Under the Income Tax Act (Canada) (ITA), interest is generally deductible provided that a taxpayer has a legal obligation to pay interest and the interest is paid or payable on borrowed money used for the purpose of gaining or producing income from a business or property. Interest expense deductions are limited to the lesser of the amount of interest that is paid or payable in the year and a “reasonable amount.” The ITA also contains specific rules that limit the deduction of interest expense, such as the thin capitalisation rules discussed below.
Recent legislative proposals issued by the Department of Finance (Canada) seek to amend the ITA to further limit the deduction of interest and other financing expenses for Canadian income tax purposes. This draft legislation, referred to as the “excessive interest and financing expenses limitation” (EIFEL) rules, aims to implement the recommendations of the Organisation for Economic Co-operation and Development’s (OECD’s) Action 4 report under the Base Erosion and Profit Shifting (BEPS) Action Plan. The new EIFEL rules will limit deductions for “interest and financing expenses”[i] to a fixed percentage of “adjusted taxable income” (ATI) which is, generally speaking, a proxy for earnings before interest, taxes, depreciation and amortisation (EBITDA), computed in accordance with tax principles.
According to the OECD, multinational groups can use a combination of substantial third-party debt in high-tax jurisdictions and intercompany loans to generate interest deductions exceeding the group’s actual third-party interest expenses. The EIFEL rules are intended to curtail this perceived base erosion concern by addressing “BEPS issues arising from taxpayers deducting for income tax purposes excessive interest and other financing costs, principally in the context of multinational enterprises and cross-border investments”.
However, as stated in the Department of Finance’s explanatory notes, “there is no avoidance or purpose test” governing the application of the EIFEL rules. Accordingly, the proposed rules apply to all entities meeting the definitions in the draft legislation in a mechanical and automatic manner. The mechanical operation of the EIFEL rules may lead to inappropriate results in certain circumstances.
Existing Interest Deductibility Limitations: Canada’s Thin Capitalisation Rules
The thin capitalisation rules prevent Canadian resident corporations and certain trusts from deducting interest on amounts owed to “specified non-residents”[ii] to the extent that the debt owed to such non-residents exceeds 1.5 times the equity of the corporation or trust. Before the enactment of the thin capitalisation rules, non-residents could leverage their Canadian subsidiaries with significant debt, resulting in large interest deductions by the Canadian subsidiary. This structure was generally advantageous where the Canadian subsidiary’s interest deduction was allowed at a higher rate compared to the rate of tax imposed on the interest income of the non-resident. To prevent a perceived erosion of the tax base, Canada implemented the thin capitalisation rules to restrict the amount of interest that could be deducted by a Canadian corporation by limiting debt investment to 1.5 times equity.
The EIFEL rules will not replace the thin capitalisation rules. Instead, the draft legislation specifically contemplates that the thin capitalisation rules will take precedence over the EIFEL rules. Thus, amounts for which deductions are denied under the thin capitalisation rules will not be included in the calculation of the taxpayer’s interest and financing expenses under the EIFEL rules.
Given the preference for interest deductibility restrictions based on an “earnings stripping” approach under BEPS Action 4, it would seem logical to choose one regime or the other, instead of a hybrid of both. However, there is no indication that the Department of Finance intends to abandon the thin capitalisation regime in light of the new EIFEL rules.
The EIFEL Rules In Brief
The proposed EIFEL rules aim to “limit the amount of net interest and financing expenses, being the taxpayer’s total interest and financing expenses less its interest and financing revenues, that may be deducted in computing a taxpayer’s income to no more than a fixed ratio of EBITDA”. Under the EIFEL rules, deductions for interest and financing expenses are capped at either a fixed ratio equal to 30 per cent of ATI or the group ratio percentage of ATI.
Mechanically, the EIFEL rules apply by calculating a proportion of otherwise deductible interest and financing expenses and denying a deduction in respect of that proportion. The restriction is computed using a complex formula that can generally be summarised as a proportion of a taxpayer’s net interest and financing expenses in excess of its interest and financing revenues[iii] plus 30 per cent of ATI, all divided by the taxpayer’s interest and financing expenses for the year.
The draft legislation also includes an elective group ratio rule that can be utilised by “consolidated groups”.[iv] If certain criteria are met, Canadian resident corporations and trusts that are members of a consolidated group can jointly elect to be subject to the group ratio rules for a specific tax year. Because the election applies on an annual basis, the group ratio could be utilised in one year and the fixed ratio of 30 per cent could be utilised in another year if it would be beneficial to do so.
