Reconstructing EIFEL: Significant Amendments Introduced in November 2022 Revised Legislation

On November 3, 2022, Finance released a revised version of the proposed excessive interest and financing expenses limitation (EIFEL) rules, which will limit taxpayers’ deductions for interest and financing expenses (IFE) on the basis of their tax equivalent of earnings before interest, taxes, depreciation, and amortization (EBITDA).

The draft rules, first released in February 2022, have been deferred and are now proposed to come into force for taxation years commencing on or after October 1, 2023, which provides taxpayers with more time to prepare for these complex, formulaic provisions.

This article focuses on the main changes in the second set of draft proposals, which were subject to a consultation period that closed on January 6, 2023. For details on the original EIFEL proposals, please refer to our earlier (May 2022) article in this publication. Other articles in this issue of the newsletter cover specific issues arising from the interaction between (1) the EIFEL rules and section 216 returns for non-residents (see the article by Ken Griffin), and (2) the EIFEL rules and the foreign affiliate (FA) regime (see the article by Nathan Boidman and Eivan Sulaiman).

Although the rules are deferred, the number of taxpayers to which the higher transitional fixed ratio of adjusted taxable income (ATI) can apply has been reduced. The 40 percent transitional ratio (which, when applied to a taxpayer’s ATI, determines the allowable interest deduction for a year) will now apply only to taxation years ending between October 1, 2023 and December 31, 2023. As a result, calendar-year taxpayers will become subject to the rules for the first time in 2024, with the immediate application of the 30 percent fixed ratio proportion.

Exceptions to the Rules

The exceptions to the EIFEL rules were expanded through revisions to the exceptions for (1) Canadian-controlled private corporations with less than $50 million of taxable capital employed in Canada; and (2) taxpayers that are part of a group with a net group interest expense of less than $1 million. However, this net group interest de minimis threshold remains significantly lower than thresholds introduced by other OECD members that have implemented interest limitation rules based on the BEPS action 4 report.

The third exception to the rules, which seeks to exempt businesses that have substantially all of their operations in Canada, was extended such that

• the requirement to carry on the business in Canada is applied to each taxpayer and eligible group entity, rather than to “each business”;
• a taxpayer can hold de minimis FAs, unless their total book values or asset values are $5 million or greater; and
• the restriction on IFE paid to tax-indifferent investors is now limited only to those that are not dealing at arm’s length with the taxpayer.

The last of these is a welcome change for taxpayers with publicly traded debt that may be held by non-residents of Canada.

The third exception also requires that the taxpayer have no non-resident specified shareholder or beneficiary (broadly speaking, those that hold more than a 25 percent interest in the taxpayer). In the revised rules, this exception was further limited so as to prevent the requirement from being met in circumstances where non-residents hold this interest through a majority-held partnership.

In addition, the revised proposal includes an “exempt IFE” carve-out for private-public infrastructure projects (P3 projects), which could have otherwise led to adverse implications for the private partners. However, this is a limited, sector-specific exception, and other highly leveraged industries will need to continue to rely on other forms of relief provided in the rules (for example, the group ratio, the transfer of cumulative unused excess capacity, and the excluded interest election) to mitigate the impact of EIFEL.

Application of EIFEL to Controlled Foreign Affiliates

One of the more significant changes relates to the fact that the revised legislation now seeks to apply EIFEL, through the following new measures, to controlled foreign affiliates (CFAs) held by a taxpayer:

• Taxpayers are required to include their proportionate share of a CFA’s relevant affiliate interest and financing expenses (RAIFE) and relevant affiliate interest and financing revenues (RAIFR) in their own EIFEL limitation proportion calculation.
• RAIFE and RAIFR include only IFE amounts that are relevant in computing foreign accrual property income (FAPI), not IFE amounts deducted against active business income.
• If the taxpayer faces a denial of IFE deductions through the operation of proposed subsection 18.2(2), the limitation proportion is also applied to the RAIFE of the CFA, which may produce a FAPI inclusion or reduce a foreign accrual property loss (FAPL) for the taxpayer under the FAPI rules (with a similar rule to produce a FAPI inclusion or reduce a FAPL when the CFA holds a partnership that incurs denied IFE).
• The CFA will have no EIFEL attributes of its own; instead, non-deductible interest of a CFA contributes to the restricted interest and financing expenses (RIFE) of the participating taxpayer.

