This updated is intended for those seeking additional insights into the revised draft legislative proposals regarding the proposed excessive interest and financing expenses limitation regime released in November 2022.
On November 3, 2022, the Department of Finance released revised draft legislative proposals in respect of the new excessive interest and financing expenses limitation regime (the "EIFEL Regime"). The Department originally released draft legislative provisions in respect of the regime on February 4th, 2022 (the "Original Proposals"). The EIFEL Regime limits the amount of interest and financing expenses that a taxpayer may deduct in calculating its taxable income to the extent that such interest and financing expenses exceed a fixed percentage of earnings before interest, taxes, depreciation, and amortization ("EBITDA").
The stated objective of the EIFEL Regime is to address the concerns raised and the recommendations outlined in the Base Erosion and Profit Shifting (BEPS) Action 4 Report published by the Organisation for Economic Co-operation and Development (OECD). The EIFEL Regime adopts an "earnings stripping" approach which is intended to prevent taxpayers from deducting excessive amounts of interest and other financing costs for income tax purposes. The intended effect of the regime is that an entity (or a group of entities) will not be able to deduct an amount of interest, or financing expenses, in an amount that is not commensurate with the entity's (or group's) business activities in Canada. This bulletin provides an overview of the new EIFEL Regime and provides a brief summary of its corresponding rules.
The EIFEL Regime is currently proposed to come into force on October 1, 2023. This is a delay from the original coming-into-force date of January 1, 2023 in the Original Proposals. For taxation years beginning on or after October 1, 2023, and before January 1, 2024, the fixed ratio of 40% will apply, reducing to 30% for tax years starting on or after January 1, 2024. The Department of Finance is inviting submission in respect of the revised EIFEL proposals due by January 6, 2023.
The core rules of the EIFEL Regime are set out in proposed sections 18.2 and 18.21 of the Income Tax Act (the "ITA"). Generally, the EIFEL rules limit the amount of net interest and financing expenses, being the amount by which "interest and financing expenses" exceed "interest and financing revenues", to no more than a fixed ratio, defined as the "ratio of permissible expenses" is of "adjusted taxable income", which approximates tax-adjusted EBITDA, for the year. Alternatively, where certain conditions are met and a group of corporations and/or trusts so elects, a higher "group ratio" may be applied instead of the fixed ratio (see discussion below).
Limitation on Deductions
The EIFEL Regime limits the amount of interest and financing expenses that a taxpayer may deduct in calculating its income for a taxation year. In particular, proposed subsection 18.2(2) provides that a taxpayer (that is not an excluded entity) may only deduct a particular percentage of its interest and financing-related expenses. 1 The particular percentage equals (A – (B + C + D + E)) / F, where:
A = Interest and Financing Expenses
The taxpayer's "interest and financing expenses" for a taxation year. This amount includes interest (but not "excluded interest") and various other financing-related expenses and losses incurred or realized by the taxpayer during or in respect of the taxation year. The definition also captures the taxpayer's pro rata share of interest and financing expenses of a partnership of which the taxpayer is a member and a specified portion of the interest and financing expenses of a controlled foreign affiliate of the taxpayer. The definition also includes an adjustment for amounts received or receivable by the taxpayer in respect of a "hedge" that reduces the cost of a borrowing or financing. The definition excludes exempt interest and financing expenses which is intended to exclude certain interest and financing expenses that are incurred in respect of certain Canadian public-private partnership infrastructure projects (see discussion below).
B = Ratio of Permissible Expenses * Adjusted Taxable Income
The taxpayer's "ratio of permissible expenses" for the year, being 30% (or 40% for the transitional period for taxation years beginning on or after October 1, 2023, and before January 1, 2024), multiplied by the taxpayer's "adjusted taxable income" for the year. The "adjusted taxable income" of a taxpayer for a taxation year approximates its EBITDA for the year. In general, the adjusted taxable income of a taxpayer equals its taxable income for the year (i) plus any deductions for interest and financing expenses, certain tax expenses, and capital cost allowance and (ii) minus various amounts otherwise included in the taxable income of the taxpayer for the year, including interest and financing revenues and recaptured capital cost allowance (among other amounts).
C = Interest and Financing Revenues
The taxpayer's "interest and financing revenues" for the year includes interest income (but not "excluded interest") and various other financing-related income and gains (e.g. fees or similar amounts in respect of a guarantee or similar credit support, lease financing amount, etc.). The definition also captures (i) the taxpayer's pro rata share of interest and finance revenues of a partnership of which the taxpayer is a member and (ii) a specified portion of the interest and financing expenses of a controlled foreign affiliate of the taxpayer. The definition also includes an adjustment for amounts paid or payable by the taxpayer in respect of a "hedge" that increases the cost of a borrowing or financing.
D = Received Capacity
Subsection 18.2(4) provides a mechanism under which a taxable Canadian corporation (or a fixed interest commercial trust) may transfer a portion or all of its cumulative unused excess capacity to another taxable Canadian corporation (or fixed interest commercial trust) in the same corporate group. The meaning of "cumulative unused excess capacity" is discussed below.
In particular, a taxpayer (the "transferor") may make a joint election with another taxpayer (the "transferee"), each of which is part of the same corporate group, to designate all or portion of the transferor's cumulative unused excess capacity such that it becomes (i) an amount of "transferred capacity" of the transferor for the taxation year, and (ii) an amount of "received capacity" of the transferee for the taxation year. The transferor must deduct the amount of the transferred capacity in calculating its cumulative unused excessive capacity. However, the transferee may include the amount of the received capacity in calculating the amount of interest and financing expenses that it may deduct in calculating its income.
