Canadian Inbound Investment: The EIFEL Trap?

On the basis of draft legislation proposed to be effective from January 1, 2023, we can expect new rules that will limit interest and financing expense deductions to a percentage of a “tax-EBITDA” vis-à-vis “adjusted taxable income” (ATI). The terms are defined in the proposed legislation. (For a review of this legislation, see the article by Alex Cook and Ken Buttenham in the previous issue of this newsletter.)

Not Just an International Measure

Concerns have been raised that the excessive interest and financing expenses limitation (EIFEL) restrictions, although they are generally referred to as an international tax measure, will extend to ordinary Canadian corporations. This could occur if the group falls offside of being an “excluded entity” —by having, for example, non-resident shareholders, a foreign affiliate (however small), or merely debt from a tax-indifferent investor such as a non-resident, a charity, or a pension fund. Many tax professionals who do not practise international tax may have failed to recognize the potential impact of these proposals.

A May 5, 2022 submission from the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada expressed numerous concerns about the proposed EIFEL rules, and it illustrated these misgivings with some simple but realistic examples. In this article, we extend these examples to include Canco, an active Canadian technology corporation in the context of inbound investment, and we consider potential EIFEL traps. The conclusions that we draw can apply to any corporation seeking foreign investment.

Canadian Business Examples

Canco is a CCPC with an active R & D program. Its activities meet the qualifying criteria for SR & ED tax credits pursuant to subsection 37(1), as well as for related provincial tax credits. Canco has actively pursued outside investors, and it has attracted both resident and non-resident investors with its development of promising new technology. Such a scenario is fairly common in the technology sector. Canco might capitalize its operations with debt, possibly convertible to equity. With its non-resident investments increasing, Canco may be blindsided when seeking additional capital infusions within the context of the EIFEL regime.

If a foreign investor is given an option to convert debt into equity, the provisions of paragraph 251(5)(b) will deem this to be exercised for purposes that include CCPC status; therefore, Canco has ensured that the exercise of these rights will not result in more than 50 percent ownership by non-residents. However, with a smaller ownership interest by non-residents—25 percent of votes or value (see subsection 18(5), incorporated into the proposed definition of “excluded entity”)—the investor could become a specified person, which will cause Canco to fall offside of the excluded entity definition under proposed paragraph 18.2(2)(c). Furthermore, if any member of Canco’s corporate group (including related and affiliated entities under the proposed definition of “eligible group entity”) is given such an option, the entire corporate group will become subject to the EIFEL regime.

Given that the other exceptions have modest proposed de minimis limits—$15 million of taxable capital or interest, and financing expenses not exceeding $250,000 (which will translate to a debt ceiling of $5 million, assuming a borrowing rate of 5 percent)—that are based on the entire corporate group, it is easy to envisage a successful Canco becoming subject to these restrictions. When, in particular, R & D work constantly requires the inflow of new cash in addition to what needs to be borrowed for working capital and operations, many CCPC groups will exceed these de minimis limits. The third possibility for achieving excluded entity status requires meeting numerous criteria, which will create a greater administrative burden when it comes to assessing whether Canco will be subject to the EIFEL restrictions.

In what follows, in order to assess the potential impact of the EIFEL regime, we consider two scenarios: (1) the stand-alone startup venture and (2) a situation where Canco is part of a larger corporate group.

Stand-Alone Startup Venture

Canco is a startup with a non-resident investor that has an option to convert debt into equity accounting for a minimum of 25 percent in value, thus falling within the proposed excluded entity definition in subsection 18(5). However, this investor fails to qualify for either the taxable capital exception or the $250,000-of-financing-costs exception (considering all of its debt and leasing costs). In such a case, the EIFEL rules will not affect Canco. Canco, in its current form, is indifferent to EIFEL rules, but future expansion could easily result in the application of these rules to restrict Canco’s deductions, including deductions of earlier years that may have increased its non-capital losses in the startup years. If Canco, despite being an excluded entity, does not maintain records of such costs, it may in future—when it becomes profitable and its excluded entity status is lost—incur significant expense in determining the portion of non-capital losses that the deductions represent.

