Understanding the proposed EIFEL rules

Draft legislative proposals for the excessive interest and financing expenses limitation (EIFEL) rules were introduced in early 2022 to limit interest and other financial cost deductions in accordance with an entity’s taxable earnings in Canada.¹ These rules are consistent with the recommendations made under Action 4 of the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting Project² and are set to be in effect for taxation years beginning on or after October 1, 2023.

While the rules have not yet been enacted—and may be subject to further changes before being passed into law—the current draft legislation has a much broader reach than the stated target of multinational entities and cross-border investments. If enacted as they currently stand, the rules could have a significant impact on domestic entities by restricting deductions of interest and financing expenses (IFE) that are otherwise deductible after the application of other provisions in Canada’s Income Tax Act, including general interest deductibility and thin-capitalization rules.

The EIFEL rules summarized

The proposed rules³ would apply to any taxpayers that are corporations or trusts, with the exception of “excluded entities,” as described in the next section. Although partnerships would not be directly affected, any IFE allocated to corporate or trust partners would be included in their respective EIFEL calculations.

The EIFEL rules would restrict the deductibility of IFE to 30% of the taxpayer’s adjusted taxable income (ATI) for the year, which is EBITDA (earnings before interest, taxes, depreciation, and amortization) adjusted for tax purposes. There would be a transitional period for taxpayers with taxation years starting between October 1, 2023, to December 31, 2023, where the deductible IFE is up to 40% of ATI.

The calculation of ATI would start with an entity’s taxable income before IFE, capital cost allowances, and various other adjustments. Since a corporation’s taxable income would be calculated after the deduction for intercorporate dividends, corporations that earn dividend income would not be able to rely on the dividends earned to increase the deduction room for IFE. Moreover, because ATI would also be reduced by non-capital losses carried forward and deducted in the year, taxpayers could find themselves with a lower ATI even when they have a profitable year.

Generally, if a taxpayer’s IFE is greater than the allowable deduction as determined by the fixed ratio (i.e., 30% or 40%) of ATI, the restricted IFE could be carried forward indefinitely. If a corporation’s net IFE is lower than the allowable deduction, the corporation would have an “excess capacity” that could be carried forward for up to three tax years. The excess capacity would have to be used to shelter the taxpayer’s own restricted IFE carried forward (i.e., the ordering rule). Any excess capacity could be transferred under a joint election to another corporation in the eligible group entities and could then be deducted by the transferee corporation.

With the EIFEL rules being potentially punitive to businesses and adding extra complexity to an already complex tax reporting system in Canada, it is not surprising that business owners and their tax advisors want to be excluded from them.

Excluded entities

As noted in the previous section, the proposed legislation includes an exception for excluded entities. An excluded entity is defined as any of the following:

1. A Canadian-controlled private corporation that, together with any associated corporations, has taxable capital employed in Canada of under $50 million;
2. A Canadian corporation or trust that, together with other entities (each being an eligible group entity), has aggregate IFE (net of interest and financing revenues) of $1 million or less; or
3. A Canadian corporation or trust that, together with other entities (each being an eligible group entity), carries on substantially all of its business in Canada, where non-resident persons do not have material interest in any group members, and no group members have material investments in any foreign affiliates. Further, no group member could have more than 10% of its IFE payable to a tax-indifferent investor that does not deal at arm’s length with any group members. The definition of a tax-indifferent investor includes, but is not limited to, discretionary trusts and not-for-profit organizations.

While it is encouraging to see the increased thresholds of $50 million for taxable capital and $1 million for net IFE, private companies in highly leveraged industries (e.g., real estate) could still find themselves not qualifying as excluded entities under the first two conditions. These companies would potentially need to rely on the third test to be excluded, which would require deeper analysis of the taxpayer and each eligible group entity’s activities.

