Proposed Change in Tax Policy Affecting Canadian MNEs
By the McCarthy Tétrault National Tax Group
On February 4, 2022, the Canadian federal government released for public comment a package of draft legislative proposals to implement a number of tax measures. The package included proposed amendments to the Income Tax Act (Canada) (the “Tax Act”) that, if enacted, would limit the deduction of interest to 30% of “tax EBITDA”(the “30% EBITDA Rule”). Consistent with the Action 4 report under the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, the 30% EBITDA Rule is intended to address concerns about base erosion arising from the deduction for income tax purposes of excessive interest and other financing costs, principally in the context of multinational enterprises (“MNEs”) and cross-border investments. The 30% EBITDA Rule is complex, and this is especially the case since the 30% EBITDA Rule is intended to apply in conjunction with, and not replace, the myriad of existing rules that target the deductibility of interest expense for Canadian tax purposes.
Since the existing rules primarily target non-residents investing into Canada, enacting the 30% EBITDA Rule without removing any of the existing rules suggests that the 30% EBITDA Rule is targeted at Canadian MNEs and represents a significant shift in Canadian tax policy. The primary effect of the 30% EBITDA Rule will be quite similar to a previous interest deductibility rule that was enacted and subsequently repealed in the 2000s after an international advisory panel commissioned by the Canadian government concluded it would significantly impair the ability of Canadian MNEs to compete internationally. A fundamental aspect of Canadian tax policy is to allow Canadian MNEs to borrow to invest in their foreign operations to allow them to become stronger Canadian companies and not themselves become targets of foreign takeovers. The international tax advisory panel concluded it would be a mistake to abandon this policy, but it appears that the Canadian government is intending to now make this shift.
Highlights of the 30% EBITDA Rule
The 30% EBITDA Rule limits the amount that a Canadian taxpayer may deduct in respect of interest and financing expenses in any given year to a fixed ratio (40% for any taxation year that commences in the 2023 calendar year, and 30% thereafter) of its “adjusted taxable income” (i.e. tax EBITDA) for the year. The “adjusted taxable income” of a taxpayer is essentially the taxpayer’s taxable income for the year (or, if the taxpayer is a non-resident, its taxable income earned in Canada), adjusted to add back any deductions claimed in computing taxable income in respect of interest and financing expenses, certain tax expenses and capital cost allowance and to subtract any income inclusions for interest and financing revenues, untaxed income (including foreign source income in respect of which a foreign tax credit is claimed in Canada) and certain other amounts. Notably excluded from the computation of a taxpayer’s “adjusted taxable income” is dividend income to the extent the taxpayer is entitled to claim an off-setting deduction under section 112 (for inter-corporate dividends from Canadian corporations) or section 113 (for dividends received from foreign affiliates). Adjusted taxable income is effectively “tax EBITDA” earned in Canada.
The 30% EBITDA Rule is intended to apply broadly to both Canadian-resident and non-resident corporations and trusts. There are, however, exceptions for certain specified categories of entities whose interest and financing expenses are thought to pose a low BEPS risk. These categories of entities include, in general terms, (i) Canadian-controlled private corporations with taxable capital employed in Canada of less than $15 million, (ii) groups comprised of corporations and trusts whose aggregate net interest and financing expenses is $250,000 or less, and (iii) groups that are comprised exclusively or almost exclusively of Canadian-resident corporations and trusts provided that all or substantially all of the business of each group entity is carried on in Canada and all or substantially all of the group’s interest and financing expenses are paid to persons or partnerships that are not “tax-indifferent investors”.
The 30% EBITDA Rule includes a number of ancillary rules that are generally relieving in nature. Under the proposed rules, a taxpayer that is a member of an accounting consolidated group may elect to compute its interest and financing expense limit using a “group ratio” (generally, the group’s ratio of net third-party interest expense to book EBITDA) in lieu of the fixed ratio, where the “group ratio” exceeds the applicable fixed ratio. This group ratio should effectively exempt a taxpayer with only Canadian operations from the application of the 30% EBITDA Rule. The proposed rules also provide for the ability in certain circumstances to transfer unused capacity to claim interest and financing expense deductions to other Canadian members of the group. Finally, the 30% EBITDA Rule contains provisions that permit the carry forward of denied interest and financing expenses for up to twenty years, and provide for a three-year carry forward of unused deduction capacity (effectively equivalent to a three-year carry back of denied interest and financing expenses).
