In April 2021, Canadian Deputy Prime Minister and Federal Finance Minister, Chrystia Freeland, delivered the Federal Budget 2021 – 2022 (Budget 2021): A Recovery Plan for Jobs, Growth, and Resilience.   

It was the first federal budget for more than two years.  It contained some announcements that could affect taxation in the Canadian project finance sector.  The main ones were introducing a new earnings-stripping rule, changes to capital cost allowances, and a new investment tax credit.  

In this blog we discuss the proposed introduction of an earnings-stripping rule. 

Interest Deductibility Limit 

Budget 2021 proposes introducing a new earnings-stripping rule consistent with Base Erosion and Profit Shifting (BEPS) Action Point 4 recommendations.  The new rule will limit the amount of net interest expense that may be deducted to a fixed share of earnings, as is the case in a number of other tax jurisdictions around the World, including the UK.


The new earnings-stripping rule will apply to corporations, trusts, partnerships and Canadian branches of non-resident taxpayers. 

We expect that standalone Canadian corporations and Canadian corporations that are members of a group with non-resident members will, in most cases, not be affected by the proposed rule. 

Under the proposed limits: 

  • Fixed Ratio Rule: the amount of net interest expense that a corporation may deduct in computing its taxable income would be limited to no more than 30% of its “tax EBITDA (earnings before interest, tax, depreciation and amortisation)”; 
  • Group ratio rule: will enable a taxpayer to deduct interest in excess of the fixed ratio, where it can be demonstrated that the ratio of net third party interest to book EBITDA of its consolidated group implies that a higher deduction limit would be appropriate; 
  • Tax EBITDA: will exclude intercompany dividends, whilst interest expense and interest income will include payments that are economically equivalent to interest, and other financing relating expenses and income; 
  • Interest expense: will exclude non-deductible interest, including interest that is not deductible under the existing thin capitalisation rules;  
  • Exclusion: interest expense and interest income relating to loans between Canadian members of a corporate group will be excluded from the calculation of tax-EBITDA;  
  • Unused capacity: a Canadian member of a group that has a ratio of net interest to tax-EBITDA below the fixed ratio may be able to transfer unused capacity to other members of the group to enable them to deduct additional interest;  
  • Special rules: will apply to banks and other financial institutions to restrict their ability to transfer unused deduction capacity to group members that are not regulated banking or insurance entities; and 
  • Applicable to all debt: the measure will apply to existing borrowings as well as new borrowings. 

Transition Year 

The ratio of net interest to tax-EBITDA will be set at 40% for tax years beginning on or after 1 January 2023, but before 1 January 2024, and then reduce to 30% in all subsequent years. 

Disallowed interest 

Interest disallowed under the proposed rule will be able to be carried forward for up to 20 years or carried back for up to 3 years. 

Consolidated group 

For the group ratio rule, a consolidated group includes the parent and all of its subsidiaries fully consolidated in the parent’s audited consolidated financial statements. 


Canadian Controlled Private Corporations (CCPCs) that, together with associated corporations, have taxable capital employed in Canada of less than CAD 15 million will not be impacted. 

In addition, groups of corporations and trusts whose aggregate net interest expense amongst their Canadian members is less than CAD 250,000 will be exempt. 


Draft legislative proposals are expected to be released for comment in the summer, with the rule applying for tax years beginning on or after 1 January 2023. 

Impact on the project finance sector 

P3 projects are often undertaken by an entity that is either a general or limited partnership, with the partners not necessarily being CCPCs.  The announcement did not include any suggestion that there would be an exemption for public infrastructure projects, as there often is under the equivalent rules in other tax jurisdictions.  However, this might be something that is added as a result of the consultation later this year.   

Based on the proposal within Budget 2021, the earnings stripping rule is likely to have a negative impact on transactions by delaying the deduction of interest incurred.  In turn, this will lead to higher taxable income in early years of transactions.  This is because, typically, towards the start of project finance transactions, the amount of outstanding debt is relatively high, which leads to a relatively high amount of interest being incurred.  On the other hand, EBITDA is typically relatively low compared to later years.  This means that whilst a high amount of interest is incurred in early years, the allowable interest at 30% of tax-EBITDA will be low.  The resulting disallowed interest would typically be carried forward.   

As time passes, debt is repaid, which reduces the outstanding debt balance and therefore interest incurred, but tax-EBITDA tends to increase.  The maximum allowable interest at 30% of tax-EBITDA therefore increases, but the interest incurred decreases.  This should allow entities to deduct interest previously disallowed as they will be able to claim an additional deduction for tax purposes.  This additional deduction will be equal to the minimum of the previously disallowed interest brought forward and the difference between 30% of EBITDA and the actual interest incurred. 

As currently proposed, we anticipate that, whilst in a typical transaction all interest incurred will still eventually be allowable, the rule is likely to bring forward the timing of tax payable.  The proposed rule can therefore negatively impact on the returns to sponsors. 

From our knowledge and modelling expertise of similar interest deductibility restrictions in a number of other tax jurisdictions, we can help you assess the impact of the proposed earnings stripping rule on your transaction and group.  We would be happy to discuss how we can work together to provide input into the consultation to try to ensure that the final legislation does not adversely impact project finance transactions. 

Read part two of this blog here.

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