Canada releases new tax rules to limit interest deductions

On February 4, 2022, the Canadian Department of Finance released a package of draft legislative proposals (the “Proposals”) which include measures previously announced in the 2021 Federal Budget. Although the Proposals do not address all of the 2021 budget measures — notably, they do not include legislation implementing previously announced anti-hybrid measures — they include rules designed to prevent earnings stripping through new limitations on the deductibility of interest and other financing expenses. The excessive interest and financing expenses limitation (“EIFEL”) proposals build upon the recommendations found in the OECD’s BEPS Action 4 report Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, which recommends that an entity’s net interest and financing expenses deductions be linked to its level of economic activity, based on taxable earnings before deducting net interest expense, depreciation and amortisation (EBITDA). Canada’s chosen approach includes two distinct regimes: a fixed ratio rule based on a benchmark net interest/EBITDA ratio and a group ratio rule which allows an entity to deduct more interest expense in certain circumstances based on the tax position of its multinational group.

Targeted taxpayers

The Proposals are intended to apply to any entity that is not an “excluded entity”. For these purposes, an excluded entity is:

• a Canadian-controlled private corporation (CCPC) that, together with associated corporations, has taxable capital employed in Canada of less than $15 million (representing the top end of the phase-out range for the small business deduction);
• a Canadian corporation or trust which, together with other Canadian members of their group (referred to as “eligible group entities” in the Proposals), have aggregate net interest expenses of $250,000 or less; and
• a standalone Canadian-resident corporation or trust (and groups consisting exclusively of Canadian-resident corporations and trusts) carrying on substantially all of their business in Canada. This latter exclusion generally applies only if no non-resident corporation is a foreign affiliate of, or holds a significant interest in, any group member, and no group member has any significant amount of interest and financing expenses payable to a “tax-indifferent investor” (which, as defined, includes non-residents and tax-exempt entities).

Applicable regimes

The EIFEL rules will not only restrict the deduction of interest expenses, but also any financing costs, including interest and financing expenses that are capitalized and deducted as capital cost allowance (CCA) or as amounts in respect of resource expenditure pools, imputed interest in respect of certain finance leases, certain amounts that are economically equivalent to interest or that can reasonably be regarded as part of the cost of funding, as well as various expenses incurred in obtaining financing.

The Proposals will effectively restrict the deductibility of a taxpayer’s net interest and financing expenses, (being the taxpayer’s “interest and financing expenses”, less its “interest and financing revenues”). “Interest and financing revenues” includes interest income, as well as other income from the provision of financing, (for instance, guarantee and similar fees, and income from certain lease financing).

Fixed ratio

Under the fixed ratio approach, a corporation or trust (the provision does not apply to natural persons and partnerships) will not be allowed to deduct net interest and financing expenses if those expenses exceed the “ratio of permissible expenses” — effectively, 30% of tax-adjusted EBITDA, with a 40% transition period ratio for taxation years of taxpayers that begin on or after January 1, 2023 and before January 1, 3023.‎¹‎ For these purposes, the taxpayer’s EBITDA is referred to as “adjusted taxable income” (ATI).  The starting point of the ATI definition is the taxpayer’s taxable income determined for the purposes of the Income Tax Act (Canada) (not amounts reported for financial statement purposes), adjusted to effectively:

• add back deductions for interest and financing expenses, certain tax expenses, capital cost allowance; and
• reverse income inclusions for interest and financing revenue, foreign source income for the year to the extent it is sheltered by foreign tax credits, income and gains allocated from a trust, and any amount of taxable income that is not subject to tax under Part I of the Income Tax Act (Canada).

Because the starting point for the computation of ATI is the taxpayer’s taxable income, ATI does not include deductible inter-corporate dividends received from Canadian subsidiaries or foreign affiliates. As a result, the Proposals potentially restrict the deductibility of interest expenses incurred for the purposes of acquiring shares that give rise to such dividends. In addition, losses deducted from previous years also reduce ATI to the extent they are not attributable to the taxpayer’s net interest and financing expenses for a prior taxation year.

Although the EIFEL rules do not apply directly to partnerships, interest and financing expenses and revenue of a partnership are attributed to its members in proportion of each member’s interest in the partnership. Excessive interest and financing expenses of a taxpayer in respect of a partnership are included back in the partners’ income.

Group ratio

Canadian group members of a “consolidated group” that are taxable Canadian corporations or trusts resident in Canada throughout a particular year can jointly elect into the group ratio regime for that year, if they meet certain conditions.‎²‎ The group ratio rules allow a Canadian member of a “consolidated group” whose ratio of net third-party interest expenses to book EBITDA exceeds the permissible fixed ratio of 30% to benefit from the higher “group ratio”, to the extent that the group is able to demonstrate the higher ratio on the basis of the group’s consolidated financial statements. For these purposes, a “consolidated group” includes the ultimate parent entity and the entities that are fully consolidated into the parent entity’s consolidated financial statements (or that would be if the group were required to prepare financial statements in accordance to IFRS). The group ratio rules rely on the definitions of “group net interest expenses” and the “group adjusted net book income”, which parallel the definitions of net interest and financing expenses and ATI, but are based on amounts determined by reference to the group’s consolidated financial statements.