Impact of 30% EBITDA Rule on Canadian MNEs Investing Abroad
Canada has been an active participant in the BEPS Project since its inception in 2013 while also working unilaterally to implement domestic anti-BEPS measures. This has resulted in the Tax Act containing a number of complex and overlapping sets of rules targeting base erosion, particularly in the context of inbound direct foreign investment into Canada, including the thin capitalization rules, the foreign affiliate dumping rules and the back-to-back rules. Unlike in most countries that have adopted an EBITDA-based interest limitation, in Canada the 30% EBITDA Rule is intended to operate in conjunction with, rather than in lieu of, these existing rules. As a result, from a practical perspective, the proposals are not expected to have a material impact on the amount of interest a foreign enterprise investing into Canada can use to reduce its Canadian tax cost. Instead, the 30% EBITDA Rule is likely to have a material impact on Canadian MNEs that borrow to invest internationally. In addition, as a result of the group ratio, it is expected that the 30% EBITDA Rule will not have an impact on Canadian taxpayers that only carry on business in Canada.
In this regard, the 30% EBITDA Rule is similar in effect to a more targeted rule in the Tax Act (which also happened to be section 18.2) that was proposed by the Canadian government in the March 2007 federal budget. The Canadian government introduced section 18.2 in response to growing concerns about the erosion of the Canadian tax base due to the deductibility of interest by Canadian corporations in respect of borrowed money used for the purpose of earning tax-exempt dividends from foreign affiliates. Section 18.2, as originally proposed, was intended to operate as a general limitation rule restricting the deductibility of interest on borrowed money used to invest in foreign affiliate shares. In response to feedback from the Canadian business community, in late 2007, the Canadian government formed an advisory panel to study Canada’s system of international taxation (the “Advisory Panel”), and later enacted a scaled back version of section 18.2 that was limited to targeting so-called “double-dip” financing structures.
In December 2008, the Advisory Panel released its final report (the “Advisory Panel Report”). Appropriately titled “Enhancing Canada’s International Tax Advantage”, the Advisory Panel Report adopted as an “overriding principle” the proposition that Canada’s international taxation system should ensure that Canadian businesses are competitive when investing internationally. In the Advisory Panel’s view, “having companies that are internationally competitive is particularly crucial for Canada” because “the Canadian market is relatively small” and “access to foreign markets is key for Canadian firms to grow and achieve economies of scale”. Guided by this “overriding principle”, the Advisory Panel recommended (among other things) that the Canadian government “broaden the existing exemption system to cover all foreign active business income earned by foreign affiliates” and “impose no additional rules to restrict the deductibility of interest expense of Canadian companies where the borrowed funds are used to invest in foreign affiliates and section 18.2 of the Income Tax Act should be repealed”. Based on the Advisory Panel’s recommendation, in 2009, the Canadian government repealed section 18.2.
When viewed against the history of the development of Canada’s system of international taxation, the 30% EBITDA Rule represents a radical shift in international tax policy in Canada. Under the 30% EBITDA Rule, where a Canadian corporation receives dividends from a foreign affiliate and an offsetting deduction under section 113 is available, the dividend income is excluded from the computation of “adjusted taxable income” and such dividends do not generate additional deduction capacity for the Canadian corporation. This will be the case even in circumstances where the Canadian corporation’s investment in the foreign affiliate has been financed, in whole or in part, with interest-bearing debt. The 30% EBITDA Rule will thereby detract from Canada’s advantage to compete internationally with our major trading partners and will effectively result in the re-enactment of former section 18.2 in a different form. It is not clear what has changed to override the earlier determination that restricting the deductibility of interest on borrowed money used to invest in foreign affiliate shares undermined Canada’s policy of promoting the international competitiveness of Canadian businesses. The 30% EBITDA Rule will also undermine the 2021 federal budget’s focus on promoting the growth and international presence of Canadian businesses involved in, for example, clean energy, artificial intelligence technology and biotechnology, particularly having regard to the significant capital investment required by these businesses in infrastructure and technology.
