On February 4, 2022, the Department of Finance introduced the long-awaited rules relating to Excessive Interest and Financing Expenses Limitation (EIFEL) which will affect multinational corporations, cross-border investments, and other Canadian public and private enterprises. These rules implement the recommendations in Action 4 of the Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project.
When do the new rules apply?
In general, these rules will apply to taxation years of a taxpayer that begin on or after January 1, 2023. Submissions on the proposed rules may be made until May 5, 2022 with final legislation expected later in the year. The EIFEL rules are complex because they are intended to apply in combination with other interest limitation rules in Canada. Although the OECD did not recommend any additional restrictions on interest deductibility, Canada is proposing to maintain its existing limitations on interest deductibility - the Canadian thin capitalization rules together with transfer pricing rules.
We have briefly summarized the current version of the rules below. However, we anticipate additional revisions once public submissions have been made to the Department of Finance.
The operative rule for EIFEL limits 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. This is to provide transitional relief on these 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 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
- and imputed interest in respect of certain leases.
These rules apply the net IFE. Accordingly, interest expense may 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 significant impact on taxpayers using existing credit facilities in Canada to make downstream loans to foreign affiliates.
Furthermore, there are various positive and downward adjustments required based on the proposed definition of adjusted taxable income. The starting point for calculating this income is using the taxable income and adjusting it for certain items. For example, items which increase adjusted taxable income include IFEs and recapture of 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 group ratio rules allow a Canadian taxpayer to deduct interest in excess of the fixed ratio of 30% (40% for the transitional year) when 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.
Consolidated group refers to a parent company and all its subsidiaries that are fully combined with the parent's audited consolidated financial statements, and the calculation of EBITDA is based on consolidated audited financial statements based on acceptable accounting standards. If there are significant book to tax differences that result in accounting income being lower, the use of the group ratio may not be beneficial. There are several interpretive issues on how this consolidated financial statement rule could apply. We expect additional guidance on this matter.
Under the group ratio rule, the maximum amount of IFEs the consolidated group members is permitted to deduct can be allocated among its Canadian members. This flexible allocation mechanism allows taxpayers to allocate the group ratio deduction capacity where it is most needed. The group members must file a joint election in order 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 allows for a deduction of restricted IFEs when a taxpayer has not applied the group ratio and has ‘excess' capacity in three immediately preceding taxation years.
In the instance where one or more other Canadian group members has “cumulative unused excess capacity” of restricted IFE's and another group member does not have sufficient capacity, the unused excess capacity carryforwards may be transferred by one Canadian Group member to another member of the group. 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 must file a joint election. A group generally includes related corporations.
The EIFEL rules will impact Canadian corporations, trust, corporate members of partnerships as well as Canadian branches of non-resident corporations. However, there is a carve-out for excluded entities. The following entities are excluded from the application of the EIFEL rules because they do not present a significant risk to the erosion of the Canadian tax base. An entity is excluded when it satisfies any of these conditions:
- A Canadian-controlled private corporation that, together with any associated corporations, have taxable capital employed in Canada of less than $15 million (i.e., practically speaking, larger private Canadian groups will not benefit from this exclusion);
- A group of corporations and trusts whose aggregate net interest expense among their Canadian members is $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. This exclusion applies only if:
- no non-resident is a foreign affiliate of, or holds a significant interest in, any group member,
- no group member has any significant amount of IFEs payable to a “tax-indifferent investor”, which includes non-residents of Canada or various tax-exempt entities.
Unfortunately, the rules do not contain any exceptions for public benefit projects, regulated entities which 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 to which taxpayers should pay attention include:
- The EIFEL rules 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.
- The IFEs that are denied can be carried forward for up to twenty years. There is no carry-back mechanism; however, there is a three-year carry-forward of excess capacity.
- In the instance where there is a loss restriction event (i.e., an Acquisition of Control (AOC)), the taxpayer's carryforwards of restricted IFEs generally 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 will expire on an AOC.
BDO observations and key takeaways
The numerous rules and details that taxpayers need to digest regarding these new interest deductibility rules can feel overwhelming and complex. While it is important to review all details, BDO has 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 who are looking to expand operations internationally should evaluate the commercial feasibility in 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 need to 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 cap rules currently still apply before the new interest deductibility rules. Non-residents who are financing their Canadian operations will need to ensure they meet both interest deductibility provisions.
- Canadian taxpayers who are members of larger multinational group should evaluate whether there are any benefits in participating in the larger group ratio.
- There are several provisions that require elections to be filed. 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.
The draft legislation will have a significant impact on the deductibility of interest and financing for any Canadian group that operates internationally, or any non-resident group that has operations in Canada.