More detail regarding the application of EIFEL to FAs is provided in the article by Boidman and Sulaiman, elsewhere in this issue.

Amendments to Adjusted Taxable Income

ATI reflects a taxpayer’s capacity to deduct interest expense in any taxation year, broadly starting with the taxpayer’s taxable income or non-capital loss for the year, with adjustments to result in a tax-EBITDA equivalent.

First, the starting point for ATI has been amended to remove the inclusion of net capital losses. Adjustments to increase ATI now include an addback of the resource pool expenses deducted, and of terminal losses. The adjustment for non-capital losses arising in another taxation year has also been significantly amended to require taxpayers to consider the proportion of the loss arising in the “loss year,” which relates to amounts (IFE, interest financing revenues [IFR], and CCA, for example) that would be adjusted for the purposes of determining ATI in that “loss year.” In addition, ATI is not adjusted for “exempt IFE” arising from the new public-private infrastructure exemption introduced.

Reductions from ATI now also include the removal of both (1) any recaptured depreciation included in taxable income in the year, and (2) income earned that is attributable to the new category of exempt IFE.

The ATI definition also includes a number of changes reflecting the fact that the rules now apply to CFAs. These amendments include (1) a change to the portion of FAPLs that relates to net RAIFE in the starting point of the taxpayer’s ATI, and (2) a similar upward adjustment to ATI for FAPLs being utilized in a current year that arose in another affiliate’s “loss year.”

Certain amendments were also introduced to the way in which ATI is determined for a trust upon the addback of amounts that flow to beneficiaries, so as not to include adjustments on dividends flowing out that are designated as taxable dividends (with a similar rule aimed at removing designated dividends from the adjustment to a beneficiary’s ATI for amounts received from a trust).

Defining Interest and Financing Expenses/Revenues

The inclusion of capitalized interest in IFE has been amended so that only amounts paid or payable after February 4, 2022 (the original EIFEL release date) should be included. A similar grandfathering rule is applied to the inclusion of terminal losses, which are now included in IFE—but included only to the extent that they relate to interest and financing expenses paid or payable after February 4, 2022.

IFR now explicitly includes certain amounts of deemed interest income prescribed by other rules in the Act, including deemed interest income on a pertinent loan or indebtedness (PLOI) or accruals in respect of specified debt obligations. Notably, subsection 17(1) deemed interest income has not been included in the definition of IFR; the explanatory notes do not provide an explanation for this.

As noted above, both IFE and IFR for the taxpayer now include RAIFE and RAIFR, which are relevant in computing FAPI for CFAs—meaning that no separate limitation proportion is calculated for CFAs. For RAIFR, the inclusion in the taxpayer’s IFR is reduced by the amount of any deduction claimed for foreign accrual tax (FAT) in respect of this income.

Clarifications were also made to IFE regarding the inclusion of amounts paid as a result of certain agreements or arrangements that may include a cost of funding. The amendments clarify that hedges of the cost of funding are explicitly included. Similar clarifications were made regarding the inclusion in IFR of returns received by a taxpayer from hedging arrangements. Both provisions continue to be worded broadly and may need consideration in the context of wider agreements or arrangements entered into by taxpayers (beyond hedging arrangements) that could be considered to have a “cost of funding” or “return” element involved for the taxpayer.

Relief Mechanisms: Changes to Transferring Capacity, Excluded Interest, and the Group Ratio Rules

For taxpayers seeking to share cumulative unused excess capacity (CUEC) among Canadian group members, the condition that taxpayers must have the same Canadian tax-reporting currency was removed, and the ability to share capacity was extended to “fixed interest commercial trusts.” It should be noted that the draft rules still render an election invalid if the amount claimed is even $1 greater than the CUEC available to be claimed. Although the ability to make late or amended elections has been introduced, the acceptance of these elections is in certain cases at the discretion of the CRA.

The ability of entities to classify interest expense or income as “excluded interest” has now been extended to partnerships whose partners are entirely taxable Canadian corporations and eligible group entities. This may prove problematic for partnerships with minority partners that were hoping to rely on the election being extended to partnerships. Using this election, taxpayers can also now exclude “lease financing amounts,” along with interest expense/income from the EIFEL rules.

