Canada Introduces Excessive Interest and Financing Expense Limitation Rules
Following recommendations of the Base Erosion Profit Shifting (BEPS)[1] report by the Organisation for Economic Co-operation and Development (OECD), Canada is introducing excessive interest and financing expenses limitation (EIFEL) rules. In general terms, EIFEL rules limit the amount of net interest and financing expenses that may be deducted in computing a taxpayer's income to no more than a fixed ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA). The rules are expected to take effect for taxation years that begin on or after 1 October 2023.
In terms of limiting the deduction of interest and financing expenses, the rules include amounts that are economically equivalent to interest, or that can reasonably be considered part of the cost of funding. It will limit the amount to a fixed ratio of 30% of a tax EBITDA. Nonetheless, to facilitate the transition, a fixed ratio of 40% will apply for taxation years beginning on or after 1 October 2023 and before 1 January 2024.
The rules will apply to resident and non-resident taxpayers that are corporations and trusts. Partnerships whose expenses and revenues are attributed to members that are corporations or trusts will also be subject to EIFEL rules. For non-residents, the rules will apply to taxable income earned in Canada. The rules will be applied to taxpayers that fall within its scope, with no avoidance or purpose conditions applicable. They will also be applied after existing limitations on the deductibility of interest and financing expenses rules in the Income Tax Act, such as the thin capitalization rules.
Certain Exclusions and Elections Will Apply
EIFEL rules will include a notion of excluded entities. These are Canadian-controlled private corporations that, together with any associated corporations, have taxable capital employed in Canada of less than C$50m. In addition, groups of corporations and trusts whose aggregate net interest expense among Canadian members is $1,000,000 or less are excluded. Certain standalone Canadian-resident corporations and trusts, including groups consisting exclusively of Canadian resident corporations and trusts that carry-on all their business in Canada are excluded. However, this exclusion does not apply if any non-resident is a foreign affiliate of, or holds a significant interest in, any group member, or any group member has any significant amount of interest and financing expenses payable to a tax-indifferent investor, such as those exempt from tax and non-residents. Furthermore, there is also an industry-specific exemption for Canadian public-private partnership infrastructure projects. The exemption will apply to third-party interest and financing expenses that are incurred in respect of a borrowing or other financing that was entered into in respect of an agreement with a Canadian public sector authority to design, build, finance and maintain real or immoveable property owned by a public sector authority.
In terms of elections, Canadian members of a group of corporations or trusts will have the possibility to jointly elect for a group ratio rule to apply for a taxation year. In essence, the group ratio rule will allow a taxpayer to deduct interest and financing expenses more than its fixed ratio, provided the taxpayer is a member of a consolidated accounting group whose ratio of net third-party interest expense to book EBITDA exceeds its fixed ratio. The group will need to be able to demonstrate this based on audited consolidated financial statements under International Finance Reporting Standards (IFRS).
Unused excess capacity and carry forwards of denied interest and financing expenses
If a taxpayer's net interest and financing expenses exceed the maximum permitted for a taxation year, it can use its "excess capacity," i.e., unused capacity from previous years, to allow the deduction. The taxpayer's unused excess capacity can be carried forward from the three taxation years immediately preceding a given taxation year and is automatically applied to reduce the amount of interest and financing expenses whose deductibility would otherwise be denied in the given year. Interest and financing expenses that are denied under the rules are carried forward for up to twenty years. Taxpayers will be allowed to deduct their restricted interest and financing expenses to the extent of their excess capacity in a future taxation year.
Loss Restriction Event
Like the treatment of non-capital loss carry forwards, a taxpayer's carry forward of restricted interest and financing expenses generally remain deductible following a loss restriction event, such as an acquisition of control by an arm’s length third party, to the extent the taxpayer continues to carry on the same business. However, a taxpayer's cumulative unused excess capacity does not survive a loss restriction event.
Transitional Rules
The transitional rules allow electing taxpayers a three-year carry forward of their excess capacity for pre-regime years, as this excess capacity is included in computing a taxpayer's cumulative unused excess. The transitional rules seek to approximate what would have been the unused portion of the taxpayer's excess capacity had the EIFEL rules applied. Without these transitional rules, a taxpayer would not have excess capacity for pre-regime years when the EIFEL rules did not apply.
Plan Ahead
Given the nature of these new rules, capital-intensive industries, such as real estate and startups, will be disproportionately impacted. Canada has indicated that the final version of these provisions will remain largely unchanged but did not rule out the possibility of making some minor amendments. Corporations should therefore assume that the rules are in final form and should factor them into their future forecasts.
Although these rules will be applied mechanically, corporations will have the choice of applying these rules individually or grouped. It may be wise to forecast the impact of these different avenues now to facilitate optimal planning.
[1] Item 4 of the BEPS report
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Michel Rhéaume | Shayne Pringle |