Canada confirms its intention to introduce new rules on interest and deductibility
The Department of Finance (Canada) (Finance) released a bill on February 4, 2022 that would limit the deduction of “interest and financing charges” to a fixed percentage of earnings before interest, taxes, depreciation and amortization (EBITDA) for Canadian income for tax purposes (EIFEL rules). Following a consultation period during which the Department received over 60 submissions, the Department of Finance confirmed (at the International Fiscal Association Canada Tax Conference held on May 17, 2022 [IFA Conference]) that it would proceed with the implementation of the proposed EIFEL rules (excessive limitation of interest and financing charges) essentially in the same form as originally proposed, with some significant proposed changes that are under consideration.
The EIFEL scheme follows a broad international effort to combat base erosion and profit shifting (BEPS). More specifically, the EIFEL rules derive from the recommendations made by the Organization for Economic Co-operation and Development (OECD) in its Action 4 report of October 2015 as part of the BEPS action plan. By implementing the EIFEL rules, the Department of Finance seeks to prevent tax planning techniques used by multinational corporations, whereby favorable tax results are achieved by shifting taxable income from entities located in high-tax jurisdictions to beneficiaries who are not subject to tax or who are taxed at relatively low rates. tax rate or not at all.
The EIFEL rules will generally apply to tax years beginning on or after January 1, 2023, with a fixed ratio of 40%, this ratio decreasing to 30% (in line with the international standard) for tax years beginning on or after January 1. , 2024.
Key points to remember
- The deductibility of net interest and financing costs of corporations and trusts that are not excluded entities will be limited to a “fixed ratio” of 30% of EBITDA for taxation years beginning in 2024 or later (40% for taxation years beginning in 2023 or later) .
- Although it is effectively an anti-avoidance rule (even if it is not worded as such), these restrictions may in fact have an impact on a significant number of Canadian taxpayers who would not have expected what the rules apply to them because their transactions have no underlying motivation for tax avoidance. .
- Certain capital-intensive industries such as real estate and infrastructure will be disproportionately affected and the internal rate of return on their assets will be reduced. Canada’s international competitiveness will also be affected compared to other countries such as the United States, whose legislation explicitly excludes real estate and infrastructure.
- These rules appear to run directly counter to the government’s stated goal of increasing infrastructure spending, building more homes and making housing more affordable across the country.
- Taxpayers eligible for relief under a “group ratio” rule will be encouraged to model how the fixed ratio and group ratio would apply on an annual basis, to determine which regime would offer the most advantageous for a given year.
The EIFEL rules will apply to taxpayers that are corporations or trusts, excluding individuals and partnerships. However, the rules will apply to partners in partnerships if those partners are corporations or trusts, with interest and financing costs and income allocated to them in proportion to their interest in the partnership.
Although the rules are not meant to apply to purely domestic entities, the “excluded entity” exception is quite narrow and therefore the threshold for the rules to apply is low. In other words, a significant number of taxpayers will not be considered excluded entities and will therefore be subject to the new restrictions on the deduction of interest and financing charges, even if their activities are not motivated by tax evasion. .
“Excluded Entities” include
- Canadian-controlled private corporations and all associated corporations, with less than $15 million of taxable capital employed in Canada;
- taxpayers (corporations and trusts) resident in Canada with less than $250,000 of net interest and financing charges in a taxation year; and
- taxpayers (corporations and trusts) resident in Canada if
- substantially all of the business of the taxpayer and its group is carried on in Canada;
- substantially all of its interest and financing costs are payable to persons or partnerships that are not “tax-indifferent investors” (e.g., tax-exempt entities), which includes typically a lender owned by a pension scheme or Crown entity;
- no foreign subsidiary is part of the corporate group; and
- no non-resident holds more than 25% of the taxpayer’s votes or fair market value.
At the IFA conference, the Department of Finance indicated that it was considering increasing the threshold for taxable capital employed in Canada from $15 million to $50 million and increasing the threshold for net interest and funding of $250,000. We note that the $250,000 threshold is significantly lower than the threshold adopted by Germany and France (€3 million each) and the UK (£2 million).
