Details and impact of proposed interest deductibility rules
9 March 2022
On 4 February 2022, Canada’s Department of Finance released for public consultation the long-awaited draft rules relating to the Excessive Interest and Financing Expenses Limitation (EIFEL). These rules—originally announced in the 2021 Canadian federal budget—would implement the recommendations in the OECD’s report on Action 4, “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments,” of the OECD Base Erosion and Profit Shifting (BEPS) project (for a prior analysis of the interest deduction limitation rules in the 2021 budget, see our tax alert dated 19 July 2021). Once enacted, the EIFEL rules would have a significant impact on the deductibility of interest and financing for Canadian groups that operate internationally, cross-border investments and any nonresident group that has operations in Canada.
In general, the EIFEL rules would apply to taxation years of a taxpayer that begin on or after 1 January 2023. The EIFEL rules are complex because they are intended to apply in combination with Canada’s other interest deduction limitation rules. Although the OECD did not recommend any additional restrictions on the deduction of interest expense, Canada is proposing to maintain its existing limitations under the thin capitalisation and transfer pricing rules.
This alert summarizes the current version of the proposed rules, although revisions are anticipated once the public consultation is completed. Submissions on the proposed rules may be made until 5 May 2022, with final legislation expected later this year.
The operative rule for EIFEL would limit net interest expense to a fixed ratio of taxable income before interest, taxes, depreciation and amortization (referred to as tax EBITDA). The fixed ratio includes two periods:
- 40% of adjusted tax EBITDA for taxation years beginning on or after 1 January 2023, but before 2024 to provide transitional relief on the rules; and
- 30% for taxation years beginning on or after 1 January 2024.
The term “Interest and Financing Expense” (IFE) is broadly defined to include more than just traditional interest. For example, some additional items that would need to be considered include:
- Capitalized interest and expenses incurred in obtaining financing that are capitalized and deducted under the capital cost allowance (CCA) rules;
- Amounts in respect of resource expenditure pools, amounts payable in respect of certain financial instruments or certain agreements that may reasonably be considered to relate to the cost of funding the taxpayer (i.e., hedging derivatives); and
- Imputed interest in respect of certain leases.
These rules would apply to the net IFE. Accordingly, interest expense would be able to be reduced where the taxpayer receives interest income from financing provided by the taxpayer in relation to loans made or economically equivalent amounts (i.e., income from guarantee fees, certain lease financing amounts). However, this income does not appear to include interest derived on loans made to foreign affiliates and may have a significant impact on taxpayers using existing credit facilities in Canada to make downstream loans to foreign affiliates.
Furthermore, various positive and downward adjustments would be required based on the proposed definition of adjusted taxable income. The starting point for calculating adjusted taxable income would be using the taxable income and adjusting it for certain items. For example, items that increase adjusted taxable income include IFEs and recaptured CCA. In this calculation, it is important to note that intercorporate dividends or certain dividends received from foreign affiliates, as well as non-capital and net capital losses, would need to be excluded.
Group ratio relief
The proposals include a group ratio rule that would be available to a Canadian member of a multinational tax group. The group ratio rule could be used to allow a Canadian taxpayer to deduct interest in excess of the fixed ratio of 30% (40% for the transitional year) provided the taxpayer is able to demonstrate that the ratio of the consolidated group’s net third-party interest expense to its book EBDITA exceeds the fixed ratio.
A “consolidated group” refers to a parent company and all its subsidiaries that are fully combined with the parent’s audited consolidated financial statements; the calculation of EBITDA would be based on consolidated audited financial statements prepared in accordance with acceptable accounting standards. If there are significant book-to-tax differences that result in accounting income being lower, the group ratio may not be beneficial. There are several interpretive issues on how this consolidated financial statement rule could apply and we expect additional guidance on this matter.
Under the group ratio rule, the maximum amount of IFEs the consolidated group members would be permitted to deduct could be allocated among its Canadian members. This flexible allocation mechanism would allow taxpayers to allocate the group ratio deduction capacity where it is most needed. The group members would need to file a joint election to take advantage of this provision.
