July 19, 2022 | By Julius Melnitzer
With the international and domestic commercial landscape changing so rapidly of late, it’s perhaps no surprise that tax rules are changing as well. Here are three important developments in that sphere.
Interest deductibility for foreign investors
Under a proposed revamp of Canada’s interest deductibility regime, foreign investors who, through a Canadian entity, borrow to finance their Canadian acquisitions may soon face more robust and complex limitations on their ability to deduct interest on their borrowings.
“In essence, an affected taxpayers’ interest and financing deduction will be limited to a fixed percentage — eventually 30 per cent — of the taxpayer’s EBITDA [earnings before interest, taxes, depreciation and amortization],” said John Lennard, a tax partner in Stikeman Elliott LLP’s Toronto office. “Higher ratios may be available for taxpayers in multinational groups with audited consolidated financial statements.”
Capital intensive industries, such as real estate and infrastructure, will be particularly affected.
“Relative to other countries that have similar rules, Canada’s are arguably more onerous as currently drafted, because they kick in at lower thresholds and do not provide as many carve-outs,” Lennard said. “The U.S., for example, has exceptions for real estate, so these new rules will create a lot of questions for American investors.”
But David Rotfleisch of Toronto tax boutique Rotfleisch & Samulovitch Professional Corporation downplays the significance of the changes. He points out that “thin capitalization” rules, which limit capital injection through borrowing, have been part of the Income Tax Act for about 50 years, and show no signs of disappearing. The upshot is that foreign investors’ ability to leverage is in any event limited.
“I don’t believe the changes to the interest deductibility regime will make a huge difference,” he said. “Canada remains an attractive investment target, and if a particular investment makes sense, foreign investors will still go through with it — though they may be holding their noses as they do so.”
Base erosion and profit shifting (BEPS)
BEPS is a long-standing initiative by the Organisation for Economic Co-operation and Development (OECD) to combat revenue shifting from jurisdictions where profit is earned to places where tax rates are lower.
To that end, the OECD has announced a “two-pillar” approach.
The first pillar, which applies to very large companies whose revenue exceeds 20 billion euros, reallocates — through a complex formula — a portion of the profit to the country where the revenue is earned.
The second pillar, also quite complex and much broader than the first pillar, applies to multinationals whose annual revenue exceeds 750 million euros, requiring them to pay a 15 per cent minimum tax to the jurisdiction where revenue has been earned.
The second pillar in particular could prove disadvantageous to Canadian concerns.
“Historically, Canada’s tax treaties or tax information exchange agreements provide that active business income from the treaty partner can revert to Canada without tax consequences in the country of origin,” Lennard explains. “And the 15 per cent tax means less money will come back to Canada to grow businesses, hire people and reinvest.”
However, when the OECD announced that the measure was moving forward, the Canadian government published a press release saying it expected Canada to recoup any lost revenue.
“But the government didn’t explain how they’re planning to regenerate the billions that will be lost,” Lennard points out. “There’s quite a few tax practitioners out there who are skeptical about that claim, and whether it’s in Canada’s interest to proceed with this aspect of BEPS.”
Debt forgiveness rules
With many Canadian and world economists predicting a post-pandemic global economic slowdown, businesses need be aware that recessions raise a number of tax issues.
One of the most significant relates to debt forgiveness and debt-parking transactions, where a related party acquires debt for less than 80 per cent of the amount of the debt.
“Debtor corporations, particularly those that are highly leveraged, may need creditors to forgive some debt,” Lennard said. “The difficulty is that the Income Tax Act treats debt forgiven or reduced as income to the debtor in certain circumstances, and more or less at a capital gains rate.”
To be sure, not all of a forgiven sum is treated as income. Debtors may apply it first to reduce any loss carry forwards, undepreciated capital costs and resource expenditures, the adjusted cost base of certain capital properties, or current year capital losses. Only the portion of the forgiven sum that remains after these reductions is added to income.
Overall, the rules are very complex, and vary depending on such factors as whether the debt is interest-bearing, whether debt-for-debt refinancing occurs and whether the corporation meets the criteria to issue a special class of distress preferred shares in satisfaction of a debt.
Julius Melnitzer is a Toronto-based freelance legal affairs journalist and communications and media consultant to the legal profession. He can be reached by e-mail directly at [email protected]or at his website, www.legalwriter.net.