Limitations on deductible interest expense
Taxpayers may want to review proposed changes to the interest expensing rules and other significant new draft tax legislation that was recently issued by the Department of Finance (Finance). This extensive package of legislation, which was released on 4 February 2022, features a wide range of corporate, personal and trust tax changes. This article looks at the proposed limitations on deductible interest expense and other measures. Subsequent articles in this series will provide an overview of:
- mandatory disclosure;
- trust reporting;
- immediate expensing; and
- cryptoasset mining.
Finance has released these draft measures for public consultation and will accept feedback by the deadlines specified for each measure.
Limitations on deductible interest expense
This draft legislation includes changes to limit the amount of interest and other financing expenses that businesses may deduct for income tax purposes. The new legislation includes further details of the proposed rules, which were originally announced in the 2021 federal budget.
Among other awaited details, the draft legislation includes several key definitions, including what constitutes "interest and financing expenses" and "interest and financing revenues" under the new rules. Finance will accept comments on the draft legislation to limit deductible interest expense until 5 May 2022. Generally, these rules provide that certain businesses are only eligible for a net interest expense deduction of up to a fixed ratio of 30% (40% in the first year of application) of "adjusted taxable income".
Adjusted taxable income generally refers to a corporation's taxable income and adds back interest and financing expenses, certain deductions for tax expenses and capital cost allowance (CCA), among other items. Adjusted taxable income also deducts other amounts, such as interest and financing revenues and untaxed income. As the calculation is based on taxable income, dividends are also excluded to the extent they qualify for the inter-corporate dividend deduction. These rules apply after existing limitations on the deductibility of interest and financing expenses, including the thin capitalisation rule.
The draft interest expensing rules also include a group ratio rule. Where certain conditions are met, this rule allows a taxpayer to deduct interest in excess of the fixed ratio of adjusted taxable income, up to the ratio of net third-party interest expense to book earnings before interest, taxes, depreciation and amortisation of the consolidated group. The rules allow Canadian members of a group to transfer unused capacity to deduct interest to other Canadian members of a group in certain situations and provide up to a three-year carryforward of unused capacity and a 20-year carryforward for certain denied interest and financing expenses.
Certain transitional rules also apply for purposes of determining the excess capacity of the taxpayer for the three years before the new rules apply. These new rules apply to corporations, trusts and certain non-resident taxpayers, and indirectly in respect of partnerships. Certain entities are excluded from these rules, including Canadian-controlled private corporations that, together with any associated corporations, have:
- taxable capital employed in Canada of less than $15 million;
- groups of corporations and trusts whose aggregate net interest expense among their Canadian members is $250,000 or less; and
- certain standalone Canadian-resident corporations and trusts.
Under these rules, the limit will be 40% of adjusted taxable income for taxation years beginning on or after 1 January 2023 and before 1 January 2024, and 30% for taxation years beginning on or after 1 January 2024.
Finance's release also included draft legislation for additional tax changes, on which it will accept comments by 7 March 2022. These measures:
- provide a 50% reduction of the general corporate and small business income tax rates for businesses that manufacture zero-emission technologies;
- expand access to the accelerated CCA for certain clean energy equipment (classes 43.1 and 43.2) and implement certain restrictions;
- expand the eligibility for the disability tax credit;
- include postdoctoral fellowship income in "earned income" for registered retirement savings plan (RRSP) purposes;
- allow plan administrators of defined contribution pension plans to correct for both under-contributions and over-contributions;
- update the rules for electronic filing and certification of tax and information returns to allow electronic signatures and electronic means for filing, among other changes;
- temporarily extend certain timelines for the Canadian film or video production tax credit (CPTC) and the film or video production services tax credit (PSTC);
- address an error in the covid-19 goods and services tax credit top-up;
- address issues with the revocation tax for organisations that have their registration as a charity revoked in certain situations.
In addition, Finance's release also includes draft legislation for additional tax changes, on which it will accept comments by 5 April 2022. These measures:
- amend certain taxes that apply to registered investments (eg, registered disability savings plans, RRSPs and tax-free savings accounts);
- address complex transactions that attempt to circumvent the tax debt avoidance rule;
- ensure the Canada Revenue Agency has the authority to conduct audits and undertake other compliance activities; and
- update the rules that address tax planning relating to allocations to redeeming fund unit holders in the mutual fund industry.
Taxpayers, including corporations, partnerships, trusts, individuals and non-residents, may want to review the new package of draft legislation to determine how they may be affected. Although this release includes draft legislation for many long-anticipated tax measures, there are still certain outstanding legislative proposals that have not yet been released, including:
- measures to introduce a new luxury tax;
- hybrid mismatch rules;
- changes to "modernise" the General Anti-Avoidance Rule; and
- other amendments affecting certain intergenerational share transfers.
For further information on this topic please contact Sabrina Wong or Sam J Tyler at KPMG Law by telephone (+1 416 777 8000) or email ([email protected] or [email protected]). The KPMG Law website can be accessed at www.kpmg.com.