Under the group ratio rule, the maximum amount that a group member can deduct in interest and financing expenses for the year is not limited by the 30 per cent fixed ratio, but rather by the proportion of the “group net interest expense” over the “group adjusted net book income”.[v] Accordingly, if this proportion exceeds the fixed ratio in a particular year, a taxpayer can deduct interest and financing expenses beyond the fixed ratio, so long as they jointly elect with all other “eligible group entities”[vi] in the consolidated group to apply the group ratio for that year.
The maximum amount of interest and financing expenses that the members of a group can collectively deduct under the group ratio rule is generally determined by multiplying the total of each member’s ATI by the group ratio, with the resulting amount then being allocated among the group members in the group ratio election.
Exceptions To The EIFEL Rules
Notable exceptions to the EIFEL rules are found in the definitions of “excluded interest” and “excluded entity”. Generally speaking, these exceptions are intended to provide relief where the base erosion concerns underlying the EIFEL rules are not engaged. However, the exceptions are narrow in scope and may not provide adequate relief where group members include non-corporate entities, such as trusts, or where a non-resident holds an ownership interest in a group entity through a trust.
A specific exception is also provided in respect of certain Canadian “public-private partnership” (P3) infrastructure projects.[vii] Unlike the comparable United States rules limiting deductions for business interest expense,[viii] the Canadian EIFEL rules do not contain a general exception for real estate businesses.
In certain circumstances, an election can be made to exclude payments of “excluded interest” in computing the payer’s interest and financing expenses and the payee’s interest and financing revenues.[ix] The stated purpose of this exception is to ensure that the EIFEL rules do not negatively impact so-called “loss consolidation” transactions whereby the losses of one member of a Canadian corporate group are used to offset the income of another member of the group.[x] The excluded interest election is only available to eligible group entities that are taxable Canadian corporations or partnerships all of the members of which are taxable Canadian corporations. Thus, if either the payer or the payee is an individual, a trust, or a partnership whose members include an individual or a trust, the election would not be available.
Certain entities, referred to as “excluded entities”, are excepted from the EIFEL rules altogether. This exception is intended to provide relief to small and medium-sized Canadian businesses and Canadian groups having only de minimis foreign activities.
“Excluded entities” include: (i) Canadian-controlled private corporations[xi] that, together with any associated corporations, have less than $50 million of taxable capital employed in Canada;[xii] (ii) taxpayers resident in Canada that, together with all other Canadian group members, have less than $1 million of net interest and financing expenses for the year; and (iii) taxpayers resident in Canada if substantially all of the businesses, undertakings and activities of the taxpayer and its group are carried on in Canada and substantially all of the group’s interest and financing expenses are payable to persons or partnerships other than non-arm’s length tax-indifferent investors,[xiii] provided that the group’s foreign affiliate holdings are de minimis, no member of the group has a non-resident specified shareholder or specified beneficiary, as applicable, under the thin capitalisation rules, and no partnership that is majority-owned directly or indirectly by non-residents holds a 25 per cent or greater interest in any member of the group.
As excluded entity status is lost if a single group member has a non-resident specified shareholder or specified beneficiary, the EIFEL rules could apply to fairly common structures involving non-resident family members. For example, the rules could apply to the following structure:
Despite the restrictions placed on the trustees’ discretion, the trust would nonetheless be considered to have a non-resident specified beneficiary because the Canadian resident beneficiaries are siblings of the non-resident beneficiary and are thus deemed not to deal at arm’s length with the non-resident beneficiary for purposes of the ITA.[xiv] The EIFEL rules could therefore apply to the group unless one of the other tests for excluded entity status is satisfied. This is the case notwithstanding that all of the group’s debt is owed to taxable Canadian corporations and base erosion concerns should not therefore arise.
Application Of Proposed Rules
The EIFEL rules are scheduled to come into effect for taxation years beginning on or after 1 October 2023.[xv] Once the rules are enacted, non-residents seeking to invest in Canadian businesses will need to consider the impact of the EIFEL rules in addition to the existing thin capitalisation rules in assessing their after-tax investment returns. Canadian groups having direct or indirect non-resident owners may also need to consider whether they qualify under one of the limited exceptions to the EIFEL rules discussed above. In the case of highly-leveraged groups, the elective group ratio rules may provide additional capacity to deduct interest and financing expenses in excess of the fixed 30 per cent ratio of ATI.
It remains to be seen whether the proposed EIFEL rules are appropriately tailored to address the Department of Finance’s base erosion concerns without discouraging foreign investment in Canadian businesses or placing an undue tax burden on Canadian businesses, particularly those operating in capital-intensive industries or whose ultimate shareholders include non-residents.
