The EIFEL Rules: A Significant Reduction to Interest Deductions
Authored by Vincent de Angelis, CPA, Partner, Richter; Jenna Schwartz, LL.B., B.C.L., Vice President, Richter; Anthony Arquin, Partner, Davies; and Marc André Gaudreau Duval, Partner, Davies
As originally appearing in Espace Montreal, volume 31, #2, 2022.
Interest Deduction Limitations in Canada
Real estate is by nature an asset class with an accepted degree of financial leverage. Managing that leverage model from the initial acquisition through the holding period to the eventual divesture is critical to maximizing an investor’s return. One of the benefits of debt attached to real estate or any asset class is the deductibility of interest charges against income for tax purposes. This deductibility provides for cash tax savings and a heightened return on investment. That is, each dollar of deduction against income allows a taxpayer to a savings of taxes that would otherwise be payable.
Recent tax proposals from Finance Canada are looking to add additional restrictions to the deductibility of interest when determining income for tax purposes and are known as the “Excessive Interest and Financing Expense Limitation” rules or “EIFEL” rules.
These draft proposals stem from the initiative of the Organization for Economic Co-Operation and Development’s (“OECD”) project to limit the base erosion of profits (“BEP”) for multinationals. More specifically, the initiative as it relates to interest charges is intended to limit the stripping of profits by way of the charges of interest within the international community. The intention is to create greater equity in the taxation of global profits and to eliminate the ability to allocate profits to countries or jurisdictions with lower or no income taxes.
By way of context, Canadian income tax laws currently include other restrictions on the deductibility of interest for tax purposes. For example, in a set of rules known as the “thin-capitalization rules”, interest deductions are denied when a taxpayer borrows from certain related foreign stakeholders and is capitalized in a matter that exceeds a 1.5 to 1 ratio of debt to equity. Any amount of interest in excess of this threshold may be considered as a profit repatriation to shareholders who reside outside of Canada and is consequently considered a “deemed dividend” which is subject to Canadian withholding tax.
These thin-capitalization rules imply that there is an inherent tolerance for a 60:40 debt to equity split in the Canadian income tax legislation. This example of a limitation to interest deductibility has as one of its objectives to protect the Canadian income tax base of profits from leaving Canada with no incident, or a significantly reduced incident, of Canadian income taxes. That is, absent these rules, a reduction of corporate profits by way of an interest deduction leads to a Canadian corporate tax savings in the range of $25-$27 dollars for each $100 of interest expense. This corporate tax savings may be reduced by a need to withhold Canadian taxes on the payment of interest to the foreign stakeholder.
It should also be noted that Canada has extensive transfer pricing legislation which, even when then the thin-capitalization ratio is met, might reduce interest expenses paid to non-residents if they exceed what is reasonable.
What is the EIFEL?
The EIFEL rules apply in addition to the existing thin-capitalization and transfer pricing rules. These EIFEL rules are very broadly drafted. As a result, their impact will extend far beyond multinationals as well as beyond the ambit of other interest limitation rules. In fact, traditional Canadian real estate investors are likely to be impacted as are interest payments made to traditional third-party lenders.
The EIFEL rules will apply to corporations and trusts. Where real estate is held through a partnership, the corporation or trust will have to consider the partnership’s interest and other financing expenses in determining its EIFEL application.
Given the broad application of these rules, and the degree they will impact taxpayers, Finance Canada has requested and received comments from stakeholders across Canada, including the Joint Committee on Taxation of The Canadian Bar Association and Chartered Professional Accountants of Canada. Likewise, a variety of industries are responding as they begin to understand the impact of these rules to their own stakeholders. As of the date of publication of this article, Finance Canada has begun to review these proposals and intends to make modifications to the proposed rules with the goal of enactment for taxation years starting after January 1, 2023. It is hoped that the revisions to legislation will be announced with enough time for taxpayers to properly prepare.
