Canadian Foreign Affiliates, FAPI, and Upcoming Legislative Changes
On August 9, 2022, Canada’s Ministry of Finance released details of proposed changes to the Income Tax Act (“ITA”), many of which are drafted to take effect as of April 7, 2022. The following are the implications for Canadian foreign affiliates.
These amendments impact the tax consequences of Canadian businesses with subsidiaries in other countries. This article will focus on the changes for passive business and property-based income generated by these foreign subsidiaries.
Canadian Controlled Private Corporation Changes
The ITA refers to private Canadian businesses as Canadian-Controlled Private Corporations (“CCPCs”) and there are specific rules regarding the international tax obligations of CCPCs when it comes to their subsidiaries and affiliates abroad. Moreover, although all Canadian Taxpayers (Corporate and Individual) are liable for reporting and including their “worldwide income” when calculating their tax return, foreign Taxpayers are only liable for income derived from a Canadian source.
The proposals change certain rules around the taxation of property-based income and passive business income generated by Canadian Foreign Affiliates (“CFAs”). CFAs are foreign subsidiary entities that are wholly controlled by their Canadian parent (often a CCPC) and the ITA has select rules that navigate the international taxation regime to prevent double taxation while curbing tax evasion.
Foreign Accrual Property Income Changes
Section 91 of the ITA classifies income derived from property and passive businesses as Foreign Accrual Property Income (“FAPI”), which generally includes amounts from capital gains, renting properties, interest on loans, royalties from licensing, dividends etc. Although certain recharacterization rules may apply to treat FAPI as active business income, such as the income generated by CFAs that run an investment business, the general rule is that income from a CFA’s property or business other than an active business will be classified as its parent CCPC’s FAPI and the corresponding taxation rules will apply.
The proposal effectively prevents deferring the tax consequences for CCPCs that arise from FAPI generated by their CFAs for the taxation year, and instead shifts the onus on the CCPC to restructure their dividend payout from the CFA to capture any differences between the foreign accrual taxes paid and the additional Canadian taxes attributable to any FAPI inclusions.
This is important for Canadian businesses since it increases the chances of both double taxation, as well as losing out on the taxation benefits provided by bilateral taxation treaties between Canada and other jurisdictions.
Canadian Foreign Affiliate Changes
The CFA will likely pay taxes on the income it generates at the rate prescribed to the country they are operating within. The taxes paid on the portion of income attributable to FAPI is referred to as Foreign Accrual Taxes and the Canadian parent can collect FAPI from the CFA based on a calculation using the Relevant Tax Factor. Under the current rules (and based on the taxation treaties involved), this often results in the Canadian parent being able to deduct FAPI amount in full, thus not paying taxes on FAPI in Canada.
The proposed changes increase the Relevant Tax Factor, which results in decreasing the allowable deduction to FAPI inclusions for the Canadian parent. The result is that the Canadian parent will have an initial tax obligation of approximately 52.6% for FAPI which is payable for the taxation year the FAPI is incurred, and must recoup the proper tax rate (which is usually lower, such as 25% with the US-Canada Treaty) using a dividend payout from the CFA.
Although these changes are not yet realized, international taxation is complicated and taxpayers have a highly burdensome duty to be alert of legislative reform. At R&A Tax Law, we aim to make the complex regime more accessible to everyday taxpayers. If you have questions or need help with international and domestic tax issues, give us a call today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.