[i] Defined broadly in the proposed legislation to include financing expenses that would not generally be considered interest under Canadian law, such as expenses incurred in connection with issuing indebtedness, annual standby charges, guarantee fees and other similar fees in respect of borrowed money, depreciation expenses related to interest deductions and the financing component of a lease, among others.
[ii] Generally speaking, non-residents who, together with non-arm’s length persons, hold a 25 per cent or greater interest in the trust or corporation, as the case may be. For these purposes, each beneficiary of a fully discretionary trust is generally considered to hold a 100 per cent interest in the trust. In the case of a corporation, the test is satisfied where a non-resident and persons with whom the non-resident does not deal at arm’s length collectively own shares of the corporation that (i) are entitled to at least 25 per cent of the votes that could be cast at a shareholders’ meeting, or (ii) represent at least 25 per cent of the total fair market value of all of the corporation’s shares. Contingent rights to acquire interests in a trust or corporation are also deemed to have been exercised.
[iii] “Interest and financing revenues” generally include interest income and other income related to the provision of financing.
[iv] “Consolidated group” is a defined term under the EIFEL rules and refers to two or more entities, including the ultimate parent entity, that are required to prepare consolidated financial statements for financial reporting purposes, or would be required to do so if they were subject to International Financial Reporting Standards (IFRS). If a single entity is not otherwise part of a consolidated group, it is deemed to be a consolidated group of one.
[v] In simplified terms, “group net interest expense” represents the group’s net third-party interest expense for the year and “group adjusted net book income” represents the book EBITDA of the group.
[vi] “Eligible group entity” is defined to include, in general terms, a trust or corporation that is resident in Canada and is (i) related to or affiliated with the taxpayer for purposes of the ITA, (ii) a discretionary trust in which the taxpayer holds an interest, or (iii) a beneficiary of the taxpayer, if the taxpayer is a discretionary trust.
[vii] In general, third-party interest and financing expenses are exempted from the EIFEL rules where (i) those expenses are incurred in respect of borrowing or other financing entered into in connection with an agreement with a Canadian public sector authority to design, build and finance real property owned by the public sector authority, and (ii) the economic cost of those expenses is borne by the Canadian public sector authority.
[viii] Found in section 163(j) of the Internal Revenue Code.
[ix] The effect of the election is generally to cause payments of “excluded interest” to not be subject to the EIFEL rules.
[x] As Canadian corporate groups are not permitted to report their tax position on a consolidated basis, loss consolidation transactions are commonly undertaken to more efficiently utilise losses within the group.
[xi] In simplified terms, a Canadian-controlled private corporation is a corporation that is not directly or indirectly controlled by non-residents or Canadian public corporations.
[xii] Taxable capital employed in Canada generally includes the amount of a corporation's capital stock, retained earnings, contributed surplus and the amount of all loans and advances to the corporation at the end of a taxation year.
[xiii] Tax-indifferent investors generally include (i) persons who are exempt from Canadian federal income tax, (ii) non-resident persons, (iii) Canadian resident discretionary trusts, and (iv) partnerships or Canadian resident trusts in which interests representing more than 10 per cent of the fair market value of all interests are held by any combination of the foregoing persons.
[xiv] Such that the interests of the non-resident beneficiary and the Canadian resident beneficiaries would be aggregated in determining whether the family trust has a specified beneficiary under the thin capitalisation rules.
[xv] Subject to an anti-avoidance rule which accelerates the coming-into-force date where transactions are undertaken for the purpose of deferring the application of the EIFEL rules.
Elie S. Roth is a partner in the taxation law practice group in Toronto. Elie’s practice concentrates on all aspects of domestic and international tax planning, corporate taxation, and private client matters. He has also represented taxpayers in tax audits and tax litigation proceedings at all levels of Canadian courts including the Supreme Court of Canada. Elie is co-author of the textbook Canadian Taxation of Trusts (Canadian Tax Foundation, 2016), among other books and publications. He is a member of the IFA Canada council, a former governor of the Canadian Tax Foundation, a council member and member of the Taxes Committee of The International Academy of Estate and Trust Law, and an International Fellow of ACTEC.
Ryan Wolfe is an associate in the taxation law practice group in Toronto. Ryan’s practice focuses on domestic and cross-border tax planning, mergers and acquisitions, private client matters and tax audits and disputes. Ryan received his B.A. (with Distinction) from the Ivey Business School at the University of Western Ontario and his J.D. (with Distinction) from the University of Western Ontario.