The fix is simple once the rule is read correctly. Getting the timing wrong only fixes part of the year.
Short answer
Yes, once a specific ratio is crossed. Section 18(4) of the Income Tax Act denies a proportion of a Canadian corporation's interest deduction on debt owed to specified non-resident shareholders once that debt exceeds 1.5 times the corporation's equity amount for the year — and the equity amount counts only paid-up capital on shares actually owned by the non-resident shareholder, which is a narrower number than the company's total share capital.
The test is in s.18(4): interest is denied in the proportion that outstanding debts to specified non-residents exceeds “1.5 times the equity amount of the corporation or trust for the year.” The trap is in the definitions at s.18(5): “equity amount” is built only from paid-up capital, contributed surplus and retained earnings referable to a specified non-resident shareholder, not to every shareholder. A Canadian management co-investor's paid-up capital does not enlarge the equity base at all, even though it is real money in the company.
The ratio is also measured on an averaging basis across the whole year, not a single balance-sheet date, which is why converting debt to equity mid-year only partially fixes it: a conversion effective at the end of month eight fixes roughly the last four months of averaging, not the full year.
This only applies to debt owed to a specified non-resident shareholder: broadly, a non-resident who owns, alone or together with related persons, 25% or more of the corporation's shares by votes or by value. Purely domestic shareholder loans, or debt from a non-resident below that threshold, are not tested by s.18(4) at all. s.18(4) is also computed before section 18.2, the newer excessive interest and financing expenses limitation rule, which can apply its own separate cap on top; the two are not alternatives to each other. Treadstone Law's library does not cover thin capitalization (s.18(4)) specifically; its debt-versus-equity guidance is written for purely domestic structures and does not address this test.
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