Impact of 30% EBITDA Rule on Foreign MNEs Investing in Canada
The 30% EBITDA Rule is based on an “earnings stripping” approach to limiting interest deductibility, by restricting the amount of interest (and financing expenses) that are deductible by a Canadian taxpayer to a fixed ratio of its “tax EBITDA”. Interestingly, the Advisory Panel Report raised an “earnings stripping” rule as a possible approach to target “excessive” interest deductions, but ultimately rejected that approach in favour of the existing thin capitalization rules, on the basis that “earnings stripping rules tend to be more complicated than fixed-ratio approached” and introducing such rules into Canada’s existing income tax regime “would be particularly complex given that Canada does not have a consolidation regime for tax purposes”.
As noted above, over the past few decades Canada has adopted various measures to combat erosion of the Canadian tax base through excessive leveraging of Canadian subsidiaries of non-resident investors. For example, Canada’s thin capitalization rules are designed to prevent non-resident investors from extracting profits from a Canadian subsidiary in the form of interest rather than dividends. These rules limit the amount of interest that the Canadian subsidiary may deduct in respect of debt owing to specified non-residents to the extent that the aggregate amount of the debt owing by the Canadian subsidiary to specified non-residents exceeds 1.5 times the equity amount of the Canadian subsidiary.
The Advisory Panel Report made a number of recommendations to address perceived abuses to the tax system and erosion of the Canadian tax base. These recommendations were subsequently enacted by the Canadian government, including very expansive amendments to Canada’s thin capitalization rules and the introduction of the “foreign affiliate dumping” rules. These rules, combined with the many other rules in the Tax Act addressing perceived abuses involving borrowings by Canadian businesses, such as the back-to-back loan rules and the transfer pricing rules, provide more than adequate protection against inappropriate Canadian tax base erosion from financing transactions.
The Action 4 Report of the BEPS Project reviewed various alternatives to protecting a country’s tax base from inappropriate erosion, including thin capitalization and similar rules. Contrary to the Advisory Panel Report, it identified numerous concerns with thin capitalization regimes and concluded that earnings-based limitations should be the standard. It did not recommend that countries adopt multiple overlapping regimes as Canada is proposing.
The Future of the 30% EBITDA Rule
While the 30% EBITDA Rule is very similar to the rules adopted by many of Canada’s trading partners and are intended to comply with the Action 4 Report of the BEPS Project, the proposals do not take into account Canada’s existing myriad of rules to counter perceived abuses arising from financing transactions, rules which have generally not been adopted by these other jurisdictions. Moreover, the 30% EBITDA Rule fails to recognize the lessons learned from the Advisory Panel Report about the benefits of Canada’s existing approach to combat tax base erosion arising from financing transactions nor does it reflect the long-standing tax policy that serves as the foundation of Canada’s international tax system, namely, to ensure that Canadian businesses are competitive internationally.
The Canadian government has invited stakeholders to provide comments on the 30% EBITDA Rule. The deadline for making submissions is May 5, 2022. In addition to the tax policy concerns discussed above, there are a number of technical issues in the draft legislation that we expect to be raised in the various stakeholder submissions. The public will likely not know whether and how these technical issues will be rectified until late 2022. In light of this uncertainty and the considerable time and cost to Canadian MNEs involved in restructuring existing debt structures, and against the background of Canada’s nascent recovery from the COVID-19 pandemic, we expect that the Canadian government will be under considerable pressure to delay the implementation of the 30% EBITDA Rule. Such respite would no doubt be welcomed by Canadian MNEs and their tax advisors, and may provide an additional opportunity for the Canadian government to consider more fully the impact of the 30% EBITDA Rule on Canadian MNEs and the broader Canadian economy.
Income Tax Act EBITDA