EIFEL Rules: Planning for Domestic Private Businesses—TBD
On August 4, 2023, Finance released updated draft legislation, with
several changes to the proposed excessive interest and financing
expenses limitation (EIFEL) regime. The November 3, 2022 draft
legislation for this regime had broadened the exclusions available, with
a view to relieving CCPCs from the restrictions imposed by the rules.
However, the updated rules, if enacted, could still have an impact on
large successful Canadian private businesses. It is not unrealistic to
expect a business to exceed either the $50 million taxable capital
threshold or the $1 million interest and financing expense threshold,
especially in the context of capital-intensive businesses such as real
estate, construction, vehicle dealerships, and private health practice
chains, to mention only a few. (Insightful commentators on the new
regime include Kyle A. Ross and Trent J. Blanchette, who highlight these
exclusions, and the potential impact on CCPCs, in “Issues with the
‘Excluded Entity’ Exception to the EIFEL Rules” (
Tax for the Owner-Manager (2023) 23:4).)
EIFEL: Formulaic Legislation
Broadly speaking, under proposed subsections 18.2(1) and (2), the EIFEL
regime will determine “excessive” —and therefore non-deductible—interest
and finance expenses (IFE) for a taxation year. Under proposed
subsection 18.2(2), IFE will generally include ordinary interest and
financing expenditures that are otherwise deductible. In principle, the
deduction will be limited to 30 percent of taxable income before IFE and
CCA, although complex provisions will permit the capacity to be
transferred among members of a corporate group. If the “excessive IFE”
of a taxpayer is denied in one year, it is carried forward indefinitely
as “restricted IFE” and can be claimed in future years if the taxpayer’s
IFE in that year is less than the maximum deduction.
Finance’s explanatory notes discuss the details of each element in the
formula. In this article, our aim is to consider a simple, realistic
example of IFE and to show the impact of IFE on domestic tax planning.
Illustration of Denied or Restricted IFE
Consider Canco, a successful CCPC with a calendar year-end. Canco has
more than $50 million of taxable capital, and it incurs IFE in an amount
well over the $1 million threshold. Its common shares are held by a
holding company (Holdco), which is held by a family trust previously
created in the course of estate planning. One of the trust’s
beneficiaries, a child of the founder, gave up her Canadian residence in
the year. The “domestic exception” is unavailable, although Canco is
wholly based and operated in Canada.
Assume that, in 2025, Canco has taxable income of $2 million after
deducting IFE of $5 million and CCA of $1 million. Assume also that
Canco has no interest and financing revenue.
The proportion of non-deductible IFE is determined by the formula
(A − (B + C + D + E))/F. This formula may be applied to our example as
follows (leaving aside various aspects of these elements that are
inapplicable to this simple example):
- A = $5 million—Canco’s IFE;
- B = $2.4 million—Canco’s ATI (taxable income of $2 million plus IFE
of $5 million and CCA of $1 million) times the fixed ratio of 30 percent
proposed for 2025 and subsequent years;
- C = nil—Canco’s interest and financing revenues;
- D = nil—“received capacity” transferred from another corporation in the group;
- E = nil (assumed)—“absorbed capacity” relevant to amounts carried over from other taxation years; and
- F = $5 million (equals A, absent adjustments not relevant to this illustration).
This formula, producing 52 percent, results in denied IFE of
$2.6 million ($5 million × 52 percent). In this basic example, this
amount is equal to the amount by which IFE exceeds 30 percent of Canco’s
taxable income before CCA or IFE is deducted. This addback to Canco’s
taxable income increases that income from $2 million to $4.6 million.
The $2.6 million becomes restricted IFE, to be carried forward.
Impact on Safe Income
Because of the increase in Canco’s taxable income, additional taxes of
$728,000 will be payable (assume a combined federal and provincial
corporate tax rate of 28 percent), reducing Canco’s safe income on hand
(SIOH). Because the restricted IFE remains an economic cost, it too will
reduce SIOH, in accordance with the CRA’s historical interpretations
regarding non-deductible expenses.
Assume that Canco plans to pay a $1.5 million dividend to Holdco, an
amount based on the expected safe income from Canco’s 2025 operations
($2 million less $500,000 taxes, before IFE is considered). Assume that
the purpose of the dividend attracts subsection 55(2) exposure (for
example, the purpose of creditor protection, which CRA considers
offensive to the subsection), and assume that all SIOH from prior years
was distributed. Thus, subsection 55(2) will deem the amount of $728,000
(the additional tax cost) to be recharacterized as a capital gain,
which results in an unanticipated tax cost to Holdco at aggregate
investment income rates, albeit with the potential tax benefits of
capital dividend account additions, and the ability for Holdco to
recover refundable dividend tax on hand in the future.
Assuming that Canco is subject to the general-rate income pool (GRIP)
regime for the purposes of eligible dividends (that is, it has not
elected under subsection 89(11) to be treated as a non-CCPC and has
elected to track a low-rate income pool [LRIP] instead), the company
will likely have designated the dividend as eligible. The CRA believes
that an eligible dividend subject to subsection 55(2) does not increase
the recipient’s GRIP but does reduce the payer’s GRIP. On this basis,
the group has lost access to the ability to pay future eligible
dividends of as much as $728,000.
Although the deduction of the $2.6 million of restricted IFE, if it can
be claimed in a future year, should recover the $728,000 of income taxes
paid and should increase SIOH, future intercorporate dividends will be
unable to benefit from this addition if the value of the shares is not
sufficient to support this additional SIOH.
Planning Possibilities
Can Canco’s status as an excluded entity be restored? In our example,
such restoration would require either that the non-resident beneficiary
(the child of the founder) return to Canada or that she be removed as a
beneficiary of the trust. In many cases, neither alternative will be
practical.
Even if such a course were possible, Canco will be subject to the EIFEL
regime for all years in which these criteria are not met at any time in
the year. Furthermore, the legislation does not provide for the
deduction by an excluded entity of restricted IFEs from years in which
the entity was not excluded; therefore, Canco will be required to
continue determining its excess capacity on an ongoing basis so as to
determine whether any portion of its restricted IFE can be deducted in
future years.
When excluded-entity status cannot be regained, other strategies may
exist. Many owner-managers can choose to be compensated in the form of
either salary or dividends. Because salaries are deducted from corporate
income, they reduce deductible IFE. Adopting a dividend strategy for
remuneration would result in the retention of greater taxable income,
thus increasing deductible IFE. Of course, numerous other considerations
go into determining whether an owner-manager should be remunerated with
salary or with dividends.
In a similar vein, if financing through equity (for example, via
preferred shares) rather than through debt can reduce IFE, this choice
of financing would be another means of reducing excessive IFE. Again,
numerous other tax and non-tax considerations will bear on such a
strategic decision.
Conclusion
Although many CCPCs will be excluded from the proposed EIFEL regime, it
is clear that some larger private businesses will be affected.
Practitioners who focus on private business clients cannot afford to
ignore these proposals, which are to apply to years beginning on or
after October 1, 2023.
Balaji (Bal) KatlaiToronto
Hugh NeilsonVideo Tax News, and Kingston Ross Pasnak LLP, Edmonton