The EIFEL rules propose to restrict the deductibility of interest and other financing costs in a fiscal period. In this instance, interest and financing costs include interest on debt, depreciation of capitalized assets that has a reasonable link to the payment of, or in satisfaction of an interest expense, leasing costs and partnership financing costs. It will do so by limiting the deduction of interest to a permissible percentage of “adjusted taxable income”, which is comparable to the concept of earnings before interest, taxes, depreciation and amortization (“EBITDA”). In the initial year of the law’s enactment (currently, 2023), the rate to apply will be 40% and thereafter the rate will be 30%.
The EIFEL rules must also consider the impact not only to the one taxpayer determining its income for tax purposes but also to those in the same “eligible group”. This defined group includes companies that are related to each other. As a simple example of a related group, one may consider a group of corporations that have the same shareholder or ultimate shareholder. The definition also addresses relationships where trusts (which are common in a Canadian context) are found in the ownership structure. As will be shown below, it is necessary to look at the entire “eligible group” to determine if a taxpayer is exempt from the EIFEL rules or if certain elections can be made to decrease the impact of these rules for the group.
As a simplified example of the application of the proposed EIFEL rules, assume in 2020, a taxpayer has acquired a building and completed renovations to that building. The total cost for tax purposes was $15 million. The taxpayer financed $10 million of the cost at an interest rate of 5%. The interest expense claimed in the 2023 period is $500,000. The taxpayer’s depreciation claim for 2023 for tax purposes related to past capitalized interest during the period of renovation is $20,000. The taxpayer arrives at a zero balance in determining its income for tax purposes before the application of the EIFEL rules. Upon the application of the EIFEL rules, the taxpayer’s adjusted income or “EBITDA” income will become $520,000 (being the $500,000 of interest plus the $20,000 of tax depreciation). In applying the EIFEL rules, and assuming the use of a fixed ratio of 40% (note this ratio will be 30% for years after 2023), the taxpayer would be limited to a deduction of interest and financing cost of $208,000 so that its adjusted taxable income would now be $312,000 (being, $520,000 minus $208,000). Assuming the taxpayer in this example pays tax at a rate of 25%, the tax payable is now $78,000 where it was otherwise nil before the application of the restriction on deduction of interest under these EIFEL rules. The deduction of $312,000 not claimed may, if available, be used by the taxpayer in the future for a period up to 20 years but only when it may satisfy the EIFEL limitation.
The above example is intended to be simplistic to illustrate the impact of the EIFEL rules but there are complex definitions and considerations that must be reviewed by a taxpayer and their advisor before arriving at the final EIFEL adjustment in a taxpayer’s annual filing. For instance, if there are multiple companies in a group, there may be scenarios where some of those companies may have excessive interest and financing expenses and others that do not. Consequently, an election is provided to pass excess capacity with other members within an eligible group of corporations.
As is often the case, there are arrangements in corporate groups where one borrower in the group lends funds to another member of the eligible group. The EIFEL rules accommodate for these sorts of arrangements to effectively nullify the impact of intercompany interest revenues and expenses unless those revenues are derived from companies in the group that are not Canadian companies.
In certain circumstances, the taxpayer may also elect to apply a special “group ratio” regime that may entitle it to a higher ratio of permissible interest deductions. This calculation is based on a consolidated group’s ratio of net third-party interest expense to its book EBITDA. Under this regime, the amount of deductible interest is determined on a group basis and is allocated between the entities. In order to elect under these rules, the taxpayer must meet a number of conditions, including the requirement to have audited consolidated financial statements (or audited financial statements in the case of an entity that is not part of a consolidated group). This election is made on an annual basis and must be jointly filed by all the members of the consolidated group. While the application of this regime is intended to allow certain highly-leveraged taxpayers to deduct more interest than they would under the fixed ratio, if there are significant book to tax differences that result in a lower book income, the use of the “group ratio” rules may not be beneficial. There are also several interpretive issues on how these rule could apply.
