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Welcome to BDO Canada's Cross-Border Podcast Series. In this tenth episode of the series, we're discussing finance operations for companies entering the Canadian marketplace. My name is Angeline Chandra, and I lead BDO Canada’s Transfer Pricing practice.
As countries try to rebuild their economies in a post-Covid world, many corporations are looking to invest in other jurisdictions. Our podcast will focus on issues multinationals should consider when financing business operations in Canada.
Joining me today is Dr. Jamal Hejazi, Chief Economist for BDO Canada. Jamal is a member of the transfer pricing practice and provides Economic Consulting Services to many industries and special interest groups across Canada. Also joining us is Hetal Kotecha who is a Partner in our International Tax Practice and Leader of the Toronto M&A Tax Practice.
Hetal, let’s kick things off with your thoughts for companies looking to expand into Canada. What are some considerations for those companies looking to finance their operations here?
Trends in the M&A space
Thank you, Angeline. As many of you may be aware, M&A activity was at incredibly high levels in fiscal 2021. For example, Canadian deal activity increased by 117% compared to 2020, and deal volume increased by 24% over the same time period. While M&A activity levels in fiscal 2022 may not surpass 2021 levels, we expect M&A activity to be robust in 2022.
We have also observed that with the strong liquidity in capital markets and access to funding, there is fierce competition in the marketplace for quality targets. We have regularly seen multiple bidders with elevated premiums being paid for target companies.
It remains to be seen if there will be some downward pressure on the purchase price premiums being paid for target companies in fiscal 2022. This is particularly the case for companies operating in the technology sector, where such companies do not have strong balance sheets or good cash flow.
We have also observed the number of Canadian companies looking to go public has softened in 2022 for various business, commercial and geopolitical reasons.
We have observed an increasing importance on environmental, social and governance (ESG), and we expect this to become a critical deal point going forward.
Finally, many purchasers want key management and owners to continue with the business for period of time after closing. Accordingly, having continuity of management and key resources is a key deal consideration given the current labour shortages.
An important variable in any M&A deal is how the transaction will be financed. Jamal, what are some of your observations on this?
Thank you, Angeline. As the world economy becomes more globalized, the need for M&A activity will increase. M&A activity will rely on the ability to secure finance for new operations. The question often becomes “do we finance internally or externally?” Most companies have non-investment grade credit quality standing. Securing debt in this space is difficult as the non-investment grade space in Canada is small in comparison to other markets such as the US. If debt is secured intercompany, any such internal debt will need to meet the standards under transfer pricing rules found under Section 247 of the Income Tax Act.
Debt financing: Intercompany and 3rd party debit and capital market trends
Now, lots of trends are occurring in this space. Many companies are turning to internal debt financing. Debt financing from third parties, such as banks or investment banks, is not easy to obtain in the non-investment grade space. It is often expensive and is associated with a lot of conditions attached to such loans. Securing 3rd party debt reduces transfer pricing audit risks as these debts are between unrelated parties where rates and terms are deemed arm’s length.
Often, the simplest way to secure financing is if internal capital exists where the parent or the sister company has access to capital it can loan to entities in Canada, for instance. Given the related party nature of such transactions and the incentive to tax plan, governments require such intercompany debt be structured such that it meets the arm’s length standard. This often requires some compliance costs but may be one of the best ways of securing debts. Hetal, over to you.
Thanks, Jamal. While Jamal does raise some interesting observations, many purchasers of Canadian businesses are private equity funds together with strategic buyers. Typically, the buyers have strong balance sheets, access to larger, more sophisticated capital pools, and their ability to secure external financing is not constrained. In our experience, a key variable for non-Canadian purchasers is whether they should use external debt, internal leverage, or a combination thereof when purchasing a Canadian target. In addition, if external debt is being utilized, an important consideration is whether the funds should be sourced from Canadian or non-Canadian lenders. This may influence how the external financing is sourced and whether the borrowing will be in Canada or outside of Canada. Finally, the cost of funding and the type of security being requested by the lender are important business considerations. Now, I will turn it over to Angeline to discuss some issues pertaining to debt capacity.
