shareholder balances too
Loan confirmation, T106 and currency, plus whether to convert to share capital later, worked out together. We also check with the parent's advisers in China on how the money is sent.
Annual review
Run the thin capitalization test at each year-end and keep the T2 and withholding tax filings consistent with it.

Sources

Income Tax Act: Income Tax Act s.18(4) – Limitation re deduction of interest by certain corporations
Background reading (unofficial): Osler – Thin capitalization rules · BDO – New interest deductibility rules (EIFEL)
Background reading (unofficial): Shajani CPA – thin cap rules · BLG – Transfer Pricing in Canada · Debt forgiveness rules (Mondaq)
Outbound lending from China: People's Bank of China and SAFE: Measures for the Administration of Outbound Lending by Domestic Enterprises (Yin Fa [2026] No. 63, in force April 20, 2026) (in Chinese)
Income Tax Act: s.80 – Debt forgiveness and settling debts with shares
CRA: Applicable rate of Part XIII tax under tax conventions (IC76-12)

Disclaimer

This article is general information only and is not tax advice. Every company's situation is different; please consult a CPA about your specific arrangements. For Chinese foreign exchange and tax rules, please consult professional advisers in China. Service fees are as set out in our written quote.