Finance provides pointers on the proposed earnings-stripping rules

Points made by Shawn Porter at the IFA Finance Roundtable on May 5, 2021 on the proposed earnings-stripping rules included:

• There is not contemplated to be a specific safe harbour for mostly Canadian firms – instead they likely will not be caught simply because their interest expense all fundamentally relates to the Canadian business and its earnings capacity and therefore comes in below the fixed ratio of 30% (or a higher group ratio rule applies).
• Part of the impetus for adopting these rules is that other countries are adopting them as well, and Canada wants to protect against more debt being pushed into Canada.
• The framework of the default 30% fixed ratio rule will be rooted in ITA concepts of what is a group and an entity.
• Each entity will determine whether it has net interest expense in a year, so that if that is less than 30% of its EBITDA, it has excess or unused capacity; if it is more, it has excess interest which would be denied.
• It is contemplated that what gets transferred within the group is the unused capacity of some members – rather than the excess interest being transferred, so that the interest can be deducted (if at all) only in the entity that incurred it.
• If excess interest remains in that group in the year after all unused capacity of other group members has been transferred within it, then the carryover rules come into play - the entity with the excess interest can look back three years to see whether it, or other group entities, have capacity in that time window to reduce the excess interest in the current year. If there is insufficient capacity looking back, then the denied interest can be carried forward for 20 years and deducted to the extent of the group’s unused capacity in those future years.
• “Net interest expense” is broader than the legal meaning of “interest,” and will includes interest expense, equivalents to interest expense, and financing expenses. This will only be partially informed by the concept of “equivalents” in BEPS Action 4.
• Capacity that emanates from net interest income of a group member would be eligible for transfer to other group entities – which would suggest that banks and insurers (if they have net interest income) would not be subject to these rules. In this regard, there potentially might be some sort of ring fencing around transfers of excess capacity by financial institution members to other members in a different business.
• The concept of EBITDA would start with taxable income, but it would make sense to provide for an add-back of deductions in computing taxable income, such as under s. 110(1)(k), for items that represent taxes rather that economic losses.
• The rules will accommodate tax loss transfer transactions according with CRA policies in that regard.
• In contrast to the 30% default fixed ratio, consolidated GAAP measures will be used for both the numerator, and denominator in determining whether external leverage permits using a higher ratio. Design issues include the choice of the appropriate ultimate parent (including the related issue of the provision of credit-support to the consolidated group, as so defined, by someone outside of the group), distortions to the extent that the group is loss-making overall, and different kinds of distortions if there are constituent entities within the group that are loss-making, as well as averaging effects for diversified multinationals in very different business-lines.

Neal Armstrong. 5 May 2021 IFA Finance Roundtable.