Navigating the evolution of EIFEL rules: From proposal to final legislation

In a bid to curb deductibility of excessive interest and financing expenses, the Department of Finance unveiled the final legislation on June 20, 2024 marking a significant milestone in Canada's tax landscape. For a comprehensive understanding of the evolution of these proposals, please refer to our earlier BDO publications analyzing both the original and updated proposals.

Background and application of EIFEL rules

The Excessive Interest and Financing Expenses Limitation (commonly referred to as ‘EIFEL’) rules are designed to align with Action 4 recommendations outlined in the Organization for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting Project, commonly referred to as the BEPS Action 4 report.

EIFEL limits the deductibility of net Interest and Financing Expenses (IFE), capping them at a 30% fixed ratio[1] of Adjusted Taxable Income (ATI). Any interest amounts denied under these rules are carried forward, providing taxpayers with the opportunity to offset them against future taxable income.

As businesses and tax professionals navigate the intricacies of EIFEL rules, understanding its scope and implications is paramount. This article marks the first installment of a four-part series aimed at dissecting the key changes observed from the original proposals to the final legislation. Each segment of the series will delve into a distinct technical area, with the aim of providing clarity and items to consider for affected parties.

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[1] 40% fixed ratio of ATI is available under transitional rules for taxation periods commencing on or after Oct. 1, 2023 and ending on or before Dec. 31, 2023.

Part I – Ultimate parent

Navigating tax regulations across borders can often present challenges for multi-national corporations. The EIFEL legislation has introduced additional complexities in the pre-existing interest deductibility landscape. There have been a series of discussions, both in the explanatory notes and articles, on the fixed ratio regime, yet equal attention has not been directed toward the group ratio regime and its potential opportunities, particularly for private equity structures.

The group ratio election lies in leveraging the financial structure of the worldwide group, particularly in cases where significant third-party debt resides beyond Canadian borders or where the group's consolidated EBITDA is relatively low. If applicable, it will allow for a greater interest deduction by the Canadian entity above the 30% fixed ratio amount.

A pivotal condition for accessing this elevated deduction room is ensuring that the ultimate parent of the worldwide group produces audited consolidated financial statements. An ultimate parent for the purposes of the EIFEL rules is an entity, in which no other entity holds directly or indirectly an interest, that is required to prepare consolidated financial statements, or would be so required if it were subject to International Foreign Reporting Standards. Current explanatory notes lack comprehensive examples with respect to on the identification of an ultimate parent in common organizational structures, i.e. private equity.

Examining this within the context of private equity offers valuable insights. Private equity group structures typically involve intricate hierarchies, with investments structured through various entities. Consider a typical private equity group structure:

In scenarios where an investment fund would be mandated under International Financial Reporting Standards (IFRS) to prepare consolidated financial statements as the ultimate parent, even if it doesn't typically produce such statements, it is unlikely the investment fund would consider the group ratio election. Preparation of audited consolidated financial statements by the investment fund, or it’s controlling parent for that matter, would result in significant costs from a compliance, time, and team coordination perspective.

The ultimate parent concept under the EIFEL rules and those proposed under the Global Minimum Tax Act's Pillar 2 are very similar in terms of their application. Both frameworks emphasize determining entities with controlling interests, aligning with accounting principles governing consolidated financial statements preparation.

Exemptions within IFRS allow certain entities, deemed ‘investment entities,' to bypass consolidation requirements. This raises questions about the identification of the ultimate parent within private equity structures. Assuming Can LP meets the definition of an investment entity under IFRS, could it be argued that the Canadian corporation directly beneath the limited partnership assumes the designation of ultimate parent? Such an interpretation could offer private equity portfolio groups access to the group ratio election without undue penalization under the wording of the existing legislation.

In essence, navigating tax benefits for Canadian eligible group entities demands a nuanced understanding of global financial structures, regulatory frameworks, and the evolving landscape of international tax law. The strategic application of group ratio elections, particularly within specialized industries like private equity, can unlock significant advantages while ensuring compliance with legislative requirements.

Key takeaways and next steps

Electing to apply the group ratio regime can unlock potential increased interest deduction opportunities where an alternative ultimate parent can be identified, particularly within complex structures like those found in private equity. It is interesting that the EIFEL rules look to apply accounting principle’s in determining the ultimate parent. BDO has prepared a few items to consider as next steps:

• Review the group as a whole to assess whether the group currently holds, or is anticipated to hold, substantial third-party debt outside the Canadian entities, or if the consolidated EBITDA of the Canadian group is reduced by the worldwide group's EBITDA.
• Analyze the broader group structure under IFRS to identify entities that could qualify as the ultimate parent and those who may qualify as investment entities.
• In the case of private equity structures, determining the ultimate parent entity may pose challenges. A formal opinion from IFRS accounting experts is advisable.
• Model the impact of the EIFEL rules under both the fixed ratio and group ratio regimes to determine which method yields enhanced interest deductions. Importantly, note that the group ratio election can be made annually. Should the fixed ratio method offer an increase in interest deduction in a specific tax period, there may be no need to elect the group ratio method.

Contact your BDO advisor to learn more about how we can help you manage the impact of these proposals on your business.

Harry Chana , International and Cross-Border Tax Services Leader

Jaskirit Randhawa, CPA , Senior Manager, International Tax