On Nov. 3, 2022 the Department of Finance released the next round of proposed changes to the Excessive Interest and Financing Expenses (EIFEL) rules based on feedback and consultations received from various stakeholders impacted by these rules (Updated Proposals).
Originally introduced in the 2021 Canadian Federal Budget, proposed rules were introduced on Feb. 2, 2022 (Original Proposals). Please see our previous BDO publication, which discusses the Original Proposals. This article focuses on the key changes from the Original Proposals to the Updated Proposals.
Background and application of EIFEL rules
The EIFEL rules were brought in to implement the recommendations in Action 4 of the Organization for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting Project (the “BEPS Action 4 report”). EIFEL generally restricts the deductibility of net Interest and Financing Expenses (IFE) to a fixed ratio (40% or 30%) of Adjusted Taxable Income (ATI) with any denied interest to be carried forward and available for deduction in a future taxation year.
Key changes to EIFEL in updated proposals
The new EIFEL rules apply for taxation years that begin on or after Oct. 1, 2023. Previously these rules were to apply starting Jan. 1, 2023 for most taxpayers.
For taxation years that begin on or after Oct. 1, 2023 and before Jan. 1, 2024, a Fixed Ratio of 40% applies to determine the amount of ATI that is permitted to be deducted under EIFEL. Otherwise, a Fixed Ratio of 30% applies for taxation years that begin on or after Jan. 1, 2024.
While deferral of the EIFEL rules is welcomed, the trade-off is the 40% Fixed Ratio will only be applicable to a smaller population of taxpayers. Most taxpayers with Dec. 31 calendar years will not be able to benefit from the 40% Fixed Ratio and will have to apply the 30% Fixed Ratio.
A new definition was included for Exempt IFE which provided a safe harbour for the P3 industry. Essentially the rules do not apply to limit the deductibility of interest and financing expenses on third party borrowings or other financing expenses that were entered into in respect of an agreement with a Canadian public sector authority to design, build, and finance real or immovable property owned by the public sector authority. This potential relief is consistent with other countries' exemptions and while it is welcome news, there are still concerns that Canada's rules go well beyond what was recommended in the BEPS Action 4 Report. Furthermore, depending on the nature of the P3, some projects may not be covered by the exemption.
Unfortunately, no other exclusion has been provided for other industry groups (i.e., taxpayers engaged in the development of renewable energy, real estate, and other highly leveraged industries).
In general, entities that are excluded entities would be exempt from application of the EIFEL rules subject to certain anti-avoidance provisions. Based on the Department of Finance's commentary, such entities do not present a risk of significant erosion to the Canadian tax base. An excluded entity generally satisfies any of the following conditions:
A Canadian-controlled private corporations that, together with any associated corporations, have taxable capital employed in Canada of less than $50 million. Previously this amount was set at $15 million.
A group of corporations and trusts whose aggregate net interest expense among their Canadian members is $1,000,000 or less. Although this is higher than the previous amount of $250,000, it is still well below other countries such as the UK, which have set this amount at 2,000,000 Pounds.
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 businesses, undertakings, and activities in Canada. The purpose of this exception is to permit groups with no or minimal operations outside of Canada to be exempt from the EIFEL rules. In addition, a new permitted foreign affiliate exception has been added, allowing an exception from the EIFEL rules if the group's foreign affiliate holdings are less than a de minimis threshold of $5,000,000 calculated as the greater of:
Canadian generally accepted accounting principles balance sheet value of stock of all of the foreign affiliates.
The fair market value of all property of the foreign affiliates. There is also a requirement that no non-resident person be a specified shareholder or a specified beneficiary. Finally, to benefit from this exception there is also a requirement that all or substantially all of the IFE be paid to a person or partnership other than a tax-indifferent investor that does not deal at arm's length with the taxpayer (or any eligible group entity in respect of the taxpayer). While this is a welcome measure for many taxpayers, the EIFEL rules still go well beyond the recommendations of the BEPS Action 4 Report. For example, while relief is available under the test, a number of Canadian based taxpayers may be precluded from benefitting where the group has a minority interest in a foreign affiliate and the above noted $5,000,000 de minimis test fails.
The rules for how controlled foreign affiliates (CFA) are impacted by the EIFEL rules have been expanded. These rules are complex, but the general principle is that interest expense and interest income involved in computing Foreign Accrual Property Income (FAPI) are included in the calculation of a taxpayer's IFE and Interest and Financing Revenue (IFR) based on the taxpayer's proportionate interest in the CFA. Any denied IFE will impact the corresponding FAPI pick-up in the year. This will require taxpayers to track IFE/IFR at the CFA level in more detail as they compute FAPI which may be an onerous exercise. From a policy perspective, it is unclear why the EIFEL rules are being extended to foreign affiliates particularly in cases where the countries where the foreign affiliate is located have either implemented their own earning stripping rules or have adopted the recommendations of BEPS Action 4 Report. This, in our view, creates considerable tax complexity for Canadian taxpayers, and once again, our EIFEL rules have gone well beyond what was recommended.
In the calculation of IFE, capitalized IFE are only required to be tracked and included as part of IFE when they are claimed as a capital cost allowance (CCA) after Feb. 4, 2022.
Net capital losses are now excluded from the definition of the ATI which previously caused a mismatch on when net capital losses were utilized versus when they originated. These amendments resolve this inconsistency in the rules.
There are new additions to ATI for resource pool expense claims and terminal losses.
Several other measures have been introduced impacting ATI.
The definition of excluded interest has now been extended to certain partnerships and lease financing amounts.
RIFE are IFE that are not deductible in the year under the EIFEL rules and essentially results in a new tax attribute being created. The RIFE pool can be carried forward indefinitely, under the Original Proposals RIFE's expired after 20 years. RIFE carried forward will now also include any IFE which are denied in determining FAPI of a CFA of the taxpayer.
It should be noted that a taxpayer's RIFE carryforward will survive a loss restriction event to the extent that the interest is sourced to income from a business and the taxpayer continues to carry on the same business following the loss restriction event.
The indefinite carryforward recognizes that it may be more difficult to make use of RIFE as a tax attribute rather than an ordinary non-capital loss.
BDO observations and key takeaways
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. In addition, attention needs to be paid to the following:
The Canadian thin capitalization rules currently still apply before the new interest deductibility rules. Therefore, non-residents financing their Canadian operations will need to ensure both interest deductibility provisions are met.
The foreign affiliate dumping rules continue to be applicable.
There are several provisions that require elections to be filed.
Reach out to your BDO advisor to learn more about how we can help you manage the impact of these proposals on your business
The information in this publication is current as of March 15, 2023.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.