Author(s): Kim Maguire, Matias Milet, Firoz Ahmed, Ilana Ludwin
Nov 24, 2022
The Department of Finance released revised draft legislation and explanatory notes for the proposed excessive interest and financing expenses limitation (EIFEL) rules on November 3, 2022 (the Revised Proposals), concurrent with the Fall Economic Statement 2022. The revisions respond to submissions to Finance in response to the original draft legislation released on February 4, 2022 (the Original Proposals). While the Revised Proposals address many key issues raised in submissions to Finance and the delayed effective date provides taxpayers more time to prepare for implementation of the EIFEL rules, the rules continue to be highly complex and may impose a heavy tax and compliance burden on many taxpayers.
The deadline for providing comments on the Revised Proposals is January 6, 2023.
The proposed EIFEL rules contain limitations intended to address the deduction of interest and financing expenses (IFE), net of interest and financing revenues (IFR), that are considered to be excessive compared to earnings — or, more specifically, that exceed a fixed ratio equal to 30% of tax-adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), also known as “adjusted taxable income” (ATI).
This Update provides a summary of the key adjustments to the proposed EIFEL rules in the Revised Proposals. For an overview of the basic structure and original features of the EIFEL rules, see the Osler Update on the Original Proposals.
The EIFEL rules are now proposed to apply in respect of taxation years beginning on or after October 1, 2023, rather than January 1, 2023, as initially proposed. However, the higher 40% transitional fixed ratio will only apply for taxation years that begin before January 1, 2024. As a result, although taxpayers with taxation years beginning between January 1 and September 30 will not be subject to the EIFEL rules as quickly as initially proposed, they conversely will not be allowed to benefit from the higher transitional ratio.
The Original Proposals provided that a taxpayer that qualified as an “excluded entity” would be exempt from the EIFEL rules subject to a specific anti-avoidance rule now in proposed subsection 18.2(14). In the Revised Proposals, the requirements for the three categories of excluded entities have been relaxed, and a sector-specific exemption was also introduced.
Small CCPC exception: The taxable capital employed in Canada threshold for the so-called “small” Canadian-controlled private corporation (CCPC) exemption was raised from less than $15 million for the CCPC (together with any associated corporations) to less than $50 million. The increased threshold reflects the new top end of the phase-out range for the small business deduction proposed in the 2022 Federal Budget.
De minimis exception: The second exception is for taxpayers that, together with each “eligible group entity”, have IFE and exempt interest and financing expenses (net of applicable IFR) of $1 million or less for the particular year. Under the Original Proposals, the relevant threshold was $250,000 or less.
Domestic exception: The Revised Proposals also include adjustments to the exception for groups with no or minimal activities or entities outside of Canada and no material foreign ownership. While these adjustments will be meaningful to many taxpayers, they do not fully address concerns that the EIFEL rules go beyond the recommendations of the BEPS Action 4 Report. The changes include:
Canadian public-private partnership (P3) infrastructure projects: The Revised Proposals introduced a new exemption for expenses relating to certain Canadian public-private partnership (P3) infrastructure projects. The exemption can be found in the definition of “exempt interest and financing expenses” and only applies where all or substantially all of the relevant expenses are directly or indirectly borne by the public sector authority. Prior to this change, it was anticipated that entities engaged in such projects (which are typically highly-leveraged) would need to rely on the group ratio rules for relief from the 30% fixed-ratio limit.
One of the most significant changes introduced in the Revised Proposals are the proposals clarifying how foreign accrual property income (FAPI) and a foreign accrual property loss (FAPL) of a foreign affiliate controlled by a Canadian resident taxpayer will be treated under the EIFEL rules. The Original Proposals were generally silent on this front, leaving taxpayers to question whether FAPI and FAPL would be included in IFR or IFE, or simply form part of ATI.
Generally summarized, the Revised Proposals provide that FAPI and FAPL will be incorporated into the EIFEL rules as follows:
If enacted, these amendments would be applicable for taxation years of CFAs ending in the taxation year of a taxpayer beginning on or after October 1, 2023.
The EIFEL rules are intended to limit a taxpayer’s ability to deduct IFE that are considered excessive. The Revised Proposals contain a number of additions to IFE, including:
The definition of IFR is a very important concept for taxpayers since every dollar of IFR allows a taxpayer to deduct a corresponding dollar of IFE.
While the Revised Proposals do provide for additional inclusions in IFR — imputed interest income under subsection 12(9) and section 17.1 as well as “relevant affiliate interest and financing revenue” as described above — the definition of IFR was not amended to include all amounts of imputed income amounts. Notably there is no inclusion for amounts in section 17 or the hybrid mismatch arrangement rule in section 12.7.