Canco Is Part of a Larger Corporate Group

Assume, instead, that Canco is part of a larger group, such that the taxable capital and de minimis financing cost exceptions are not available. This might occur within a larger corporate group that is developing in-house R & D, as is often the case when the corporate group wants to avoid reliance on external R & D or the costs of licensing technology from outside the group. In this case, the presence of a specified non-resident investor in any member of the group will limit Canco with respect to interest and financing deductions. Although Canco may not yet be in a revenue-generating phase, the EIFEL limitations will affect the larger group’s access to deductible financing costs. Furthermore, once Canco generates revenue, it will potentially be subject to higher taxation because of restrictions on the deduction of current and past financing costs (embedded in losses carried forward).

Other Considerations

Various other considerations may also become relevant. Consider the possibility that Canco may have investors that have a strong economic influence on the company. For example, Canco may even be economically dependent on an investor and thus subject to the investor’s de facto control (subsection 256(5.11)), which could result in an association relationship and loss of access to the small business deduction. Because de facto control does not extend to the determination of related or affiliated status, the financier would not be an “eligible group entity” under the EIFEL proposals.

Note also that, although it is the presence of a non-resident investor that causes Canco to be subject to the EIFEL regime, all of Canco’s financing costs become restricted, not only the financing costs that it paid to non-residents or other tax-indifferent investors. A specified non-resident shareholder can restrict Canco’s ability to deduct interest to loans from Canadian lenders, or even leasing costs, if Canco is not an excluded entity.

Remedial Measures for Canco?

We have considered (far from exhaustively) a few possibilities that Canco could consider to ensure that its financing costs remain deductible rather than become restricted by the EIFEL regime, assuming that the company exceeds the taxable capital and financing cost thresholds for excluded entity status:

  • Canco could ensure that non-resident investment does not meet the criteria for a specified shareholder, maintaining each non-resident investor below the 25 votes-or-value threshold of a specified non-resident shareholder. However, any significant financing costs paid to non-residents will also result in the loss of Canco’s excluded entity status, because non-residents are tax-indifferent investors. All or substantially all of Canco’s financing costs must be paid to other entities if it is to remain an excluded entity.
  • Canco could structure returns on non-resident debt that are non-deductible (for example, participating payments). Although it is counterintuitive to seek non-deductible costs of this nature, it is possible that if Canco, while avoiding direct equity investment, ensures that payments to tax-indifferent investors are non-deductible, it may be able to remain an excluded entity, thus avoiding EIFEL restrictions on its other interest and financing expenses.
  • Canco could also consider projections of future taxable income in order to assess the impact of the EIFEL restrictions. If Canco’s adjusted taxable income is expected to rise over time, the impact of these restrictions may be limited to manageable timing differences, such that avoiding the EIFEL regime may not require significant effort. Of course, future projections may fail to be realized, and falling short of expectations may be even more problematic when it is accompanied by the cash flow drawbacks of an increased income tax burden.


In summary, if the proposals for EIFEL are legislated in their current form, many Canadian businesses will need to review their capitalization strategies with respect to non-resident investors, because the involvement of these investors may restrict the deductibility of interest and financing expenses paid in respect of domestic and international financiers. This may end up discouraging foreign investment in Canadian business, which seems a poor policy for Canada. The proposed effective date of January 1, 2023 leaves little time for businesses to undertake such a review or for the subsequent implementation of any responsive measures. The draft legislation requires that amendments align with the best interests of Canadian business, and a delay of the effective date should be announced as soon as possible so that businesses have time to properly consider their alternatives.

Balaji (Bal) Katlai and Hugh Neilson
Kingston Ross Pasnak LLP, Edmonton

International Tax Highlights

Volume 1, Number 2, August  2022

©2022, Canadian Tax Foundation and IFA Canada

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