Eligible group entities

Under the proposed rules, an eligible group entity would generally be defined as a corporation or trust that is related to or affiliated with (with modification) a taxpayer. A discretionary trust and its beneficiary would also be considered eligible group entities in relation to each other. Further, there is a deeming rule (similar to the association rules) which stipulates that where two taxpayers are eligible group entities to a common third person, all three taxpayers would be considered eligible group entities. Unlike the association rules, however, the EIFEL rules do not provide an election to the third taxpayer that would enable them to break the connection between the other two taxpayers (those that are otherwise not eligible group entities with respect to each other).

The broad scope of the definition means that two businesses operating independently—each controlled by two related persons—would be considered to be the same group. For example, say “Brother A” controls a corporate group in the real estate sector solely in Canada. Assuming the taxable capital and the IFE exceed the exemption threshold, Brother A would need to look at the third exemption to be considered an excluded entity. And if “Sister B” controls a software company with a large equity holding by non-resident persons, Brother A’s business would not qualify as an excluded entity.

The above scenario highlights the difficulty in assessing the application of the proposed rules. Professionals would not only need to understand their clients’ businesses, shareholders, and foreign investments, but would also have to be aware of anyone related to or affiliated with the taxpayer—as well as any discretionary trusts of which the client is (knowingly or not) a beneficiary—that could put the taxpayer offside.

Net interest and financing expenses

The definition of “interest and financing expense” under the proposed rules is critical, as it would have a direct impact on the amount that could be denied as a deduction in the relevant taxation year. Very generally, it would capture any amount deducted in the year that could legally constitute interest expense; however, it would also include other amounts incurred due to financing arrangements.

The definition is the sum of various amounts, including but not limited to the following:

• Interest expense that would otherwise be deductible (not denied by other sections of the Income Tax Act) in the year;
• Financing expenses, including those that would be capitalized for tax purposes and deductible over several years;
• The portion of an amount that would be capitalized as part of the undepreciated capital cost of assets and deducted in the year (either by way of capital cost allowance or terminal loss), as well as other amounts that would be capitalized in resource-expense pools;
• Loss or capital loss that is not captured in any of the other paragraphs in the definition and that could reasonably be considered part of costs with respect to financing;
• The portion of a lease payment that would represent the financing cost; and
• Any of the above amounts that would be included in the calculation of income from a partnership or a controlled foreign affiliate as part of the taxpayer’s income.

Any amount of income or gain made as a result of hedging against the above costs, in addition to “interest and financing revenues,” could be deducted from the above amounts to derive the net IFE being considered for deduction under the proposed rules.

Additionally, two taxable Canadian corporations of the same corporate group (not applicable to trusts) could elect to have intercorporate interest or lease financing amounts excluded from the calculation of net IFE and ATI.

Group ratio method

Under the proposed rules, a group of corporations or trusts, each being an eligible group entity and a member of the same consolidated group, could jointly elect to use the group ratio method rather than the fixed percentage of ATI to determine deductible IFE. This method could provide a group of taxpayers with a greater deductible IFE compared to the fixed ratio method, and is meant to benefit groups with net third-party interest expense that is higher than the fixed ratio.

To use this method, the group under the same ultimate parent would have to report under audited consolidated financial statements, which would eliminate intercompany IFE for the relevant period. Additionally, the Canadian group members would have to jointly elect into this method for the relevant taxation year.

Generally, the group ratio would be calculated by dividing the consolidated group’s net interest expense by its adjusted net book income under the consolidated statements. Amounts would be allocated (subject to limitations) to each Canadian group member for each relevant period, thus forming the basis to calculate the excessive IFE for the taxpayer.

Using the group ratio method, the taxpayer’s excess capacity would be deemed to be nil and no amounts could be carried forward to subsequent years or transferred to another corporation.

Next steps

Although the EIFEL rules were announced as measures designed to prevent multinationals from claiming excessive IFE and eroding the Canadian tax base, the wide net cast by these rules could ensnare many domestic groups as well. Accordingly, domestic entities with significant IFE should review the proposed rules to determine whether they would fall within the exclusions and to assess the potential impact on their bottom line and the added complexity in tax compliance.

Edmund Chow, CPA, CGA, is a senior tax manager at Smythe LLP in Vancouver, where he specializes in tax advisory and tax compliance services for owner-managed businesses.

Footnotes