The 2021 Canadian Federal Budget proposed a number of measures that will have a significant impact on interest deductibility in a cross-border context. The proposed changes bring Canada's interest deductibility rules in line with many other developed countries such as the United States.
Under existing Canadian tax rules, the payment of interest is generally deductible as long as the purpose of the borrowed money is to earn income from a business or property.
In the cross-border context, the Canadian thin capitalization rules already limit the deduction of interest on loans advanced by non-resident shareholders of Canadian companies together with certain non-arm's length persons. Under the current thin capitalization regime, the maximum amount of cross-border debt is limited to 1.5 times equity. If the thin capitalization rules are applicable, interest deducted in excess of the 1.5:1 debt-to-equity proportion is permanently disallowed. The disallowed portion is deemed to be a dividend and subject to withholding tax, even if no interest is paid to the non-resident person.
2021 Budget proposals
The 2021 Budget proposals introduce a new earnings-stripping rule, which will apply in conjunction with the existing interest deductibility tax rules. The proposed earnings-stripping rules are intended to operate as follows:
- Limit the amount of “net interest expense” that a corporation (and various other entities) may deduct to no more than a fixed percentage of “tax EBITDA.” The “tax EBITDA,” in general, would be a corporation's taxable income before taking into account net interest expense and interest income, income tax, and deductions for depreciation—each of these items as determined for tax purposes.
- “Net interest expense” should generally be interest expense as well as other financing-related expenses, less interest and financing-related income.
- The changes will be phased in with a fixed percentage of 40% for taxation years beginning on or after January 1, 2023, but before January 1, 2024 (transition year) and 30% for taxation years beginning on or after January 1, 2024.
- The proposals would allow net interest expense for a particular year that is denied to be carried forward for up to twenty years or back for up to three years.
- The proposals will not apply to Canadian-controlled private corporations that have, together with associated corporations, taxable capital employed in Canada of less than $15 million. The rules also do not apply to groups of corporations or trusts whose aggregate net interest expense among Canadian members does not exceed $250,000. Large private Canadian controlled private companies may be impacted by the rules.
- The proposals include a “group ratio” rule that may permit a taxpayer (or a Canadian member of a group) to deduct interest in excess of the fixed percentage of tax EBITDA where the taxpayer can demonstrate that the consolidated group's ratio of net third party interest expense to book EBITDA of its consolidated group is higher than the fixed ratio.
- The proposals contemplate the ability to transfer any excess deductibility capacity between members of a Canadian group (with some limitations for certain financial institutions, such as banks and insurance companies). For example, if a Canadian member of a qualifying group has a ratio of net interest to tax EBITDA below the fixed ratio, there may be an ability to transfer unused borrowing capacity to other Canadian members of the group whose ability to deduct interest is otherwise restricted under these rules. This could be an important relieving measure for larger Canadian groups.
- Provided the taxpayer is not offside the thin capitalization rules, there currently does not appear to be a provision that treats denied interest under the earnings-stripping rule as a dividend for withholding tax purposes.
- The proposals will be complex and will likely significantly affect how multinationals structure and finance their Canadian operations or potential acquisitions. Specifically we would like to highlight the following:
- The proposals will impose significant compliance burdens on taxpayers including the requirement to prepare “tax EBITDA” calculations, determine if there is qualification as a group, and to prepare group-wide leverage ratios in order to determine excess capacity, or transfers within the group. These additional items will create interesting challenges for taxpayers as they will need to be compliant under both the new rules and the existing thin capitalization rules.
- The proposals do not contain any concessions where the taxpayer only has third party debt. This will impact private equity and other investors as they traditionally use high leverage to finance their Canadian investments with significant third party or related party debt.
- There are currently no exemptions for certain capital intense businesses (i.e., real estate, infrastructure, utilities, etc.) that are usually highly leveraged unless the requirements under the “group ratio” are met.
- It is unclear if the proposals will encourage private equity and other non-Canadian investors to finance their purchases of Canadian target companies with traditional equity and maintain any external financing held outside of Canada. This would create a bias for equity based financial transactions. It is unclear if these rules will impact valuations for software and other companies in early stages of growth.
- It is unclear if the proposals could encourage more acquisitions of Canadian businesses by purely domestic taxpayers. It is expected that standalone Canadian corporations and Canadian corporations, which are members of a group none of whose members is a non-resident would not be impacted by the proposals, in most cases.
BDO can help
These changes were expected as the OECD included these types of rules in its Base Erosion and Profit Sharing Reports. The changes will significantly alter how Canadian businesses are financed. Draft legislative proposals are expected to be released for comment in the summer of 2021.
Reach out to your BDO advisor to learn more about how we can help you manage the impact of these proposals on your business.