Donald Trump’s proposal to lower U.S. federal corporate tax rates to 15% will be welcome news for Canadians who are shareholders of a profitable U.S. corporation (“Usco”).
However, in certain cases, the Canada Revenue Agency will have its hands outstretched for a piece of the tax savings.
In cases where Usco is a “controlled foreign affiliate” (“CFA”) of a Canadian resident and Usco is earning “foreign accrual property” (“FAPI”), that Canadian resident will generally have to include a share of the FAPI in income under subsection 91(1) of the Income Tax Act (“the Act”). This will be the case even if there is no actual distribution.
Many Canadians hold U.S. real estate investments via U.S. corporations. Rental income earned by those corporations, as well as real estate trading or taxable capital gains, will generally be FAPI unless Usco has more than five (5) full-time employees in the relevant business.
However, under subsection 91(4) of the Act, a deduction is allowed for underlying foreign taxes multiplied by the “relevant tax factor” (“RTF”).
If the Canadian shareholder is a corporation (“Canco”), the RTF is 4, which means that as long as the underlying U.S. tax rate is 25% or more, there would be no net FAPI inclusion.
Because of high U.S. tax rates, this generally means that FAPI would generally not be an issue for Canadian corporate shareholders of U.S. corporations.
This could change, since, even if state corporate income taxes apply, the total effective rate would likely fall short of 25%.
This can also be relevant even if Usco is not a CFA of Canco, but is still a “foreign affiliate of Canco (generally ownership of at least 10% of the shares of any class). In those situations, the taxation of FAPI will only be relevant when dividends are paid from Canco to Usco. In typical cases, high corporate tax rates meant that a paragraph 113(1)(b) deduction would fully shelter dividend receipts. Here again, an underlying corporate tax rate of 25% was all that was needed. Lowered corporate tax rates in the U.S. may fall below that level; however, in certain cases, a deduction under paragraph 113(1)(c) for the 5% US tax normally withheld may effectively cover the shortfall.
In cases where Usco is a CFA of a Canadian individual (including a trust) the RTF is only 2.2, which means that an underlying corporate tax rate of over 45% is needed to fully shelter FAPI inclusions. In such cases, usually, there already was some net FAPI inclusion, but a cut in U.S. federal tax rates will generally make this issue much more significant. For example, if the income is earned in a state without corporate income taxes, only 33% of the FAPI would be sheltered by a subsection 91(4) deduction; the remaining 67% will be taxable in Canada.