Canada’s Budget 2021 proposes earnings-stripping rules
Canada’s Federal Budget 2021—announced on 19 April 2021—includes several measures that could have a significant impact on the deductibility of interest expense in a cross-border context.
Canada has generally taken a different approach than that adopted by many countries to deal with interest deductibility in the cross-border context–that is, a balance sheet approach in the form of the current thin capitalisation rules. To bring Canada’s interest deductibility rules in line with the report on Action 4 of the OECD’s base erosion and profit shifting (BEPS) initiative, the budget proposes that Canada adopt an earnings stripping approach to effectively limit interest deductibility to 30% (with some exceptions) of “tax EBITDA.”
The Federal Budget comments imply that the scope of Canada’s existing interest deductibility rules under the thin capitalisation regime is limited, and that adopting an earnings-stripping approach would offer broader protection against erosion of the Canadian tax base, while still permitting the deduction of a reasonable amount of interest.
In addition to the changes to the interest deductibility rules, the budget proposes the introduction of a hybrid mismatch regime, intended to deny deductibility in the case of certain transactions involving hybrids. Finally, the government would also like to launch consultations on how to improve Canada’s existing transfer pricing rules.
The following comments are based on the current provisions of the Income Tax Act, proposed amendments to the Act publicly announced by the Canadian federal Department of Finance, applicable case law and our understanding of the current administrative practices and policies of the Canada Revenue Agency (CRA) published in writing and made publicly available, all of which are subject to change from time to time. No formal legislation has been tabled, but we understand draft legislation will be introduced shortly. For purposes of this summary, we assume the proposals will be enacted in accordance with the statements in the Federal Budget; however, no assurance can be given that the proposals will be enacted as described in the budget.
Interest Deductibility Rules
Under existing Canadian tax law, the payment of interest is generally deductible subject to the following requirements:
a) An amount must be paid in the year or payable in respect of the year in question;
b) The amount must be paid or payable pursuant to a legal obligation to pay interest on borrowed money;
c) The borrowed money is used for the purpose of earning or producing non-exempt income from a business or property or an amount payable for property acquired for the purpose of earning non-exempt income from the property; and
d) The amount of interest that is deductible must be reasonable.
In the cross-border context, the Canadian thin capitalisation rules also limit the deductibility of interest. These rules prevent a corporation resident in Canada, together with certain other taxpayers (including trusts, partnerships, and Canadian branches of nonresidents) from deducting interest paid on debts owing to certain nonresident persons, where the deduction of interest is limited based on a fixed debt-to-equity ratio of 1.5 to 1. If the thin capitalisation rules are applicable, interest deducted in excess of the 1.5:1 debt-to-equity ratio is disallowed and is deemed to be a dividend subject to withholding tax, even if no interest is paid to the nonresident person.
The proposals introduce a new earnings-stripping rule that would apply in conjunction with the existing interest deductibility tax rules. Generally speaking, the proposed earning stripping rules are intended to operate as follows:
- Limit the amount of “net interest expense” that a corporation may deduct to no more than a fixed percentage of “tax EBITDA”. The tax EBITDA, in general, would be a corporation’s taxable income before taking into account interest expense and interest income, income tax, and deductions for depreciation and amortisation — each of these items as determined for tax purposes. Dividends deductible under Section 112 or 113 of the Income Tax Act (both Canadian and foreign dividends) would be excluded.
- “Net interest expense” should generally be interest expense (including payments economically equivalent to interest) as well as other financing-related expenses, minus interest and financing-related income. That is, net interest generally comprises the difference between interest expense and interest income.
- The changes would be phased in with a fixed ratio of 40% for tax years beginning on or after January 1, 2023 but before January 1, 2024 (transition year) and 30% for tax years beginning on or after January 1, 2024. In addition to corporations, the proposals would apply to trusts, partnerships and Canadian branches of nonresident taxpayers. Anti-avoidance rules are expected to prevent taxpayers from deferring the application of the new rules.
- The proposals would allow net interest expense for a particular year that is denied in that year to be to be carried forward for up to 20 years or back for up to three years.
