On Feb. 4, 2022, the Department of Finance (Finance) introduced draft legislation relating to Excessive Interest and Financing Expenses Limitation (EIFEL) rules, which implement the recommendations in Action 4 of the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting (BEPS) project.
The stated objective of the EIFEL rules is to address BEPS issues arising from taxpayers deducting excessive interest and other financing costs, principally in the context of multinational enterprises and cross-border investments.1 However, subject to certain exceptions, these rules can also apply to purely Canadian businesses. Note that these rules may apply in addition to other rules that restrict interest deductibility, such as the Canadian thin capitalization rules and the transfer pricing rules.
These rules were originally proposed to be effective for taxation years starting on or after Jan. 1, 2023, but Department of Finance issued a news release on Nov. 3, pushing back implementation of these rules to taxation years starting on or after Oct. 1, 2023. In this news release, revised draft legislation was provided with a public consultation period closing on Jan. 6, 2023. The information provided below reflects the revised draft legislation.
The fixed ratio rule
The EIFEL rules will limit “the amount of net interest and financing expenses, being the taxpayer’s total interest and financing expenses (IFE) less its interest and financing revenues, that may be deducted in computing a taxpayer’s income to no more than a fixed ratio of EBITDA”. The fixed ratio will be 40 per cent of EBITDA for taxation years beginning on or after Oct. 1, 2023, but before 2024. This will go down to 30 per cent for taxation years beginning on or after Jan. 1, 2024.
The group ratio rule
Where conditions are met and a group of corporations and/or trusts so elects, a higher group ratio may be applied in lieu of the fixed ratio rule. The group ratio rules allow a Canadian taxpayer to deduct interest in excess of the fixed ratio of 30 per cent (40 per cent for the transitional year) when the taxpayer is able to demonstrate that the ratio of the consolidated group’s net third-party interest expense to its book EBDITA exceeds the fixed ratio. The “consolidated group” is defined in the proposals as an ultimate parent and all the entities that are fully consolidated in the parent’s consolidated financial statements, or that would be if the group were required to prepare such statements under International Financial Reporting Standards (IFRS).
The EIFEL regime will apply to any taxpayer (corporation or trust) that is not considered to be an “excluded entity”. Excluded entities are generally:
- A Canadian-controlled private corporation that, together with any associated corporations, has taxable capital employed in Canada of less than $50 million
- A corporation or trust if, together with all other related and affiliated Canadian resident corporations and trusts, the total net interest and financing expenses for the group is not more than $1 million
- Certain standalone Canadian resident corporations and trusts, and groups consisting of Canadian resident corporations and trusts that carry on substantially all of their business in Canada, whose shares in all foreign affiliates have an aggregate carrying amount of $5,000,000 or less, and whose foreign affiliates own assets with an aggregate fair market value of $5,000,000 or less.
Though the rules are not meant to apply to purely domestic entities, the excluded entity exception is somewhat narrow. As a result, some taxpayers will not qualify as excluded entities and, therefore, these entities will be subject to the new restrictions on the deduction of interest and financing expenses, even though their activities are not motivated by tax avoidance.
The EIFEL rules allow taxpayers to carry forward:
- excess capacity to deduct IFE for three years as cumulative unused excess capacity; and
- restricted interest and financing expenses (i.e., IFE that is not deductible in the year) indefinitely.
In addition, corporations and fixed interest commercial trusts can generally elect to transfer excess capacity to other corporations and fixed interest commercial trusts within the same group.
Here are three examples of entities that would be in scope of the EIFEL regime if the taxable capital or interest thresholds are exceeded:
- A mid-sized Canadian business with a U.S. subsidiary whose assets have a fair market value greater than $5,000,000
- A domestic Canadian corporation with debt that is held, in part, by related non-residents
- A Canadian business controlled by a foreign private equity fund, regardless of whether any cross-border debt exists
Note that being in scope does not necessarily mean an organization will be subject to further restrictions on the deductibility of interest. These organizations will need to analyze their situation carefully in context of these rules.
- As described in the 2021 federal budget.