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:
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:
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.