While the group ratio rules may allow the deduction of net interest and financing expenses by a taxpayer in excess of the permitted fixed ratio, the group ratio is also subject to some restrictions. If the group ratio exceeds 40%, adjustments gradually cap the allowable deduction to a lesser effective ratio. At no time can the effective group ratio for the purpose of the EIFEL rules exceed 100%, even though the actual ratio of net interest and financing expenses to group adjusted net book income may be significantly higher.

Canadian group members of a consolidated group that elect under the group ratio rules can collectively deduct net interest and financing expenses equal the aggregate of each member’s ATI multiplied by the group ratio. The group ratio election allows the Canadian group members to specify how the deduction will be allocated amongst them, effectively allowing the transfer of excess capacity between the group members. Consolidated groups may decide whether or not to elect into the group ratio regime from year to year. In some cases, the inability to access the relevant accounting information may prevent Canadian group members from taking advantage of the group ratio regime.

Other features of the new regime

Excluded interest

Two taxable Canadian corporations may jointly elect that certain interest payments made in respect of a debt that was, throughout the period during which the interest accrued, owed by one to the other, be excluded from the interest limitation under the EIFEL rules. This exclusion applies if the conditions in the definition “excluded interest” are met. Among other conditions, the electing corporations must be “eligible group corporations” in respect of each other (generally, related corporation or affiliated corporations taking into account only de jure control). The stated purpose of the excluded interest election is to ensure that the EIFEL rules do not negatively impact loss consolidation transactions entered into between the Canadian corporate group members.

Excess capacity and unused excess capacity

If a taxpayer’s net interest and financing expenses exceed the maximum permitted for a taxation year, such taxpayer may still be able to deduct some or all of this excess, if it has “excess capacity”. The taxpayer’s “excess capacity” for a taxation year is the amount, if any, by which the maximum amount of interest and financing expenses for the year it is permitted to deduct (based on the applicable permitted fixed ratio) exceeds its actual interest and financing expenses for the year.  The taxpayer’s excess capacity may be carried forward for three years if it has not been used for another purpose in any of those preceding years. A taxpayer that elects into the group ratio for a taxation year is considered not to have excess capacity in that year. A taxpayer’s “unused excess capacity” is the excess capacity that has not been either used against the taxpayer’s own excess interest and financing expenses, or transferred by the taxpayer to another group member in a previous year. A taxpayer’s unused excess capacity from the three taxation years immediately preceding a particular taxation year is automatically applied to reduce excess interest and financing expenses that would otherwise be denied in the particular year (an amount of excess capacity used in this manner is referred to as “absorbed capacity”). This mechanism is intended to “smooth” the impact of earnings volatility under the EIFEL rules.

If a taxpayer does not have sufficient unused excess capacity carryforwards of its own, it may use the “cumulative unused excess capacity” of other Canadian group members. Such transfers of cumulative unused excess capacity require a joint election. The transferee’s resulting “received capacity” amount can reduce the interest and financing expenses otherwise denied to the transferee.

Carryforward of denied interest and financing expenses

Interest and financing expenses denied under the EIFEL rules can be carried forward for up to 20 years in computing taxable income. This carryforward is permitted to the extent a taxpayer has “excess capacity” in a subsequent taxation year, or to the extent it has “received capacity” for a taxation year from a transfer of cumulative unused excess capacity of a Canadian group member. A mandatory ordering rule automatically reduces a taxpayer’s excess capacity or received capacity to the extent of the taxpayer has restricted interest and financing expense carryforwards. Thus, restricted interest and financing expenses must be deducted, before a taxpayer can transfer its excess capacity to another group member, or use its received capacity to deduct its excess interest and financing expenses for the current year.

The carry-forward of denied interest and financing expenses creates a new pool of tax attributes that must be tracked by taxpayers and certain amendments are required to ensure the continuation of those tax attributes on an amalgamation or winding-up. Similarly, specific rules are required to address the impact of a change of control (a “loss restriction event”) on a taxpayer’s EIFEL tax attributes. Similar to the current treatment of non-capital loss carryforwards, carryforwards of restricted interest and financing expenses will generally survive a loss restriction event, provided that the taxpayer continues to carry on the same business. However, a taxpayer’s cumulative unused excess capacity will not survive a loss restriction event.

Interaction with other provisions governing the deductibility of interest

The proposed EIFEL regime will apply only after other limitations on deductibility, such as the general limitations on interest deductibility to a reasonable amount of interest incurred to earn income from a business or property, the thin-capitalization rules (which currently deny the deduction of interest paid to specified non-residents on the basis of a 1.5:1 debt-to-equity ratio), and under transfer pricing provisions. Thus, interest expenses incurred by a taxpayer will be in scope only if they are otherwise deductible. As such, interest expenses denied under existing rules are excluded from the definition of interest and financing expenses for the purpose of the EIFEL rules.

Next steps

The Department of Finance is seeking comments and submissions on the Proposals from the public. The deadline for making submissions in respect of the EIFEL proposals is May 5, 2022. While some changes may be made to the proposed rules following the consultation period, the Proposals are expected to become effective for taxation years that begin after December 31, 2022. Affected taxpayers should examine their current financing arrangements and consider how the Proposals will affect the deductibility of their interest and financing expenses going forward.