Canadian Earnings Stripping Rules

Doing what is legally best for your business and its advancement into Canada, given Canada's strict tax-related rules.

Contact Neufeld Legal PC at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The Canadian government utilizes a variety of intricate rules with the objective of preventing "earnings stripping," being the multinational corporate practice of shifting profits from a high-tax jurisdiction (like Canada) to a low-tax jurisdiction. This is often done by a Canadian subsidiary paying deductible expenses, such as interest, to its foreign parent or related parties. The two main sets of rules that govern this are the thin capitalization rules and the new Excessive Interest and Financing Expenses Limitation (EIFEL) rules. These rules work in tandem to limit the amount of interest a Canadian company can deduct for tax purposes.

A. Thin Capitalization Rules

The traditional thin capitalization rules limit the amount of interest a Canadian corporation can deduct on debt owed to certain "specified non-residents," which are generally foreign shareholders with a significant interest (25% or more of the votes or value of the shares) and other non-arm's length non-residents.

• Debt-to-Equity Ratio: The key feature of these rules is a fixed debt-to-equity ratio. Historically, this ratio was 3:1 but has been reduced over the years. The current ratio is 1.5:1.

• How it Works: For every $1 of equity, a Canadian corporation can have up to $1.50 in debt from specified non-residents and still deduct the interest on that debt. If the debt exceeds this ratio, the interest on the excess portion is disallowed as a deduction.

• Consequences of Disallowance: The disallowed interest is not only non-deductible for tax purposes but is also deemed to be a dividend, which can trigger Canadian withholding tax (usually at a rate of 25%, subject to reduction under a tax treaty).

B. Excessive Interest and Financing Expenses Limitation (EIFEL) Rules

Canada's EIFEL rules were introduced to align with the OECD's Base Erosion and Profit Shifting (BEPS) initiative. These rules are broader than the thin capitalization rules and target a wider range of interest and financing expenses. They are designed to prevent earnings stripping regardless of whether the debt is from a related party or a third party, and they apply in addition to the thin capitalization rules.

• Fixed Ratio Rule: The core of the EIFEL rules is a fixed ratio that limits the amount of "net interest and financing expenses" (IFE) a Canadian company can deduct to a percentage of its "adjusted taxable income" (ATI). ATI is a concept similar to tax-EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

  • For taxation years beginning on or after January 1, 2024, the fixed ratio is 30% of ATI.

  • For the transitional period (taxation years beginning on or after January 1, 2023, but before January 1, 2024), the ratio was 40%.

• Net Interest and Financing Expenses (IFE): This includes a broad range of expenses beyond just interest payments, such as certain guarantee fees, financing-related standby charges, and other amounts that are reasonably considered to be part of the cost of borrowing.

• Adjusted Taxable Income (ATI): ATI starts with a corporation's taxable income and makes specific adjustments to arrive at a tax-based measure of EBITDA.

• Carryforward and Carryback: Any interest expense denied under the EIFEL rules can be carried forward for up to 20 years or back for up to three years, providing some flexibility for businesses with fluctuating earnings.

• Group Ratio Rule: The EIFEL rules provide a "group ratio" election, which can allow a Canadian subsidiary to deduct interest in excess of the 30% fixed ratio. This is applicable if the multinational group to which the subsidiary belongs is highly leveraged with third-party debt.

• Exclusions: Certain entities are excluded from the EIFEL rules, including:

  • Canadian-controlled private corporations (CCPCs) and their associated corporations with less than $50 million of taxable capital.

  • Corporations or trusts that are part of a group with aggregate net interest expense in Canada of $1 million or less.

  • Certain Canadian resident taxpayers that have all or substantially all of their business activities and assets in Canada, and no more than a de minimis foreign ownership.

Interaction of the Rules

It is important to understand that the thin capitalization rules and the EIFEL rules are not mutually exclusive. The new EIFEL rules apply to interest that would otherwise be deductible under the pre-existing thin capitalization rules. This creates a multi-layered system for limiting interest deductions. A Canadian subsidiary must first satisfy the thin capitalization rules for related-party debt, and then the remaining deductible interest (including third-party debt) must meet the EIFEL limitations.

Other Anti-Avoidance Provisions

In addition to these specific rules, other Canadian tax provisions can be used to challenge earnings stripping, including:

• Transfer Pricing Rules: These rules require that transactions between related parties be priced as if they were conducted between arm's length parties. An interest rate on an intercompany loan that is higher than an arm's length rate could be challenged under these rules.

• General Anti-Avoidance Rule (GAAR): This is a broad provision that allows the Canada Revenue Agency (CRA) to deny a tax benefit if a transaction is considered to be an "avoidance transaction" that misuses or abuses the provisions of the Income Tax Act. The CRA has specifically identified "surplus stripping" as a targeted abuse, which can involve transactions that inappropriately withdraw corporate surplus to reduce the tax base [more on general anti-avoidance rule].

With this realization as to the potential impact of Canada's earnings stripping rules, when a foreign parent corporation is planning to finance its Canadian subsidiary, it is crucial to consider both Canada's thin capitalization rules and its more recently implemented Excessive Interest and Financing Expenses Limitation (EIFEL) rules.

To learn more about how our law firm stands apart when it comes to expanding your business into Canada, in what we do differently from most larger law firms and how this can properly protect and advance your Canadian commercial venture, contact our law firm today for a confidential initial consultation at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.  

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