Debt capacity analysis
You raise a very important point, Hetal. I’d like to add that before companies consider borrowing from related parties, they need to ensure that their financial situation and business operations support their ability to borrow the funds contemplated. The OECD recently introduced new guidance that requires taxpayers to perform a debt capacity analysis. The purpose of this analysis is to prove that a taxpayer’s financial and economic status enables them to borrow such a sum of money as well as pay the stated interest rate. The debt capacity analysis is a requirement to support the arm’s length nature of the intercompany transaction and that’s very important to note. Intercompany loans cannot simply result in debt being “pushed” into Canada. The CRA will ask the question: “Would arm’s length parties be willing to assume such debt at the given interest rate?”
Hetal, I understand that there have been some recent developments on interest limitation rules in Canada.
Interest deductibility rules
That is correct, Angeline. On February 4, 2022, the Department of Finance introduced the long-awaited rules relating to Excessive Interest and Financing Expenses Limitation (commonly referred to as the EIFEL rules). The introduction of the EIFEL rules will have a significant impact on multinational corporations, investments made by private equity funds, and other Canadian public and private enterprises that are using external debt, or even related-party debt.
By way of background, the EIFEL rules implement the recommendations in Action 4 of the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project. These rules will apply to taxation years of a taxpayer that begin on or after January 1, 2023.
The EIFEL rules, in short, are complex because they are intended to apply in combination with other interest limitation rules in Canada. For example, as the rules are currently drafted, the Canadian thin capitalization and transfer pricing rules will apply in priority in comparison to the EIFEL rules.
While it is difficult to cover the entire scope of these rules in this podcast, we have observed a number of foreign and Canadian entities take notice of the rules as they evaluate potential acquisition targets. The EIFEL rules are broad in scope and they apply not only to related party debt, but to 3rd party debt as well.
A brief summary of the EIFEL rules is as follows: The EIFEL rules will limit net interest expense to a fixed ratio of “taxable income” before interest, taxes, depreciation, and amortization (referred to as tax EBITDA).
The fixed ratio includes two periods: 40% of adjusted tax EBITDA for taxation years beginning on or after January 1, 2023, but before 2024, and 30% for taxation years beginning on or after January 1, 2024. The reason there is a 40% rule is to give taxpayers a transitional period as the new rules come to be enforced.
In some cases, if certain conditions are met, a group ratio can be applied. The group ratio rules allow a Canadian taxpayer to deduct interest in excess of the fixed ratio of 30% when the taxpayer is able to demonstrate that the ratio of the consolidated group’s net third-party interest expense to its book EBDITA exceeds the fixed ratio.
The term Interest and Financing Expense (IFE) is broadly defined to include more than just traditional interest (for example, it includes capitalized interest, interest on hedging derivates, and whatnot).
In addition, the computation of “taxable income” under these rules is complex and is subject to various adjustments. For example, Canadian domestic and foreign affiliate dividends are excluded from the application of taxable income. In addition, denied interest is essentially subject to a 20-year carry forward limit with some exceptions.
It should be noted that the EIFEL rules impact Canadian corporations, trusts, corporate members of partnerships, as well as Canadian branches of non-resident corporations. However, there is a carve-out for excluded entities. In our view, although there is a carve out for excluded entities, as a practical matter, many Canadian domestic entities may still be subject to these rules as currently drafted.
We have some examples that provide some more context to these rules. For example, we have one of our clients that is developing a renewable project (solar farm) in Canada. Quite often, these projects are not taxable for several years. However, the projects often incur significant debt at the outset, and they may not generate taxable income for several years. Hence, it is important to model the cost of financing and potential tax impact where interest may be restricted for several years.
