On February 4, 2022, draft legislative proposals were released regarding the new excessive interest and financing expenses limitation (EIFEL) rules; these proposals were open for consultation until May 5, 2022.
The rules limit the deduction of a taxpayer’s interest and financing expenses (IFE), net of interest and financing revenues (IFR) (together, “net IFE”), to a fixed percentage of the taxpayer’s adjusted taxable income (ATI), which is based on a tax version of the accounting concept of earnings before interest, taxes, depreciation, and amortization (EBITDA). The fixed percentage starts at 40 percent of ATI for taxation years beginning in 2023, decreasing to 30 percent for taxation years beginning thereafter. There is also a “group ratio” rule applicable in certain cases, allowing a higher ratio.
The rules apply to all corporations and trusts, except for (1) Canadian-controlled private corporations with less than $15 million of capital employed in Canada; (2) groups with Canadian net IFE of $250,000 or less; and (3) certain groups that operate almost entirely in Canada. The de minimis exclusion for group net interest expense is notably lower in Canada than in other countries that have adopted interest limitations based on OECD BEPS action 4. The rules will indirectly apply to partnerships, owing to the inclusion of partnership interest expenses and other amounts within the calculations of corporations and trusts that hold partnership interests.
ATI is used to determine a taxpayer’s capacity to deduct net IFE in a year, and it uses “taxable income” (TI) as the starting point. ATI adjusts TI for various items, including (1) IFE and IFR; (2) non-capital losses and net capital losses for the year; (3) deductions for part VI.1 tax; (4) capital cost allowance (CCA) deductions; (5) foreign-source income sheltered by Canadian foreign tax credits; and (6) other adjustments specific to partnerships and trusts.
The IFE and IFR that are covered by the rules are broadly defined. Both definitions include a catch-all provision for interest expense/revenue amounts and specifically include other financing-related amounts, such as financing expenses that are otherwise deductible under the Act and more general amounts related to the “cost of funding.” These amounts specifically include (1) financing components of leases; (2) interest expense and revenues that are recognized in a partnership (prorated on the basis of the corporation’s or trust’s share of partnership income); and (3) CCA or resource pool deductions that specifically relate to financing.
“Excluded interest”—that is (broadly speaking), interest on a debt between two taxable Canadian corporations that are in a group relationship—may be excluded from the rules through a joint election. The explanatory notes comment that this exclusion is intended to prevent the EIFEL rules from having a negative impact on transactions that Canadian corporate groups commonly undertake in order to allow the losses of one group member to be offset against the income of another group member.
When a group’s external interest expense is high compared with its group EBITDA, it may be beneficial for the group to elect into the “group ratio” rules. An electing group may deduct IFE on the basis of a higher percentage of ATI; this percentage is based on group net interest expense (GNIE) over group adjusted net book income (GANBI) (subject to formulaic restrictions on the resulting percentage). The formulaic restrictions mean that the ratio of GNIE/GANBI would need to be 260 percent before a deduction equal to 100 percent of ATI could be achieved. When groups elect into these rules, they are required to allocate the group’s total capacity for deductions among group members. These rules use consolidated financial statements as their basis, requiring IFRS-compliant financial statements or a number of “acceptable” local GAAPs, which exclude any European GAAPs.
The EIFEL rules allow taxpayers to carry forward to later taxation years certain amounts arising in a particular taxation year. Specifically, taxpayers can carry forward
In addition, a corporation can generally elect to transfer EC to other corporations within the same group. This rule does not apply to trusts.
Transitional provisions enable taxpayers to jointly elect to determine EC for the three “pre-regime years” immediately prior to the first year for which EIFEL applies to the taxpayer, thereby enabling the calculation of a carried-forward CUEC amount that would otherwise be nil.
Groups need to pay attention to any future loss-restriction events under section 111 of the Act, because (1) RIFE is deductible in future years only if it relates to interest from a business, and that business has continued after the loss-restriction event; and (2) CUEC expires after a loss-restriction event, meaning that it can no longer be utilized, which appears particularly restrictive.
As currently drafted, the proposed EIFEL rules have several features that need to be addressed, including the following:
The EIFEL rules add additional complexity to the obtaining of an interest deduction in Canada, and there are no plans to simplify the current rules restricting interest deductibility—for example, the thin capitalization rules. Although the rules are formula-driven, groups have some informed choices to make because of the elections available to them. Canadian groups subject to the rules should undertake financial modelling prior to the introduction of the EIFEL rules so as to be in a position both to apply the rules as advantageously as possible and to consider the impact of these rules, because there is no grandfathering for existing financing arrangements.
Alex Cook and Ken Buttenham
PwC LLP, Toronto