Under the Original Proposals, interest earned by a taxpayer on loans to non-arm’s length non-resident corporations and partnerships did not generate IFR due to an anti-avoidance rule. This rule has been amended so that interest received or receivable from non-resident corporations should be included in IFR, subject to limited exceptions.
As defined, ATI means the taxpayer’s taxable income (Variable A) as adjusted for certain additions in Variable B and certain deductions in Variable C. The higher a taxpayer’s ATI, the more capacity it will have to deduct IFE.
The Revised Proposals also include adjustments to Variable C (which effectively reverses amounts otherwise included in taxable income), including income inclusions for “recapture” income and dispositions of resource properties or other recovery of resource expenses.
The Original Proposals allowed IFE that were denied under the EIFEL rules to be effectively carried forward for up to 20 years (or back for up to three years through the carry-forward of excess capacity). The 20-year restriction has now been removed, meaning denied IFE can potentially be claimed in any subsequent year in which the taxpayer has sufficient capacity.
The EIFEL rules generally permit taxpayers within an eligible corporate group to elect to transfer “cumulative unused excess capacity” to other group members under proposed subsection 18.2(4). Cumulative unused excess capacity is generally the total of the taxpayer’s “excess capacity” for the year and the three immediately preceding years, less “absorbed capacity” in those years and amounts transferred in previous years.
The Revised Proposals contain a number of changes to the proposed rules for the transfer and receipt of unused capacity among eligible group members:
The Original Proposals contain an alternative regime under which, if certain conditions are satisfied, Canadian group members can elect for a “group ratio” to apply instead of the 30% fixed ratio (or the transitional 40% fixed ratio). The group ratio rules are generally intended to provide relief for groups operating in sectors that are typically highly-leveraged.
The Revised Proposals include the following changes to the group ratio rules:
The concept of “excluded interest” allows two related or affiliated taxable Canadian corporations to elect for certain interest payments to be excluded from the IFE and IFR. One purpose of this concept is to accommodate typical loss consolidation arrangements within related and affiliated groups. The Revised Proposals expand the concept of “excluded interest” to apply to lease financing amounts and some partnerships (but still not to trusts). The rules are also adjusted such that interest paid or payable by a financial institution group entity cannot be “excluded interest” unless the payee is also a financial institution group entity.
The Revised Proposals replace the “relevant financial institution” concept from the Original Proposals with “financial institution group entity.” The new term is defined to include financial institutions such as banks and insurance companies that provide regulated financial services as their regular business, as well as other entities where substantially all of their activities support other financial institution group entities (e.g. back office services). While “relevant financial institutions” were prohibited in the Original Proposals from participating in the group ratio regime, no such restriction applies to a financial institution group entity under the Revised Proposals. Financial institution group entities will, however, be restricted in their ability to transfer excess capacity. Under the Revised Proposals, financial institution group entities can only transfer their excess capacity to other financial institution group entities within the same group (with a limited exception intended to accommodate loss consolidation arrangements in insurance company groups).
There are specific anti-avoidance rules sprinkled throughout the EIFEL rules, but the primary anti-avoidance rules in the Original Proposals were contained in proposed subsections 18.2(13) and (14). These provisions were intended to target transactions that would reduce a taxpayer’s IFE or increase a taxpayer’s IFR, respectively. The wording in proposed subsections 18.2(13) and (14) in the Original Proposals was very broad and sparked concerns among taxpayers that the rules could potentially apply where a taxpayer takes reasonable steps to mitigate the impact of the EIFEL rules (e.g. arranging for a non-related non-resident to assume debt to reduce the taxpayer’s IFE) or to other innocuous transaction.
In the Revised Proposals, the anti-avoidance rules in subsections 18.2(13) and (14) in the Original Proposals are consolidated into subsection 18.2(13) and, in some ways, significantly narrowed to capture specific types of transactions. If these anti-avoidance rules apply to a particular amount that would otherwise be included in computing IFR, or deducted in computing IFE, then such inclusion or deduction is denied.
Broadly speaking, proposed subsection 18.2(13) targets three categories of transactions:
In the explanatory notes to proposed paragraph 18.2(13)(c), Finance explains that the main purposes are generally determined from the perspective of the taxpayer whose IFR or IFE is impacted, as well as any other person or partnership who would benefit from the taxpayer’s increased capacity (including a person to whom the taxpayer transfers excess capacity).
Finance specifically notes in its explanatory notes to the Revised Proposals that proposed subsection 18.2(13) does not purport to address all scenarios that are “considered not to be appropriate in policy terms” and warns that the general anti-avoidance rules in section 245 may apply in such circumstances.
The proposed EIFEL rules represent a shift in both policy and in resources required by taxpayers to comply with increasingly complex income tax rules. If you have any questions or require additional analysis on the proposed EIFEL rules, please contact any member of our National Tax Department.
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Author(s): Kim Maguire, Matias Milet, Firoz Ahmed, Ilana Ludwin