Implications of New EIFEL Rules on Real Estate and Construction Companies
One of the key measures introduced in the 2022 Federal Budget on April 7, 2022, was the Excessive Interest and Financing Expense Limitation (EIFEL) regime, which is a response to the recommendations of Action 4 of the OECD/G20 BEPS Project to limit interest deductions to correspond with an entity’s economic activity within the jurisdiction.
These rules are meant to target multinational companies using third-party and related-party interest to shift profit to a low tax jurisdiction for overall favorable tax result. The draft legislation was later amended in the Fall Economic Statements of November 2022.
In this piece, we will be looking at the details of the EIFEL rules and what implications it may have for real estate and construction (REC) companies.
With the EIFEL rules being potentially punitive to businesses and adding extra complexity to an already complex tax reporting system in Canada, it is hardly surprising that business owners and their tax advisors would want to be excluded from the rules. For this reason, being an “excluded entity” with respect to the rules is very important, as is continuously monitoring one’s status to avoid accidentally getting caught by the rules.
The proposed legislation outlines several conditions that will exclude a particular company or taxpayer from being subject to the EIFEL rules. These include:
- Canadian-controlled private corporation (CCPC) in an associated corporate group with taxable capital employed in Canada of less than $50 million.
- Groups of Canadian corporations and trusts with aggregate net interest expense of $1 million or less.
- Groups of Canadian corporations and trusts that carry on a substantial part of their business in Canada. In addition, non-resident persons do not have material interest in any group members and no group members have any material investments in any foreign affiliates. Finally, no amount of interest and financing expense except for an immaterial amount can be paid to tax-indifferent investors that do not deal at arm’s length with the taxpayer or any group members.
There are many small or medium-sized businesses who will fall within the threshold of the taxable capital of $50 million or net interest and financing expense of $1 million. For the REC industry, though, the picture might not be as rosy since businesses in this space tend to be highly leveraged and accumulate taxable capital.
This is compounded by the untimely rise in interest rates since the EIFEL rules were introduced in the Spring of 2022. This means most REC companies will need to rely on the third test, which exempts taxpayers that have a substantial part of their business in Canada.
Components of the Rules
The key components of the EIFEL rules are as follows:
- The new rules apply to taxpayers that are corporations or trusts. Partnerships are impacted on a look-through basis to the members of the partnerships.
- There are exceptions to the rules if the taxpayer is considered an “excluded entity” (see below), which may be especially relevant for the REC sector.
- Taxpayers subject to the rules are limited to deduct net interest and financing expenses of up to 30% of each taxation year’s adjusted taxable income, which is a tax version of Earnings Before Interest, Taxes, and Amortization (EBITA).
- It will be effective for tax years beginning on or after Oct 1, 2023. There is a transition period where the percentage of deductible net interest and financing expenses is 40% of the tax EBITA if the year started before January 1, 2024.
- A corporation in an eligible group entity can transfer unused deduction room or “excess capacity” to another corporation of the eligible group entity.
- Unused excess capacity can be carried forward for up to three taxation years to deduct interest and financing expenses in those years.
- Net interest and financing expenses that are restricted as deductions can be carried forward indefinitely to be used against excess capacity in future years.
- A group ratio method is also available where group of entities under a parent’s consolidated financial statements may allocate permitted deduction within the group as long as the amount allocated does not exceed the allowable ratio (i.e., 30% or 40%) to the group’s tax EBITA. However, a corporate group that elects to use the group ratio method will be deemed not to have any excess capacity in that year.
What Are Net Interest and Financing Expenses
The definition of “interest and financing expense” is critical as it directly impacts the amount that could be denied as a deduction in the relevant taxation year. Very generally, it captures any amount deducted in the year that could legally be an interest expense but also includes other amounts incurred due to financing arrangements. The definition is the sum of various amounts, including but not limited to the following:
- Amount of interest expense that is deductible (not denied by other sections of the Income Tax Act) in the year,
- Financing expenses that are capitalized for tax purposes and deductible over several years,
- The portion of an amount that is capitalized as part of the available undepreciated capital cost of assets and deducted in the year (either by way of capital cost allowance [UCC] or terminal loss), as well as other amounts capitalized in resource-expense pools,
- Loss or capital loss not captured in any of the other paragraphs in the definition, but can reasonably be considered part of costs with respecting to financing,
- Portion of a lease payment that represents the financing cost, and
- Any of the above amounts are included in the calculation of income of a partnership or a controlled foreign affiliate as part of the taxpayer’s income.
Any amount of income or gain that is as a result of hedging against the above costs may be deducted to derive at the interest and financing expense.
Just as important is the definition of “interest and financing revenues”. This amount reduces the interest and financing expenses of a taxpayer to arrive at a net amount that may be deducted in the year. Essentially, it creates extra room for a taxpayer to deduct interest and financing expenses. It is also included in a taxpayer’s “excess capacity”, which can be transferred to another company in the group in the year or can be carried forward to future tax years.
The definition is similar to that of interest and financing expense, but as income from the perspective of a creditor. Certain paragraphs in the expense definition are not relevant (i.e., UCC or resource-expense pool), but certain deemed income that is included in the calculation of the taxpayer’s income becomes relevant.
Intercorporate Revenue and Expense
Two members in the same corporate group can elect to have intercorporate interest or lease financing amount to be excluded from the calculation interest and financing expense and revenue. These amounts would also be disregarded in computing a taxpayer’s tax EBITA (i.e., interest expense will not be added, and revenue will not be deducted for the calculation). The election should be made in the year when the interest or financing amount is deductible or included in income, as opposed to the year when it is paid or received.
As with many other new tax rules, the devil is in the details. Businesses should not brush off these tax changes simply because they do not perceive themselves to be multinationals with excessive interest or financing expenses. It is doubly important that real estate and construction companies review the EIFEL rules and their applicability, given that there are already a number of laws governing ownership and operations of all REC activities.
The second consultation period for these tax changes ended on January 6, 2023, so it may not be long until the final version of the legislation is released, and the proposals become law. Now is the time for business owners to undertake a detailed review of these rules to ensure that all entities in a corporate group are considered excluded entities. It is also crucial to monitor the progress of these rules so that any updates are also taken into consideration ahead of the proposed effective date of the changes. Alternatively, Businesses may find that they have to restructure their financing arrangements to ensure they are exempt from the EIFEL rules and continue to be so in the future.
Parts of this blog were originally published in the May/June edition of CPABC’s InFocus magazine.