It should also be noted that the rules impact Canadian companies looking to expand outside of Canada. Where the Canadian companies borrow funds from external lenders to finance a potential purchase or start new operations, they will need to evaluate the Canadian EIFEL rules. In addition, US interest limitation rules would also need to be considered.
From an M&A perspective, in our view the introduction of the EIFEL rules could have a significant impact on how deals are financed and structured. For example, some observations are as follows: Private equity and other investors who are preparing to acquire Canadian target entities need to evaluate and model the potential impact of the EIFEL rules and determine whether borrowing should occur in Canada or outside of Canada.
Since the thin cap rules currently still apply before the new interest deductibility rules, non-residents who are financing their Canadian operations with related-party debt will still need to consider the impact of the thin cap rules.
It remains to be seen how the new EIFEL rules will impact inbound capital flows and whether it will reduce the purchase price of deals. Now I will turn it over to Jamal for some observations.
Thank you, Hetal. Intercompany loans must be structured such that it meets the arm’s length standards as per section 247 of the Income Tax Act. Debt capacity studies must be done to ensure the loans contemplated would exist within an arm’s length context. Credit quality analysis of related party borrowers must factor in the loans envisioned to determine what a reasonable interest rate would be. More debt generally implies higher risks and will result in higher interest rates being charged by related party lenders.
How do we determine such an interest rate? A range of interest rates must be determined based on a set of third party comparables. Adjustments to comparable 3rd party loans must be made to improve comparability between it and the related party loans. These may include term adjustments, currency adjustments and credit quality adjustments. In sum, we need to ensure the 3rd party loans are adjusted to take into account the differences between them and the related party loans. Generally speaking, related party borrowers that have a stronger economic outlook should be charged lower rates then those entities that are not as strong.
If inbound M&A are financed through third parties, negotiating a rate becomes key. Smaller companies may have a tougher time achieving better interest rates than those of bigger, more credit worthy borrowers.
These are not the only factors that determine if we should go internally or not. One thing that we often overlook is bigger macroeconomic issues. In addition to transfer pricing rules, an analysis must be performed to determine if locating in Canada is appropriate from a macroeconomic perspective. Do labour supply, infrastructure and tax incentives merit a company opening up and bringing inbound investment into Canada? The pandemic has shed light onto the attractiveness of investing in countries like Canada.
Before investing in Canada, many questions need to be answered. Are labour and input shortages in Canada pronounced than in other countries? Is the presence of universal health care a factor that makes investing in Canada more attractive than other locales in terms of cost savings? Is Canada’s position as a reliable trading partner being tarnished considering the protests that reduced trade over international borders? These are the types of questions we need to understand to ensure that an investment into Canada is sound from a macroeconomic perspective. Angeline, over to you.
Thank you, Jamal and Hetal. If there are a few takeaways from today’s conversation, they are: First, for intercompany transactions, they need to meet the arm’s length standard and the guidance provided by OECD related to intercompany debt. This includes the need for a debt capacity study to ensure that the debt assumed, and interest rates assigned in the related party context are reasonable based on a set of comparables.
Should we decide to assume third party debt, Negotiations become key. However, larger companies with strong balance sheets are likely to receive better rates than smaller companies.
Second, purchasers need to model the impact of the new EIFEL rules and how this will impact the after-tax cost of financing where the interest is restricted. This will need to be considered in connection with other normal interest limitation rules.
And, finally, in addition to technical aspects, any deal needs to investigate the macroeconomic considerations of the host country. Supply side issues brought about by the pandemic relative to other countries, issues around cost savings due to universal health care, and socio-political issues must be considered when determining the merits of an investment from a macroeconomic perspective.
In case you missed our last episode, we had a deep dive into the implications of hiring or moving employees for companies coming inbound into Canada. In our next podcast episode, we look at how companies should manage their goods and services when coming into Canada. If you haven't already done so, subscribe and tune in to the full Cross-Border Podcast series. Thanks for listening, and take care everybody.
The information in this publication is current as of April 14, 2022.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.