A Canadian resident who is a shareholder of a “controlled foreign affiliate” (“CFA”) will have special Canadian tax issues if that CFA earns “foreign accrual property income” (“FAPI”).
Any corporation that is not resident in Canada (“Forco”) will be a CFA of a particular Canadian resident if it is controlled by that Canadian resident. However, even if Forco is not controlled by that Canadian resident, Forco can be a CFA even if that Canadian resident holds as little as 1% of the shares of Forco, if other related persons, together with that Canadian resident, control Forco.
For the most part, FAPI would consist of passive investment income and taxable capital gains.
However, the FAPI definition is complex, and can sweep-in certain types of business income as well.
If a Forco is a CFA of a Canadian resident, that Canadian resident generally must include in income his/her/its share of FAPI earned by Forco, even if no amount has actually been distributed[1]. The FAPI concept is quite similar to the U.S. Subpart F regime-both are aimed at preventing residents from deferring current taxation on investment income and capital gains by using foreign corporations.
Active business income (“ABI”) earned by Forco is generally excluded from FAPI. However, in situations where Forco is used for real estate ventures in foreign jurisdictions, FAPI may be generated even if the income might otherwise be considered ABI in a domestic context.
Many professionals who don’t deal with international tax issues in any depth mistakenly think that the same rules for distinguishing ABI from investment income within a domestic context[2] also apply for the purposes of the foreign affiliate rules.
In fact, within the context of income from the rental of real estate, the test is essentially the same: an active business is one which has more than five (5) full-time employees throughout the relevant year.
However, when it comes to gains from the sale of real estate, the tests are markedly different.
The relevant concepts and definitions for the purposes of the FAPI rules are generally found in subsection 95(1) of the Act. For example, if Forco is used as a land trading company, the income will generally be FAPI[3]. In contrast, income of a CCPC from even an isolated speculative transaction whereby it earned a profit on the sale of land would be ABI, even if it had no employees at all[4].
What if Forco is in the business of building and selling homes? That sounds pretty active, and, certainly any income derived from that business would be ABI within a domestic context, regardless of the number of employees. However, for the purposes of the FAPI rules, the income will be FAPI for the same reason (since the purpose of the business is to derive profits from the sale of real estate) unless Forco meets the more than five (5) full time employee threshold[5]. It is important to note that if services are provided to Forco by unrelated, independent contractors, which is quite common in the home-building industry, those services cannot be counted in meeting the full-time employee test.
In situations where Forco pays foreign taxes with respect to its FAPI, the Canadian shareholder can claim what is in effect a grossed-up deduction for such underlying foreign taxes to offset the inclusion in income. This deduction is equal to the underlying taxes multiplied by a “relevant factor”. For a corporate shareholder the factor is 4; for an individual it is 2.2[6].
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For Forcos engaged in real estate businesses in the U.S., there generally would be no net FAPI inclusion for a Canadian parent corporation, since U.S. corporate tax rates will generally exceed 25% on any substantial amount of income[7].
On the other hand, such businesses conducted in tax-havens, such as the Bahamas, Grand Cayman, or Bermuda will generate FAPI without any offsetting deduction.
[1] Subsection 91(1) Income Tax Act (“the Act”) (subject to a de minimis exception where the total FAPI of Forco in a year is no more than $5,000)
[2]Particularly in relation to distinguishing ABI from “specified investment business income” (“SIBI”) earned by “Canadian-controlled private corporations” (“CCPC”).
[3] Income from an “investment business” of Forco will be included in FAPI, and that includes a business the principal purpose of which is to derive “profits from the disposition of investment property”. Paragraph “g” of the “investment property” definition refers to “real property or immovables”.
[4] It should be noted that, under subsection 125(7) of the Act, “active business carried on in Canada” includes “an adventure or concern in the nature of trade”.
[5] The “investment business” definition generally excludes a business that is “the development of real property or immovable for sale” where the greater than five full-time employee threshold test is met.
[6] Subsection 91(4) of the Act
[7] For this, and other reasons, corporate, rather than personal, ownership of U.S. real estate corporations is usually preferable for Canadians (other reasons: avoiding potential exposure to U.S estate taxes; avoiding personal taxation of dividends; and lower U.S. withholding taxes).
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