- The existing interest deductibility rules, including the thin capitalisation and the transfer pricing rules, would continue to be applicable, with the new earnings-stripping rule applying only to interest that is deductible under those other rules.
- The proposals would not apply to Canadian-controlled private corporations that have, together with associated corporations, taxable capital employed in Canada of less than CAD 15 million or to groups of corporations or trusts whose aggregate net interest expense among Canadian members does not exceed CAD 250,000. Practically speaking, large private Canadian-controlled private companies may be affected by the rules.
- The proposals include a “group ratio” rule that may permit a taxpayer (or a Canadian member of a multinational group) to deduct interest in excess of the fixed percentage of tax EBITDA when the taxpayer can demonstrate that the consolidated group’s ratio of net third party interest expense to book EBITDA implies that a higher deduction limit would be appropriate for members of that group. For example, if a multinational group is highly leveraged (consolidated leverage over 30%), the Canadian taxpayer that is a member of the group may be permitted to increase its percentage above 30%. Currently there is no clear definition of the term “group”. The proposals do state that the consolidated group could comprise the parent company and all subsidiaries that are fully consolidated in the parent’s audited consolidated financial statements.
- The proposals contemplate the possibility of transferring deductibility capacity between members of a Canadian group (with some limitations for certain financial institutions such as banks and insurance companies). For example, if a Canadian member of a qualifying group has a ratio of net interest to tax EBITDA below the fixed ratio, it may be possible to transfer unused borrowing capacity to deduct interest to other Canadian members of the group whose ability to deduct interest is otherwise restricted under these rules. For larger Canadian groups, this could be an important relief measure.
- Provided the taxpayer is not offside the thin capitalisation rules, there currently does not appear to be a provision that treats interest denied under the earnings-stripping rule as a dividend for withholding tax purposes.
The proposals are likely to be complex and may significantly impact how multinationals structure and finance their Canadian operations or potential targets. They will impose significant compliance burdens on taxpayers, including the requirement to prepare tax EBITDA, the determination whether there is qualification as a group and the preparation of group-wide leverage ratios to determine excess capacity or transfers within the group. It is unclear whether any additional complexity the proposals might create would result in the collection of significantly more tax revenues. Moreover, under the proposals, the existing thin capitalisation and transfer pricing rules continue to be relevant. Accordingly, there may be scenarios where a taxpayer is on-side the aforementioned rules but could be negatively affected by the earning-stripping rules. There may also be scenarios where a taxpayer could have high tax EBITDA but be restricted by the thin capitalisation rules. If enacted, the proposed rules will pose interesting challenges for taxpayers to remain compliant with the new requirements.
Some additional observations:
- The proposals do not contain any concessions for taxpayers that have only third-party debt. In our view, this would appear to be a deliberate measure designed to target private equity and other investors that leverage their Canadian investments with significant third-party or related-party debt.
- Unless the requirements under the “group ratio” are met, the proposals do not include specific exemptions for certain capital-intense businesses, such as real estate, infrastructure or utilities. The Department of Finance may need to provide some flexibility in this regard; otherwise, these rules may be problematic and could discourage inbound capital flows.
- It is unclear if the rules would encourage private equity and other non-Canadian investors to finance their purchases of Canadian target companies with traditional equity and have any external financing held outside of Canada, thereby creating a bias for equity-based financial transactions. It is also unclear if these rules might impact valuations for software and other companies that are in the early stages of growth.
- It is unclear whether the proposals would encourage more acquisitions of Canadian businesses by purely domestic taxpayers. It is expected that standalone Canadian corporations and Canadian corporations that are members of a group none of whose members is a nonresident would, in most cases, may be excluded. In other words, interest expense and interest income related to debts owing between Canadian members of a corporate group would generally be excluded.
As noted above, draft legislation is expected to be introduced in the summer. However, it is likely the rules will be subject to considerable debate and modification before final versions of the proposals are introduced.
 A transitional measure may allow denied interest to be carried back to taxation years that begin prior to the effective date of the new rules, to the extent that the taxpayer would have had the capacity to absorb these denied expenses had the proposed rule been in effect for those years.