Excess capacity relief
Excess capacity occurs when the maximum amount a taxpayer is permitted to deduct exceeds the actual IFE for the year. The excess capacity relief would allow a deduction of restricted IFEs when a taxpayer has not applied the group ratio and has “excess” capacity in the three immediately preceding taxation years.
In the event one or more other Canadian group members has “cumulative unused excess capacity” of restricted IFEs and another group member does not have sufficient capacity, the unused excess capacity carryforwards would be able to be transferred by one Canadian group member to another member. A group member’s cumulative unused excess capacity is essentially a combination of its excess capacity for the year, plus any carryforwards from the three immediately preceding taxation years. To take advantage of this provision, group members would need to file a joint election. A group generally includes related corporations.
The EIFEL rules would impact Canadian corporations, trusts, corporate members of partnerships, as well as Canadian branches of nonresident corporations. However, there is a carve-out for excluded entities. The following entities would be excluded from the application of the EIFEL rules because they do not present a significant risk of erosion of the Canadian tax base:
- A Canadian-controlled private corporation that, together with any associated corporations, has taxable capital employed in Canada of less than CAD 15 million (i.e., practically speaking, larger private Canadian groups would not benefit from this exclusion);
- A group of corporations and trusts whose aggregate net interest expense among their Canadian members is CAD 250,000 or less; and
- Certain stand-alone Canadian-resident corporations and trusts, and groups consisting exclusively of Canadian-resident corporations and trusts that carry on substantially all of their business in Canada, but only if:
- no nonresident is a foreign affiliate of, or holds a significant interest in, any group member; and
- no group member has any significant amount of IFEs payable to a “tax-indifferent investor,” which includes nonresidents of Canada or various tax-exempt entities.
Unfortunately, the rules do not contain any exceptions for public benefit projects, regulated entities that are generally more capital intensive or real estate. It remains to seen what exceptions, if any, may added to future iterations of the rules.
Other notable details
- The EIFEL rules would allow two taxable Canadian corporations to jointly elect that certain interest payments be excluded from the new interest limitation rules. This election is intended to ensure that the EIFEL rules do not negatively impact transactions that are commonly undertaken within Canadian corporate groups that allow losses of one group member to be offset against the income of another group member.
- IFEs that are denied would be able to be carried forward for up to 20 years. There would be no carryback mechanism, but a three-year carryforward of excess capacity would be available.
- If there is a loss restriction event (i.e., an acquisition of control (AOC)), the taxpayer’s carryforwards of restricted IFEs generally would remain deductible to the extent the taxpayer continues to carry on the same or similar business following the AOC. This is a similar treatment of non-capital loss carryforwards. However, a taxpayer’s cumulative unused excess capacity would expire on an AOC.
BDO observations and key takeaways
The numerous rules and details that taxpayers need to digest regarding the new interest deductibility rules can seem overwhelming and complex. While it is important to review all details, we have prepared some key takeaways to assist in understanding the impacts:
- Affected taxpayers with lending arrangements should undertake a detailed modelling exercise to assess whether they will be impacted by the proposed rules. It may not be possible to restructure existing loan agreements without significant costs.
- Canadian corporations that are looking to expand operations internationally should evaluate the commercial feasibility of having foreign affiliates borrow directly from lenders with guarantees from the Canadian-headquartered parent.
- Private equity and other investors who are preparing to acquire Canadian target entities should evaluate and model the potential impact of the EIFEL rules and determine whether financing costs should be pushed down to Canada or retained in the foreign parent.
- The thin capitalisation rules would apply before the new interest deductibility rules. Nonresidents that are financing their Canadian operations will need to ensure they meet both interest deductibility provisions.
- Canadian taxpayers that are members of a larger multinational group should evaluate whether there are any benefits in participating in the larger group ratio.
- Several provisions would require elections to be filed so it is important to take an inventory of the various elections required for each taxpayer and ensure they are filed within the time limits indicated.