On April 19, 2021, the Canadian federal government presented its first budget in over two years (“Budget 2021”) due to delays caused by the COVID-19 pandemic. The 2021 budget included the announcement of long-awaited international tax proposals resulting from Canada’s participation in the Organization for Economic Co-operation and Development (“OECD”) “Base Erosion and Profit Shifting” (“BEPS”) project aimed at defining Tax planning to address strategies used by multinational corporations that are considered to be improper shifting of profits between jurisdictions. In particular, the 2021 budget proposes the introduction of two new sets of rules to address the issues raised in the BEPS Action Plan, namely (1) interest deductibility restrictions and (2) rules to combat hybrid mismatches. In introducing these new rules, Canada is following the example of other OECD and G20 countries that have already introduced similar rules as a result of BEPS.
Limitations on Interest Deductibility
Under applicable Canadian tax laws, interest on debt incurred to generate business income is fully deductible when calculating income, subject to certain restrictions (e.g. leverage).
The 2021 budget raises concerns that excessive debt by Canadian companies can undermine the Canadian tax base, including through paying interest to related non-residents in low-tax areas, using debt to fund investments that generate non-taxable income, and the Acquisition of Canadian companies places a disproportionate burden on a multinational corporation’s debt to third parties.
To address this problem, the 2021 budget is proposing an “earnings stripping” rule to limit the deductibility of interest, in line with the recommendations of the Action 4 report of the BEPS Action Plan of the OECD and the G20.
The proposed limit would generally limit the amount of “net interest expense” that is deductible when calculating income to a fixed portion (40% for a transition year and then gradually decreasing to 30%) of “tax EBITDA”.
Net interest expense
- The net interest expense denotes the interest expense (including payments that economically correspond to the interest and other finance-related expenses), less interest and other finance-related income.
- The interest expense is limited to interest that is otherwise deductible under the existing rules, including the under-capitalization rules, so these rules would likely apply first.
- To enable loss consolidation arrangements within a Canadian group, interest expense and interest income related to debt between Canadian members of a group of companies would generally be excluded.
- Tax EBITDA means taxable income before taking into account interest expenses, interest income, income taxes and deductions for depreciation and amortization, each as determined for tax purposes
- The fixed ratio is:
- 40% for tax years beginning on or after January 1, 2023, but before January 1, 2024
- 30% for tax years beginning on or after January 1, 2024
- Canadian members of a group with a ratio (of net interest expense to tax EBITDA) below the fixed ratio could transfer the idle capacity to other Canadian members of the group.
- The proposal also includes a “group rate” rule that would allow a taxpayer to deduct net interest expense in excess of the fixed rate if the taxpayer can demonstrate that the ratio of net third party interest to book EBITDA of its consolidated group is higher is appropriate.
- Third party net interest and book EBITDA would be based on the consolidated group’s audited financial statements, with adjustments (e.g.
Denied interest expense
- Denied interest expense could be carried forward 20 years or 3 years back and deducted in those years, subject to the same quota restrictions in those years as described above.
Application and exceptions
- The proposed restrictions apply to:
- Tax years beginning on or after January 1, 2023
- Corporations, trusts, partnerships and Canadian branches of non-resident taxpayers
- New and existing debt
- Exceptions would be possible for:
- Canadian controlled private corporations with taxable capital employed in Canada of less than $ 15 million (on an associate basis)
- Groups of companies with a total net interest expense among Canadian members of $ 250,000 or “less”
- In the 2021 budget, it is expected that the proposed interest deductibility limitation will not generally apply to “Canadian Standalone Companies” or “Canadian companies that are members of a group none of which is a non-resident” and measures to reduce die Compliance burden of these companies is examined.
- Special rules can be developed for financial institutions.
- The bill will be released for consultation in summer 2021.
Rules for anti-hybrid mismatch arrangements
In the 2021 budget, hybrid arrangements are described as “cross-border tax avoidance structures that exploit differences in the income tax treatment of companies or financial instruments under the laws of two or more countries to create mismatches in tax results”. For example, a hybrid company would be a company that is treated as a separate taxpayer in one country but as a transit company in another. An example of a hybrid financial instrument is one that is treated as debt in one country but as equity in another country. These differences in tax characterization between countries can lead to tax savings for multinational companies.
Different types of hybrid mismatches are described in the 2021 budget:
- Deduction / non-inclusion mismatch – one country allows a deduction for a cross-border payment, but the other country does not allow it to be included in ordinary income (i.e. income that is taxable at the normal tax rate and not for exemption, deduction, credit or similar relief) within a reasonable period of time.
- Double deduction mismatch – A single issue can be deducted in two or more countries.
- Imported discrepancy – a payment from a legal entity resident in one country is deductible and included in the income of a legal entity resident in a second country, but the income is offset against a deduction under a hybrid mismatch agreement between the second legal entity and a legal entity domiciled in another country third country.
- Branch mismatch – the country of residence of a taxpayer does not agree with the country of establishment of the taxpayer on the appropriate distribution of income and expenditure between the two countries.
- As part of the main proposal, which is for deduction / non-inclusion and double deduction,
- A payment made by a Canadian resident under a hybrid mismatch arrangement would not be deductible unless the payment is included in the ordinary income of the recipient or causes a deduction in another country.
- A payment made by a non-Canadian resident under a hybrid mismatch arrangement that is deductible for foreign tax purposes to a Canadian resident would be included in the Canadian resident’s income, and if so if the payment was a dividend, it would not qualify for the otherwise available deduction for dividends from foreign subsidiaries.
- Proposals will be developed targeting the other types of hybrid mismatch arrangements.
- The proposed rules would be implemented in two separate legislative packages:
- The first package would generally target withdrawal / non-inclusion incongruity arrangements and would be released for consultation later in 2021.
- The second package would target other types of hybrid mismatches and open for consultation after 2021. These rules would apply in 2023 at the earliest.
These proposed changes to Canadian tax regulations will have a significant impact on the existing funding structures used by multinational corporations to fund their Canadian businesses. When it is published later this year, the draft law will certainly be complex and require some interpretation.