On April 19, 2021, the Canadian federal government presented its first budget in over two years due to delays caused by the COVID-19 pandemic (“Budget 2021”). Budget 2021 included the announcement of long anticipated international tax proposals arising from Canada’s involvement in the Organisation for Economic Co-operation and Development’s (“OECD”) base erosion and profit shifting (“BEPS”) project, which is aimed at addressing certain tax planning strategies used by multinational enterprises that are considered to improperly shift profits between jurisdictions. Specifically, Budget 2021 proposes to introduce two new sets of rules to address issues raised by the BEPS Action Plan, namely (1) limits on the ability to deduct interest expenses and (2) anti-hybrid mismatch arrangement rules. In introducing these new rules, Canada is following the lead of other OECD and G20 countries that have already implemented similar rules as a result of BEPS.

Interest deductibility restrictions

Under existing Canadian tax rules, interest on debt incurred to earn business income is fully deductible in computing income, subject to certain limitations (e.g. the thin capitalization rules limit the amount of deductible interest where debt owing to specified non-residents exceeds a 1.5 to 1 debt to equity ratio).

Budget 2021 raises the concern that excessive debt in Canadian businesses can erode the Canadian tax base, including by paying interest to related non-residents in low-tax jurisdictions, using debt to finance investments that earn non-taxable income, and having Canadian businesses bear a disproportionate burden of a multinational group’s third party debt.

To address this concern, Budget 2021 proposes an “earnings-stripping” rule to restrict interest deductibility that is consistent with the recommendations in the Action 4 Report of the BEPS Action Plan developed by the OECD and G20.

The proposal

The proposed restriction would generally limit the amount of “net interest expense” that is deductible in computing income to a fixed ratio (40% for one transition year and then phased down to 30%) of “tax EBITDA”.

Net interest expense

  • Net interest expense means interest expense (including payments economically equivalent to interest and other financing-related expenses), less interest and other financing-related income.
  • Interest expense is limited to interest that is otherwise deductible under existing rules, including the thin capitalization rules, such that those rules would presumably apply first.
  • To permit loss consolidation arrangements within a Canadian group, interest expense and interest income related to debts owing between Canadian members of a corporate group would generally be excluded.


  • Tax EBITDA means taxable income, before ‎taking into account interest expense, interest income, income tax, and deductions for depreciation and ‎amortization, each as determined for tax purposes.‎

Fixed ratio

  • The fixed ratio is:
    • 40% for tax years beginning on or after January 1, 2023, but before January 1, 2024
    • 30% for tax years beginning on or after January 1, 2024
  • Canadian members of a group with a ratio (of net interest expense to tax EBITDA) below the fixed ratio would be able to transfer the unused capacity to other Canadian members of the group.

Group ratio

  • The proposal also includes a “group ratio” rule that would allow a taxpayer to deduct net interest ‎expense in excess of the fixed ratio if the taxpayer can demonstrate that the ratio of net third party ‎interest to book EBITDA of its consolidated group implies a higher ratio is appropriate. ‎
  • Net third party interest and book EBITDA would be based on the consolidated group’s audited ‎consolidated financial statements, with adjustments (e.g. an exclusion for interest payments to ‎creditors that are outside the group, but related to or significant shareholders of Canadian group ‎members).‎

Denied interest expense

  • Denied interest expense could be carried forward 20 years or back 3 years and deducted in those years, but subject to the same ratio restrictions in those years as described above.

Application and exemptions

  • The proposed restrictions are to apply to:
    • Tax years beginning on or after January 1, 2023
    • Corporations, trusts, partnerships, and Canadian branches of non-resident taxpayers
    • New and existing debt
  • Exemptions would be available for:
    • Canadian-controlled private corporations with taxable capital employed in Canada of less than $15 ‎million (on an associated corporation basis)
    • Corporate groups with total net interest expense among Canadian members of $250,000 or ‎less
  • Budget 2021 states that it is expected that the proposed interest deductibility restriction would generally not apply to “standalone Canadian corporations” or “Canadian corporations that are members of a group none of ‎whose members is a non-resident”, and measures to reduce the compliance burden on these entities will be explored.
  • Special rules may be developed for financial institutions.
  • Draft legislation will be released for consultation in Summer 2021.

Anti-hybrid mismatch arrangement rules

Budget 2021 describes hybrid mismatch arrangements as “cross-border tax avoidance structures that exploit differences in the income tax treatment of business entities or financial instruments under the laws of two or more countries to produce mismatches in tax results”. For example, a hybrid business entity would be an entity that is treated as a separate taxpayer in one country, but as a pass-through entity in another country. An example of a hybrid financial instrument is an instrument that is treated as debt in one country, but as equity in another country. These differences in tax characterization between countries can result in tax savings to multinational enterprises.

Budget 2021 describes several types of hybrid mismatch arrangements:

  • Deduction/non-inclusion mismatch – a country allows a deduction for a cross-border payment, but the other country does not require an inclusion within a reasonable time in ordinary income (i.e. income subject to tax at the normal rate and ineligible for any exemption, deduction, credit, or similar relief).
  • Double deduction mismatch – a deduction for a single expense is available in two or more countries.
  • Imported mismatch – a payment is deductible by an entity resident in one country and included in the income of an entity resident in a second country, but the income is set off against a deduction under a hybrid mismatch arrangement between the second entity and an entity resident in a third country.
  • Branch mismatch – a taxpayer’s residence country disagrees with the taxpayer’s branch country on the appropriate allocation of income and expenses between the two countries.

The proposal

  • Under the main proposal, which targets deduction/non-inclusion and double deduction mismatches:
    • A payment made by a Canadian resident under a hybrid mismatch arrangement would not be deductible to the extent the payment is not included in the recipient’s ordinary income or creates a deduction in another country.
    • A payment made by a non-Canadian resident under a hybrid mismatch arrangement that is deductible for foreign tax purposes to a Canadian resident would be included in the Canadian resident’s income, and if the payment is a dividend it would not qualify for the deduction otherwise available for dividends from foreign affiliates.
  • Proposals targeting the other types of hybrid mismatch arrangements will be developed.


  • The proposed rules would be implemented in two separate legislative packages:
    • The first package would generally target deduction/non-inclusion mismatch arrangements, and be released for consultation later in 2021. These rules would apply as of July 1, 2022.
    • The second package would target other types of hybrid mismatch arrangements, and be released for consultation after 2021. These rules would apply no earlier than 2023.

These proposed changes to Canadian tax rules will have a significant impact on existing financing structures used by multinational enterprises to fund their Canadian operations. Once released later this year, the draft legislation will certainly be complex and require interpretation. Please contact any member of our National Tax Group if you have any questions about these proposals.