Canada’s proposed EIFEL rules would impact tax treatment of financing arrangements

May 2022 | SPOTLIGHT | CORPORATE TAX

Financier Worldwide Magazine

May 2022 Issue

On 4 February 2022, the Department of Finance (Canada) released draft legislation that would amend the Income Tax Act (ITA), which includes rules to limit the deduction of “interest and financing expenses” for Canadian income tax purposes. The legislative proposals are referred to as the ‘excessive interest and financing expenses limitation’ (EIFEL) rules.

By introducing the EIFEL regime, the Department of Finance is seeking to implement the recommendations from the Organisation for Economic Co-operation and Development’s (OECD’s) Action 4 report under the Base Erosion and Profit Shifting (BEPS) Action Plan. Under the new EIFEL rules, deductions for “interest and financing expenses” in computing a taxpayer’s taxable income would be limited to a fixed percentage of earnings before interest, taxes, depreciation and amortisation (EBITDA).

According to the Department of Finance, the EIFEL rules are meant to address “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”. Specifically, the OECD indicates that multinationals can place high levels of third-party debt in high tax jurisdictions and use intra-corporate group loans to generate interest deductions in excess of the group’s actual third-party interest expenses.

Current limitations on interest deductibility

In general, under the ITA, interest is deductible if the taxpayer has a legal obligation to pay interest and that interest is paid on borrowed money used for the purpose of gaining or producing income from a business or property. The amount of interest deducted is limited to the lesser of the amount of interest that is paid or payable in the year, or a “reasonable amount”. The ITA also provides specific rules restricting the deduction of interest payments, including the thin capitalisation rules.

The thin capitalisation rules prevent Canadian resident corporations and certain trusts from deducting interest on amounts owed to “specified non-residents” to the extent that the debt owed to such non-residents exceeds 1.5 times the equity of the corporation or trust. The thin capitalisation rules were adopted to limit the amount of foreign investment in Canadian subsidiaries by way of debt, rather than by equity.

Prior to the coming into force of the thin capitalisation rules, non-residents would leverage their Canadian subsidiaries with substantial amounts of debt, giving rise to large interest deductions with respect to that debt. This structure was advantageous where the interest deduction claimed by the Canadian subsidiary was allowed at a higher rate compared to the rate of tax imposed on that interest income of the non-resident recipient. Considering this perceived erosion of the tax base, parliament sought to limit the amount of interest that could be deducted by a Canadian corporation by capping debt investment to 1.5 times equity.

The introduction of the EIFEL rules will not eliminate the thin capitalisation rules. In fact, the draft legislation provides that the thin capitalisation rules will apply in priority to the EIFEL rules. As such, amounts for which deductions are denied pursuant to the thin capitalisation regime will be excluded in the computation of the taxpayer’s “interest and financing expenses” under the EIFEL rules.

EIFEL: the main rule – the fixed ratio

The EIFEL legislation proposes “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 new regime, no deduction is available in respect of any amount, if interest and financing expenses are above either 30 percent of EBITDA or the group ratio percentage of EBITDA.

The computation of the restriction is done via a complicated formula, which can be generally summarised as a proportion of net interest and financing expenses over revenues plus 30 percent of the taxpayer’s “adjusted taxable income”, all over the taxpayer’s interest and financing expenses for the year. The taxpayer’s “adjusted taxable income” is a defined term in the draft legislation that is essentially a calculation, for tax purposes, of EBITDA.

The definition of “interest and financing expenses” is quite broad and generally encompasses what is regularly considered to be interest, expenses in respect of financing, depreciation that can reasonably be considered attributable to interest deduction, lease financing amounts and partnership financing expenses. The definition of “interest and financing revenues” includes interest income and other income from providing financing. Although the definitions are broad, the rules include an exception for “excluded interest”.

If the following requirements are met, an entity can elect to exclude certain interest payments from its interest and financing expenses: (i) the interest must be paid or payable by a corporation to another corporation in respect of debt that is owed by the payer corporation; (ii) both corporations are taxable Canadian corporations and the payee corporation is an eligible group corporation in respect of the payer corporation; and (iii) the corporations jointly elect in writing in a prescribed manner and file an election with the minister that specifies the amount of interest and of the debt that will be considered to be “excluded interest”.

Finally, the EIFEL regime also provides an exception for “excluded entities”, relieving certain entities from the new rules. The “excluded entity” exception is quite narrow and thus the threshold for application of the EIFEL rules is low. “Excluded entities” include: (i) Canadian controlled private corporations with less than $15m of taxable capital employed in Canada; (ii) taxpayers resident in Canada with less than $250,000 of net interest and financing expenses; and (iii) taxpayers resident in Canada if the business of the taxpayer and its group is carried on in Canada and substantially all of its interest and financing expenses are payable to persons or partnerships that are not tax-indifferent investors, provided that there are no foreign affiliates of the corporate group and no non-resident specified shareholder or specified beneficiary, as applicable under the thin capitalisation rules.

EIFEL: the alternative group rule – the group ratio

The draft legislation also includes an alternative rule applicable to corporate groups. Essentially, if the requirements under the group ratio rule are met, then the Canadian members of a group of corporations or trusts can jointly elect to be subject to the group ratio rules for a taxation year. The election is made on an annual basis. As such, it seems possible that a corporation within a group could opt to benefit from the group ratio one year and, if it so chooses, benefit from the main ‘fixed ratio’ rule in a subsequent year.

If the group ratio rule applies, instead of a maximum amount that a group member is permitted to deduct in respect of interest and financing expenses for the year being determined by reference to the 30 percent fixed ratio, it is determined as the proportion of the “group net interest expense” over the “group adjusted net book income”. Therefore, if this proportion is greater than the fixed ratio, then a taxpayer can deduct interest and financing expenses in excess of the fixed ratio, provided that the taxpayer is a member of a “consolidated group”.

For purposes of the EIFEL regime, a “consolidated group” means two or more entities, including the ultimate parent entity, in respect of which consolidated financial statements are required to be prepared for financial reporting purposes or that would be so required if the entities were subject to International Financial Reporting Standards (IFRS).

Under the group ratio rule, the maximum amount of interest and financing expenses the group members are collectively permitted to deduct is generally determined as the total of each member’s “adjusted taxable income” multiplied by the group ratio. The group then allocates this amount among its members in its group ratio election.

Our observations

The proposed EIFEL rules are mechanical, applying automatically to all entities falling within the definitions provided for in the draft legislation. As the Department of Finance stated in its explanatory notes, “there is no avoidance or purpose test” to apply the rules. The complexity and formula-driven approach to the rules will necessarily increase compliance costs for taxpayers.

Moreover, certain questions remain as to the reasoning and eventual effect of these rules. For example, although the draft legislation preserves the relevance of the thin capitalisation rules by specifying that they apply in priority to the new EIFEL regime, one wonders why the Department of Finance would do so if, considering BEPS Action 4, there is a preference to opt for interest deductibility restrictions based on an “earnings stripping” approach. It would seem logical to opt for one regime or the other, rather than a hybrid of both. However, there is no indication that the Department of Finance intends to abandon the thin capitalisation regime.

Elie Roth and Rhonda Rudick are partners at Davies, Ward, Phillips & Vineberg. Mr Roth can be contacted on +1 (416) 863 5587 or by email: eroth@dwpv.com. Ms Rudick can be contacted on +1 (514) 841 6525 or by email: rrudick@dwpv.com.

Elie Roth and Rhonda Rudick

Davies, Ward, Phillips & Vineberg