Main rule: the “fixed ratio”
The main rule of the EIFEL scheme limits for a given taxpayer “the amount of net interest and financing costs that can be deducted in calculating a taxpayer’s income to a fixed ratio of EBITDA at most”. No deduction is available for interest and financing costs above 30% (or, in 2023, 40%) of EBITDA. Note that the calculation of EBITDA under the EIFEL regime (i.e. for tax purposes) may differ from EBITDA as reported in a taxpayer’s financial statements.
The EIFEL rules allow taxpayers to defer excess capacity to deduct interest for three years and restricted interest and finance charges for 20 years.
Alternative rule: the “group ratio”
As an alternative to the fixed ratio, the EIFEL proposals contain a rule applicable to groups of companies that have audited consolidated financial statements, or that would be required to have such statements if the entities were subject to International Financial Reporting Standards . If the group ratio requirements are met, Canadian members of a group of corporations and/or trusts may jointly elect to adhere to the group ratio rules for a taxation year. This choice is made on an annual basis and, thus, a company within a group could choose to benefit from the collective ratio one year and choose to benefit from the fixed ratio another year.
If the formula used to calculate the group ratio gives a ratio higher than the fixed ratio, the taxpayer can deduct interest and financing costs in excess of the fixed ratio. The maximum interest and finance charges that group members are collectively allowed to deduct is generally determined by each member’s total EBITDA, as calculated for tax purposes, multiplied by the group ratio. The group then distributes this amount among its members according to its choice of group ratio. The maximum effective ratio is calculated as follows:
We note that “group net interest expense” is adjusted for amounts paid or received from certain non-members (generally entities that are not members of the consolidated group but do not deal at arm’s length with a group member, or entities that have a material interest in a group member or in which a group member has a material interest).
- The proposed EIFEL rules do not contain any avoidance or purpose criteria. In fact, the rules are purely mechanical in their application, subjecting all entities falling within the scope of the EIFEL rules to the regime. The complexity and formula-based approach of the rules will necessarily increase compliance costs for taxpayers. In addition, due to the breadth of applicability of the rules, a significant number of Canadian corporations and trusts that did not expect to be subject to the rules would in fact be affected.
- In implementing the EIFEL rules, Finance has decided to take a multi-layered approach to limiting interest deductibility, using both the existing thin capitalization rules and the EIFEL rules. Neither during the consultation process nor at the IFA conference did the Ministry of Finance indicate its intention to abandon the thin capitalization regime in favor of the proposed EIFEL regime.
- The availability of fixed and group ratios will provide eligible entities with tax planning options. Taxpayers eligible for the group ratio will be encouraged to model how the fixed ratio and the group ratio would apply on an annual basis, in order to determine which regime would offer the most advantageous treatment for a given year.
- Certain capital-intensive industries such as real estate and infrastructure will be disproportionately affected and the internal rate of return on their assets will be reduced, inevitably making them less attractive and more expensive. Therefore, these rules appear to run directly counter to the government’s stated goal of increasing infrastructure spending in key areas and making housing more affordable.
- Both the OECD and the United States have recognized that interest deductibility rules can have negative effects on infrastructure and real estate, and have provided explicit exceptions for such investments. If the EIFEL rules do not provide similar exemptions, investors in the sector will likely increase their investments outside of Canada and reduce their investments in Canada. The proposed rules will hurt Canada’s international competitiveness in these industries.
- The rules do not apply to partnerships, but rather will apply to the partners of the partnership on their share of interest deductions. Investment funds must closely monitor the application of the rules in order to be able to respond correctly to requests for information from investors. The application of group ratio rules to portfolio entities may also be affected.
- Competitiveness of lending activities of tax-exempt entities (which would typically include a lender owned by a pension plan or government entity) or borrowing funds from non-resident or tax-exempt investors will be affected because transactions with these entities subject the borrower to the application of the EIFEL rules. This is particularly relevant in mining or venture capital.