Written By Jared Mackey, Anu Nijhawan and Denise Bright
Multinational corporations, cross-border investments and many other Canadian public and private enterprises, will likely soon face a new and complex interest expense deduction limitation in Canada.
On February 4, 2022, the Canadian federal government released draft legislation to implement a variety of proposed tax measures including the new "Excessive Interest and Financing Expenses Limitation" (EIFE Limit) first announced in the April 2021 Federal Budget. The thrust of proposed EIFE Limit, which is contained primarily in proposed sections 18.2 and 18.21 of the Income Tax Act (Canada), is to limit a taxpayer's Canadian interest and financing expense deductions to an amount commensurate with the taxable income generated by its Canadian economic activity, based on tax-adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). The EIFE Limit is aligned with the recommendations of the OECD relating to base erosion and profit shifting.
In most cases, the EIFE Limit will, if enacted, apply to tax years beginning on or after January 1, 2023. As such, affected taxpayers should take steps now to evaluate how they may be impacted by the EIFE Limit.
Application of the General EIFE Limit
The EIFE Limit is not conditioned on any avoidance or nefarious purpose; it applies mechanically. At its core, the EIFE Limit adopts an "earnings stripping" approach, restricting a taxpayer's (or a group's) deductions for net interest and financing expenses to no more than a fixed ratio of their "adjusted taxable income" generated by activities in Canada. "Adjusted taxable income" is generally EBITDA, but is determined based on tax, rather than accounting, concepts. The fixed ratio will generally be 40 percent for taxation years beginning in the 2023 calendar year and 30 percent thereafter, subject to an anti-avoidance rule for taxpayers attempting to manipulate their taxation years.
Notably, a taxpayer's "adjusted taxable income" is reduced by deductions received for inter-corporate dividends and by most non-capital and net capital losses deducted by the taxpayer. As pointed out in the Department of Finance explanatory notes, the result is that the EIFE Limit can limit the deductibility of interest expense incurred by a taxpayer to invest in dividend-paying shares.
The EIFE Limit will apply to "interest and financing expenses" which, in addition to ordinary course interest and various financing expenses, also includes interest and financing expenses that are ordinarily capitalized and deducted as capital cost allowance or as amounts in respect of resource pools and certain economically equivalent amounts, such as interest embedded in lease payments.
The EIFE Limit will also apply after the application of existing limitations on interest deductibility (e.g., the thin capitalization rules and the transfer pricing rules). As a result, if another rule denies an interest deduction, that interest is excluded when applying the EIFE Limit.
General Relief for "Excluded Entities"
The EIFE Limit is intended to apply to large multinational enterprises and cross-border investments, including non-residents of Canada, where there is an increased potential for tax base erosion and profit shifting. The rules also apply indirectly to partnerships. The proposed rules provide a carve-out for:
- Canadian-controlled private corporations that, together with associated corporations, have taxable capital employed in Canada of less than $15 million;
- groups of corporations and trusts whose Canadian members have aggregate net interest and financing expense of $250,000 or less; and
- certain 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, have no foreign affiliates, do not have any 25%+ non-resident shareholders or beneficiaries and do not pay significant interest to certain "tax-indifferent investors."
As a result, most Canadian-owned small and mid-sized businesses that operate exclusively in Canada should be exempt. Taxpayers are encouraged to review their entitlement to relief under these provisions based on their specific circumstances.
To ensure that the EIFE Limit does not negatively impact commonly undertaken loss utilization transactions between members of an affiliated group, two related taxable Canadian corporations can jointly elect to exclude one or more intercompany interest payments from the EIFE Limit.
"Excess Capacity" Carryforwards
Unless it is subject to the group ratio rule discussed below, a taxpayer will have "excess capacity" in a particular year when its deduction capacity for the year, based on its adjusted taxable income, exceeds its interest and financing expenses. Subject to the taxpayer being subject to an acquisition of control, excess capacity can be carried forward for three years and will automatically be applied to reduce the amount of interest and financing expenses whose deductibility would otherwise be denied.
Transfers of "Cumulative Unused Excess Capacity"
If a taxpayer itself does not have sufficient excess capacity carryforwards, it can rely on transfers of "cumulative unused excess capacity" from one or more of its Canadian group members to reduce the amount of interest and financing expenses whose deductibility would otherwise be denied. Transfers of cumulative unused excess capacity requires a joint election by the transferor and transferee and can only occur between related or affiliated taxable Canadian corporations.
Carryforward of "Restricted Interest and Financing Expenses"
If a taxpayer is denied an interest or financing expense deduction under the EIFE Limit, the denied amount is added to the taxpayer's "restricted interest and financing expenses" and can be carried forward for 20 years. The taxpayer can deduct its "restricted interest and financing expenses" in a future year if it has excess capacity in the year or if has received a transfer of "cumulative unused excess capacity" from another group member. A taxpayer's "restricted interest and financing expenses" generally remain deductible following an acquisition of control provided that the taxpayer continues to carry on the same business.
Group Ratio Rule
The Canadian members of a multinational consolidated group may be eligible to jointly elect into the "group ratio" rule for a taxation year, potentially allowing them to deduct net interest and financing expenses in excess of the those permitted under the general rule. The benefits of the group ratio rule will typically only be available if the ratio of a group's aggregate arm's length interest expense to its total accounting EBITDA exceeds the fixed ratio, and the group is able to demonstrate this based on audited consolidated financial statements. Under the group ratio rule, the group determines the maximum amount of interest and financing expenses that the consolidated group members are collectively permitted to deduct, and then allocates the amount among the Canadian group members, thus allowing deduction capacity to be allocated to the taxpayers who need it the most.
The group ratio rule allows entities in groups that are highly-leveraged with external debt for genuine commercial reasons to deduct net interest and financing expenses in excess of the fixed ratio. The requirement for audited financial statements will likely significantly limit the number of groups who may benefit from the rule.
The EIFE Limit, if enacted, represents a fundamental change to the existing interest deductibility regime for Canadian businesses. The new rules have the potential to impact a large number of Canadian public and private entities and even if their debt is arm's length. Taxpayers should consider whether they could be negatively impacted by the EIFE Limit, and whether any planning opportunities are available to reduce such negative impact. Businesses and investors with existing Canadian ventures and those who are planning new ventures should critically analyze whether the interest deductions that they have modeled as being available could be denied if the EIFE Limit takes effect next year. The new rules could result in projects becoming cash taxable earlier than anticipated. In addition, financial ratios calculated using taxes paid rather than accrued taxes may also be impacted.
The rules implementing the EIFE Limit are among the most complex in the Act, spanning 27 pages of draft legislation, and including various anti-avoidance provisions. The rules are subject to revision as the government has invited taxpayers to provide comments on the draft proposals with a submission deadline of May 5, 2022.
Members of the Bennett Jones Tax and Financial Services groups are available to discuss future implications of the EIFE Limit on your Canadian business or investment or to assist you with crafting a submission to the Canadian government.