The group ratio rules, which can enhance deduction capacity if the external financing deductions of the group as a whole represent a higher proportion of group EBITDA than the fixed ratio limit, were amended to remove any reduction in the calculated group ratio. The group ratio is determined as group net interest expense (GNIE) over group adjusted net book income (GANBI), but the February proposals included a formulaic reduction whereby the resulting ratio exceeded 40 percent, further limiting the benefit of applying the group ratio. This is no longer the case, and taxpayers looking to apply the group ratio will obtain the full benefit of their actual GNIE/GANBI ratio.

The group ratio rules are based on audited consolidated financial statements, and the introduction of other acceptable accounting standards, including those of many European jurisdictions, will be welcomed by Canadian taxpayers with ultimate parents in these territories.

Like the conditions for the transfer of CUEC election, the conditions for the group ratio election have also been relaxed, such that entities no longer require the same taxation year-end or Canadian tax-reporting currency in order to participate in the relief. However, no guidance seems to have been provided on how taxpayers should convert amounts in situations where there are multiple currencies involved.

Financial Institutions: Amended Definitions and Revised Limitations

Certain limitations on the application of the EIFEL rules to financial institutions—now termed “financial institution group entities” (FIGEs)—have been introduced. These changes include

• restricting the transfer of CUEC only to other FIGEs or very limited special-purpose entities;
• restricting the availability of the excluded interest election if the recipient is a FIGE but the payer is not; and
• enabling FIGEs to apply the group ratio rule—although, in many cases, the group ratio rule is unlikely to be beneficial because of the net group interest income expected to be earned by FIGEs.

Changes to Tax Attributes

The carryforward period for RIFE is now indefinite. This is a welcome change, given the many possible circumstances where it could be difficult to utilize an amount of RIFE because of the requirement that there be sufficient future ATI earned by the taxpayer (or group).

There were no major amendments to the carryforward of CUEC, which can be carried forward for up to three years. Similarly, the pre-regime election, which enables taxpayers to bring up to three years of CUEC into the regime at commencement, has not been significantly amended.

No changes were made to the rules providing that excess capacity is forfeited on a loss-restriction event, whereas RIFE generally survives to the extent that the interest relates to a source that generates income from a business and the taxpayer continues to carry on the same business following the loss-restriction event.

Revisited Anti-Avoidance Provisions

A significant relaxation of the problematic IFR anti-avoidance provision was made, such that this rule should no longer target IFR that is created on all financing to a non-arm’s-length non-resident (for example, an FA).

Instead, the new anti-avoidance rule, which covers both IFR and certain amounts that reduce IFE, applies only in circumstances where

• amounts are deductible in computing the FAPI of a non-controlled FA;
• IFR is received from a person that does not deal at arm’s length with the taxpayer and that is an excluded entity, an individual, or a FIGE (if the taxpayer itself is not a FIGE); or
• one of the main purposes of a transaction or series of transactions is either to increase IFR or to increase a certain amount that reduces IFE, where certain conditions apply.

The previous IFE anti-avoidance rule has been removed, and the new combined anti-avoidance rule in proposed subsection 18.2(13) covers only certain amounts that reduce IFE. Finance’s explanatory notes continue to mention that taxpayers should also consider the general anti-avoidance rule (GAAR) in connection with any planning they may be considering.

Conclusion

Although the deferral of the EIFEL rules’ implementation is helpful, the complexity involved in their application to Canadian taxpayers and, now, to CFAs means that taxpayers should not wait to establish an understanding of their expected interest deductibility profile under EIFEL.

Furthermore, backward-looking measures, such as the “pre-regime” election (which must be filed in the first taxation year to which EIFEL applies), require additional calculations that should be completed now.

Before the EIFEL rules begin to apply, taxpayers that, on the basis of modelling, anticipate a restriction may want to consider rationalizing or reorganizing their Canadian intragroup debt, including FA debts.

Many taxpayers are finding that scenario-based modelling is the key to understanding the implications of these formulaic new rules and to ensuring that the most beneficial elections are made when the rules are enacted, particularly in an environment where Canadian taxpayers, even before they consider the implications of EIFEL, have to navigate the adjustments imposed by transfer-pricing, thin capitalization, and hybrid mismatch rules.

Ken Buttenham and Alex Cook
PwC LLP Canada, Toronto