Proposed interest limitation rules could
devastate rental housing

By John Dickie, CFAA President

In the two most recent issues of National Outlook, CFAA warned readers of the risk of an increase in the capital gains inclusion rate, based in part on the potential influence of the NDP. Now rental housing providers face a new, even more serious risk, from a different source.

The Liberal Party election platform proposed to expand the application of the limit on the interest that corporations can claim on borrowings to finance their operations. According to well-known economist Jack Mintz, Finance Department officials have been eyeing this possible change for 20 years.

A similar restriction has been applied to limit the amount of the interest which branches of foreign companies pay to non-residents of Canada. In that context, the rule makes some sense, because profit on Canadian operations could be “converted” into interest in the hands of non-residents who do not pay Canadian income tax. However, expanding the rule to apply to interest payments to Canadians would serve no purpose since those interest payments are taxable in the hands of the recipients.

Some descriptions of the rule under consideration suggest it could have a disastrous effect on rental housing and other real estate operations.

The Liberals proposed to prevent corporations from deducting more interest than 30 per cent of the corporation’s “earnings before the deduction of interest, taxes, depreciation and amortization” (EBITDA), which is similar to a rental owner’s net operating income (NOI) less applicable administrative expenses.

Not to be outdone, the NDP has proposed that the interest deductibility limit be set at 20 per cent!

Because rental operations use a great deal of capital, most rental operations pay out more interest than 30 per cent of the building’s NOI; and in their initial stages, many new operations pay out much more then 30 per cent. See Table 1.

Table 1 shows two typical situations for a building which has been held for five or ten years: first, a typical income, expense and tax situation for a principal business corporation (a PBC), and second, a typical income, expense and tax situation for a real estate investment corporation, with five or fewer full-time employees. All the figures are based on one unit in a multi-unit building. Both situations assume a 50% borrowing ratio (loan-to-value), and a 4% interest rate.

Table 1: Typical income, expense and tax situations

SectionBuilding item (per rental unit)Principal Business Corp (PBC)Real Estate Investment Corp
Basic building facts
Property value$180,000$180,000
Gross rental income$12,000$12,000
NOI (approx = EBITDA)$7,200 $7,200
Interest payments per year$3,600$3,600
Capital cost allowance claimed$2,000$2,000
Current tax situation
Net income before tax$1,600$1,600
Total corporate tax (fed & prov – approx)$585$803
Net income after tax$1,015$797
Apparent proposal
Interest payment allowed (30% of NOI)$2,160$2,160
Notional net income for tax calculation$3,040$3,040
Total corporate taxes (fed & prov – approx)$1,110$1,526
Actual net income (from above)$1,600$1,600
Actual net income after tax$490$74
Comparison
Increase in tax (in dollars)$525$723
Increase in tax (as percentage)90%90%

Such a new interest limitation regime would dramatically increase the income taxes on real estate, and dramatically reduce actual after-tax income. While most PBCs would stay in profit (at a much reduced level), many real estate investment corporations would generate an after-tax loss every year under perfectly normal borrowing arrangements.

Governments generally say they want the rental housing sector to expand in order to obtain a larger supply of rental housing, and thus make rental housing more affordable. Much taxpayer money and government effort (by all three orders of government) is being invested in promoting new rental construction. It would run directly contrary to that important housing policy objective to apply an interest deductibility limitation to rental housing.

Conclusion

Expanding the interest deductibility limitation to corporations with loans from Canadian sources (or foreign loans at market rates) would not achieve a good policy result. It is unnecessary, and would have serious negative unintended consequences, particularly on real estate, including rental housing.

CFAA urges the government not to go forward with any expansion of the interest deductibility limitation. At the least, we urge the government not to apply an expanded test to the real estate sector, and in particular, not to apply an expanded test to the rental housing sector.

To see CFAA’s pre-budget submission on this issue, go to www.cfaa-fcapi.org. Updates will also be posted there, and distributed in CFAA’s e-Newsletter. E-mail admin@cfaa-fcapi.org to add your name to the e-Newsletter distribution list.