Active Business Income vs. FAPI
The tax benefits of setting-up an offshore structure and establishing Forco will only be present with respect to income earned by Forco that is considered to be income from an active business. If the income is classified as “foreign accrual property income” (“FAPI”), there will generally be no benefit achieved.
FAPI is a key concept that is part of Canada’s tax system for taxing income earned through “foreign affiliates”. In many respects, FAPI is similar to the US tax concept of “Subpart F income”.
Namely, it is a mechanism aimed at preventing taxpayers from deferring tax on certain types of income by arranging their affairs so that such income is earned in a controlled foreign corporation.
Since Forco will be a “controlled foreign affiliate” of its parent (Canco), any FAPI earned by Forco will be taxed in Canco’s hands [1], even if not distributed to Canco.
Most commonly, FAPI consists of investment income, capital gains, and gains from trading securities or commodities.
However, certain types of income that would otherwise be considered active business income will be FAPI, such as:
- Income from the sale of real estate, even if developed by Forco, unless Forco has more than five full-time employees[2]
- Income from services provided to Canco, unless such services relate to the purchase, sale or manufacturing of goods[3]
- Income from services if those services are provided by a Canadian resident that controls Forco, or who is related to such a person, unless such services relate to the purchase, sale or manufacturing of goods , or [4]
- “Buying commissions” paid by Canco to Forco, or profits earned by Forco on the sale of goods to Canco[5]
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However, certain types of income that might otherwise be considered investment income will be deemed to be active business income. For example, charges between foreign affiliates that relate to active business income of the payer (e.g. royalties, interests) will generally be considered active business income to the recipient [6].
Accordingly, it is essential that tax advisors should be aware of these rules and ensure that the income of Forco is not FAPI, if any tax-deferral benefits are to be achieved.
In the next article in this series, I will discuss the relevance of transfer pricing considerations in connection with the operation of Forco.
Endnotes
[1] Subsection 91(1), subject to an offsetting deduction under subsection 91(4) equal to four times underlying foreign taxes paid.
[2] As per definition of “investment business” in subsection 95(1), since real estate is “investment property”.
[3] Subparagraph 95(2)(b)(i), subject to definition of “services” in subsection 95(3)
[4] Subparagraph 95(2)(b)(ii), subject to definition of “services” in subsection 95(3)
[5] Subparagraph 95(2)(a.1)
[6] Subparagraph 95(2)(a)(ii)
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