Proposed Interest Deductibility Limitation

Electricity Canada is advocating for regulated utilities to be exempt from the interest deductibility limitation proposed in the 2021 Federal Budget.

Overview

The Canadian Federal Budget 2021 proposes a new limitation on interest deductibility, consistent with the OECD BEPS Action 4 recommendations. This new rule will limit the amount of interest expense that an entity may deduct in computing income for a taxation year to a fixed ratio of 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), applying to existing and new borrowings. There is currently no limit in Canada to the amount of interest expense that can be deducted. The proposal does not currently contain any industry exemptions. Finance Canada is currently drafting legislation for the proposed rule, which should be introduced in Parliament in 2022, to take effect taxation years beginning on or after January 1, 2023.

Electricity Canada member utilities use interest deductibility to help offset the massive cost of large infrastructure projects, avoiding the alternative of raising costs to customers. Electricity Canada and the Canadian Gas Association (CGA) are working together to advocate for a targeted exemption to the proposed new rule for regulated operating utilities and their holding companies.

History

  • In 2016, the Organization for Economic Co-operation and Development (OECD) proposed a set of 15 measures to fight tax avoidance. By improving the coherence of international tax rules, the OECD hopes to minimize the exploitation of mismatches in tax rules by multinational enterprises. One such proposed measure is an earnings-stripping rule, which limits the amount of interest expense an entity can deduct from its taxable income to a fixed ratio of the entity’s EBITDA.
  • Several countries have already implemented such limits. Canada is a relatively late adopter, proposing the Canadian earnings stripping rule in the 2021 Federal Budget.
  • Canada’s proposed earnings stripping rule will limit net interest expense up to a fixed ratio of 30% of tax EBITDA, to be phased in with an initial fixed ratio of 40% for taxation years beginning on or after January 1, 2023, but before January 1, 2024, after which the 30% fixed ratio would apply.
  • The U.S., the U.K., and some EU countries have requested an exemption for regulated utilities. In the U.S., the exemption was granted as it was recognized that uncapped interest deductibility is an important tool for regulated utilities to finance high-cost infrastructure and the loss of this financial tool could translate into rate increases for customers, and that such an exemption does not undermine the rule’s goal of restricting tax avoidance.

Why should regulated utilities be exempt from the proposed limitation on interest deductibility?

Regulated energy utilities are unique in two ways:

  • First, Electricity Canada and CGA members are highly capital intensive with long amortization periods of up to 40 years on capital investments. They require substantial ongoing infrastructure spending to ensure safe and reliable generation and delivery of energy to customers. They must also ensure a growth in new infrastructure investments to meet rising customer demand for electricity and gaseous energy to meet Canada’s emission reduction targets by investing in new, clean, and efficient technologies.
  • Second, our industries are highly regulated and fall under provincial economic regulation. Utility businesses are regulated utilities with publicly approved return on equity (ROE) levels in addition to approved debt and equity levels. Each province sets their own ROE and debt and equity levels based on specific company circumstances. Further, our members are subject to complex regulatory accounting standards, with varying rules between provinces.

These elements make the gas and electricity industries particularly vulnerable to the proposed changes to interest deductibility limits. High upfront costs and a regulated rate-of-return means most of our members have to enter into long-term debt arrangements to finance investments. Our utilities also expect to be able to carry over interest payments to their income statement and use interest deductibility to offset the massive cost of large infrastructure builds, to avoid the alternative of raising costs for consumers: the ability to do this helps ensure affordable rates for Canadians. Debt for regulated utilities, of which interest payments can be deducted, ultimately translates into customer savings.

Canada should ensure that the proposed earnings stripping rules do not increase the cost of regulated utility projects in Canada or increase utility costs to Canadian customers. This can best be achieved by following the approach adopted by the United States (i.e., a targeted exemption for regulated operating utilities and their holding companies).

For more information on OECD BEPS Action 4 Recommendations: https://www.oecd.org/tax/beps/beps-actions/action4/

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