EIFEL Exceptions are Limited
As mentioned earlier, the EIFEL rules are intended to address multinationals engaged in utilizing excess interest deductions to minimize income for tax purposes. As such, the EIFEL rules, under this theme, provide exceptions so that certain taxpayers will be exempt from their application, if these taxpayers AND its eligible group of entities (the “Group”) meet certain conditions. As of the date of the publication of this article, those exceptions apply to (i) a Canadian Controlled Private Corporation with less than $15 million of taxable capital employed in Canada or (ii) a Group whose total interest and financing expense does not exceed $250,000.
A taxpayer will also be exempted from the EIFEL rules if it meets all of the following sub-conditions: (a) all or substantially all of the Group’s business is carried on in Canada; (b) the Group does not own shares in a foreign affiliate; (c) the Group does not have corporate shareholders or trust beneficiaries that are specified non-residents of Canada; and (d) all or substantially all of the Group’s interest and financing expenses are paid or payable to “non-tax indifferent” investors.
The above exceptions may be viewed as narrow at best. For instance, the conditions of the exclusions are based on the Group in addition to the taxpayer, which makes it necessary to look at the Group’s interest and financing expenses. In a real estate setting where leverage is a general accepted model, it does not take a large portfolio to arrive at $15 million of capital or $250,000 of interest expense.
Moreover, the remaining exemption dealing with businesses “substantially” carried out in Canada has practical limitations. It is not uncommon to diversify real estate holdings by owning foreign real estate or having foreign companies that invest in real estate. This disqualifies many taxpayers from benefiting from this exemption. Additionally, a taxpayer may own real estate exclusive to Canada, without foreign ownership in its structure and still fall into their application if they borrow from a “tax indifferent investor”. A tax indifferent investor captures several common real estate lenders, including tax exempt entities. These limitations are exacerbated by the fact that these tests apply to the Group rather than the taxpayer in question. It is also not clear why, in a Canadian private family structure, why the existence of a non-resident shareholder could engage these rules when there is no transfer of funds out of Canada.
Current State of The Draft Legislation
The exchange between Finance Canada and the Canadian stakeholders is in progress. In response, Finance Canada has indicated that it would consider expanding the scope of its exceptions by increasing the capital limit for Canadian Controlled Corporations from $15 million to $50 million and increasing the $250,000 interest and financing expense exemption to align with of other countries who have enacted similar rules to participate in this OECD initiative. For example, it is understood that certain European countries utilize 2-3 million euros of interest and financing expense as their threshold.
For Your Business
Your real estate holdings may be impacted by these draft proposals. If these rules apply to you, the limitation on interest deductibility will have a cost to your capital structure, notably at a time when interest rates are on the rise and market pressures exist in certain sectors. You may want to consider working with your tax advisor now to determine if you qualify for any of the EIFEL exemptions. If one misses the exemption because of say a minority non-resident shareholder, it is perhaps time remains to consider right sizing your debt and equity stakeholders to respond to these draft rules.
In the absence of an exemption, you may start to consider preparing a financial model to understand the impact to your cashflow due to an increased tax burden. The additional tax liability may reduce cash available for intended capital expenditure, reduction in debt or distribution to shareholders and investors. Alternatively, it may prompt the need to challenge the marketplace and demand higher sale prices or rental earnings from your end use of real estate to neutralize the impact of these rules.
For those familiar with organizing year end financial detail for tax filings, these proposals will represent a need to invest more time in preparation. It will be necessary to quantify the interest and financing expenses for each company in the group, make determinations as to the benefit of certain elections and ultimately to determine the underlying interest that will be denied.
The rest of 2022 will be a challenging period as we start to evolve past the pandemic, learn to navigate through increased interest rates and now, look to manage the EIFEL proposed draft legislation. There certainly is no shortage of challenges ahead.