E = Absorbed Capacity (Carry-Forwards)
The taxpayer's "absorbed capacity" for a taxation year generally equals its cumulative unused excess capacity for the year (to the extent that such amount is less than the amount of otherwise denied interest and financing expenses for the taxation year). In general, the taxpayer's "Cumulative unused excess capacity" for a taxation year equals the sum of (i) its excess capacity for the taxation year and (ii) its excess capacity for each of the three immediately preceding taxation years (subject to any reductions for transferred amounts under subsection 18.2(4) and previously "absorbed" amounts).
The taxpayer's "excess capacity" for a taxation year is the amount (if any) by which (i) the maximum amount of interest and financing expenses deductible by the taxpayer for the year (e.g. ratio of permissible expenses * adjusted taxable income + interest and financing revenues) (ii) exceeds the actual amount of the taxpayer's interest and financing expenses for the year.
F = Interest and Financing Expenses
The taxpayer's interest and financing expenses for a taxation year but not including an adjustment for amounts received or receivable by the taxpayer in respect of a "hedge" that reduces the cost of a borrowing or financing (as outlined for the calculation of Variable A above).
Controlled Foreign Affiliates
The treatment of foreign accrual property income (FAPI) and/or a foreign accrual property loss (FAPL) of a foreign affiliate of a taxpayer resident in Canada was not addressed in the Original Proposals. The revised rules address controlled foreign affiliates (but not foreign affiliates that are not controlled foreign affiliates). As noted above, the revised EIFEL Regime definitions of "interest and financing expenses" and "interest and financing expenses" refer to a controlled foreign affiliate's relevant interest and financing expenses and revenues which include certain FAPI/FAPL amounts from the controlled foreign affiliate. Other adjustments have been made throughout the draft legislation to reflect the inclusion of controlled foreign affiliates.
Public-Private Partnership (P3) Infrastructure Projects
The revised proposals include an exemption from the EIFEL rules for interest and financing expenses incurred in respect of the financing of typical Canadian public-private partnership (P3) infrastructure projects. The stated policy behind this exemption is that such expenses, defined as "exempt interest and financing expenses" in the proposed legislation, do not pose significant BEPS risks as targeted by the new EIFEL rules.
Generally, to qualify for the exception the following conditions must be met: (i) the borrower must have entered into an agreement with "public sector authority" to design, build and finance, or design, build, finance, maintain and operate, real or immovable property owned by a public sector authority, (ii) the borrowing or other financing was entered in respect of such agreement, (iii) it can reasonably be considered that all or substantially all of the expenses were economically borne by the public sector authority (for example, where the public sector authority makes capital payments under a project agreement to cover the financing expenses of the project); and (iv) the expenses were paid or payable to arm's length persons.
The EIFEL Regime does not apply to certain "excluded entities"; i.e. entities that the Department of Finance does not believe post significant risks in respect of base erosion and profit shifting. An "excluded entity" includes: (i) a Canadian-controlled private corporation with less than $50,000,000 of taxable capital employed in Canada; (ii) a taxpayer that is part of an eligible group whose Canadian-resident members have total interest and financing expenses (net of interest and financing revenues) for a year in an amount that is less than, or equal to, $1,000,000; and (iii) certain Canadian-owned entities which carry on substantially all of their business in Canada and have limited holdings in foreign affiliates.
The new draft legislation also includes various anti-avoidance rules addressing perceived misuses or abuses of the EIFEL Regime, including rules addressing: (i) the inflation of interest and financing revenues or the understatement of interest and financing expenses; and (ii) "excluded entity" status for certain entities that pay amounts to non-arm's length tax indifferent investors. There are various other anti-avoidance rules included the EIFEL Regime.
Group Ratio Election
If applicable, the Canadian members of a group and/or trusts may jointly elect to replace the fixed (30%) ratio of permissible expenses with a higher "group ratio". The group ratio of a consolidated group for a particular period equals A / B, where: A equals the net third-party interest expenses of the consolidated group for the period; and B equals the adjusted net book income of the consolidated group for the period. The group must be able to support this ratio with audited consolidated financial statements. The election may, in effect, allow each member of the group to deduct a higher proportion of its respective interest and financing expenses in calculating taxable income.
As highlighted in the explanatory notes to the draft legislation, the EIFEL rules generally apply mechanically with no avoidance or purpose test for the limitations rules to apply. It is also reiterated that subsection 18(4) clarifies that the EIFEL rules apply after existing limitations on the deductibility of interest and financing expenses in the ITA including the existing thin capitalization rules and that any expenses whose deductibility is denied under such existing limitations are excluded from a taxpayer's interest and financing expenses for purposes of the new EIFEL rules.
The addition of the complex EIFEL regime to the existing limitations on deductibility rules will materially increase the administrative, compliance and tax burden on multinational enterprises and other businesses investing in Canada. The extension of the in-force date by nine months and the opening of another consultation period highlights the complexity of the EIFEL Regime and these changes. Nonetheless, the broadening of "excluded entities" to which the EIFEL rules do not apply is a welcome amendment to the Original Proposals.
Taxpayers with existing financing arrangements would be prudent to use the additional time to consider how the proposed EIFEL rules apply to their specific circumstances. Multinational enterprises and other businesses who are seeking to invest in Canada in the near future should be aware of the broad and complicated implication of the new EIFEL regime.
1 More specifically, the rules specify that the taxpayer may not deduct any amounts described in paragraphs (a) – (g) or (i) of the description of A in the definition of "interest and financing expenses".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.