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Overview - Foreign Accrual Property Income
Canadian persons who invest in a foreign corporation can besubject to special income inclusion rules which deem them to earnForeign Accrual Property Income (FAPI) if they own a large enoughstake in the foreign corporation and that foreign corporationearned "passive" income such as income from property orcapital gains on the sale of property not used in an activebusiness. The Supreme Court of Canada inCanada v. LoblawFinancial Holdings Inc. described the FAPI regime as"one of the most complicated statutory regimes in Canadianlaw" and "one of the most complex taxschemes, with hundreds of definitions, rules, andexceptions that shift regularly." This article providesan overview of the primary components of FAPI.
If a Canadian person owns 10% of a foreign corporation, thatcorporation will qualify as a foreign affiliate. Having a foreignaffiliate means a Canadian taxpayer is required to file a specialinformation return,form T1134, each year along with the Canadiantaxpayer's T1 or T2 tax return, which provides the CanadaRevenue Agency (CRA) with information about the foreignaffiliate.
A Canadian person will only have a FAPI inclusion with respectto a foreign corporation that is a controlled foreign affiliate ofthe Canadian person. When a Canadian controls a foreign corporation(generally but not exclusively by owning more than 50% of itsshares) then the foreign corporation is a controlled foreignaffiliate of the Canadian taxpayer. A foreign corporation can alsobe a controlled foreign affiliate if the Canadian taxpayer and adistinctly specified small group of other Canadian taxpayerscollectively own sufficient shares to control the foreigncorporation. A more detailed description of the definition offoreign affiliate and controlled foreign affiliate is available inthisarticle.
Canadian persons with a controlled foreign affiliate need toreport and pay tax on foreign accrual property tax income each yearproportional to their interest in the controlled foreign affiliate,even if that foreign income is not repatriated to Canada. Thiseliminates the tax deferral advantage that might otherwise beavailable through holding passive investments through anon-resident holding company. The cost base of the shares in thecontrolled foreign affiliate will be increased by the amount ofFAPI earned by the Canadian resident owner to prevent doubletaxation on the eventual disposition of the shares. If thecontrolled foreign affiliate eventually pays a dividend, then adeduction is available for the Canadian resident to account for theFAPI the Canadian resident has already paid to prevent doubletaxation when the foreign affiliate distributes its earnings.Canadian persons can also accrue foreign accrual property losseswhich can be carried forward up to 20 years or backward up to 3years to offset foreign accrual property income.
Canadian income tax law also allows the equivalent of foreigntax credits to reduce foreign accrual property income based on theamount of foreign taxes paid on the controlled foreign affiliatesincome that is included in FAPI.
The Rationale for FAPI - Foreign Accrual Property Income
In the absence of Canada's controlled foreign affiliaterules, the following tax planning idea would be tempting forCanadian taxpayers with substantial investment portfolios:
- Incorporate a corporation ("ForeignCo") in ajurisdiction with no income tax or income tax rates lower thanthose that apply in Canada;
- Hold passive investments such as stocks, bonds, or real estatein ForeignCo; and
- Have ForeignCo reinvest, offshore, the dividends, interest,rent and other investment income generated by the portfolio.
This approach would effectively allow Canadian taxpayers todefer paying Canadian tax indefinitely by only having the ForeignCopay dividends to the Canadian taxpayer when necessary (e.g. to fundconsumption). This would be a substantial tax advantage as itallows ForeignCo to reinvest and earn a return on money that wouldotherwise be paid to CRA.
TheIncome Tax Act's way of preventing taxplanning of the type described above is with the concept of foreignaccrual property income ("FAPI"). Canadian income tax lawwill treat Canadian residents as having received income, FAPI,based on certain types of "passive" income earned bytheir controlled foreign affiliates even in the absence of thecontrolled foreign affiliate paying that money to the Canadianresidents as dividends. If the controlled foreign affiliatesubsequently pays dividends from income previously taxed as FAPI,an adjustment is available to prevent double taxation.
Components of FAPI - Foreign Accrual Property Income
FAPI Inclusions
Income from Property
Unless otherwise excluded, income from property is included inFAPI. The typical forms of income from property include dividends,rent, interest, and royalties. Realized capital gains, another typeof prototypical "passive" income also often included inFAPI, though they are not considered "income fromproperty" within the legislation. The idea behind "incomefrom property" is that of income to which the owner of aproperty is entitled by virtue of ownership of the property withoutrequiring a level of activity constitutive of running a business.Normally under Canadian income tax law income from an adventure orconcern in the nature of trade is considered income from a businessnot income from property, but for the purposes of Foreign AccrualProperty Income it is considered income from property. Income thatpertains to or is incidental to an active business may be excludedfrom FAPI.
Income from an Investment Business
Income from an "investment business" is also includedin FAPI. Prior to 1995 legislative amendments, the courts foundthat relatively low levels of activity would be sufficient forforeign income to be excluded from Foreign Accrual Property Incomeon the basis that it was business income not income from property.The government responded by introducing the concept of aninvestment business, which is a business carried on principally toearn income from property, income from insuring or reinsuringrisks, income from factoring accounts receivable, and thedisposition of certain types of property.
There is however an exception from investment business statusthat applies if three criteria are met. First, the business must beconducted primarily with arm's length persons. Second, thebusiness must be of a specific type including a real estatedevelopment business, a leasing or licensing business, an insurancebusiness, a money lending business, or a regulated financialbusiness. Third, the business must employ more than five full-timeemployees in carrying on the business.
Sales of Property Deflecting Canadian SourceIncome
Income earned by a foreign affiliate through the sale ofproperty which 'deflects' away from Canada can give rise toFAPI. In particular, if a Canadian resident taxpayer (or a Canadianperson not arm's length with the taxpayer) has a foreignaffiliate which
- sells property which was not produced in or otherwisesufficiently connected to the foreign affiliate's jurisdiction,and
- the cost of that property to a person is relevant to theCanadian resident taxpayer's (or a person not at arm'slength from the Canadian resident taxpayer) income from a businesscarried on in Canada,
then the sale of that property will be deemed to be a separatebusiness whose income will be included in foreign accrual propertyincome. This has a similar effect to Canadian tax law'stransfer pricing rules, but may apply in some situations where thetransfer pricing rules do not apply.
Income from Insuring Canadian Risks
Income earned by a foreign affiliate for insuring or reinsuringrisk in respect of a person resident in Canada, a property situatedin Canada, or a business carried on in Canada will be included inFAPI even though it may be active business income. There is howeveran exception that can apply if more than 90% of the foreignaffiliate's gross insurance premium revenue was from insuringthe risks of persons at arm's length from the foreignaffiliate.
Income Related to Canadian Debt and LeaseObligations
Income earned by a foreign affiliate deriveddirectly or indirectly from the indebtedness or lease obligationsof persons resident in Canada or in respect of businesses carriedon in Canada will be included in Foreign Accrual Property Income.This includes income from the foreign affiliate's purchase andsale of Canadian indebtedness or lease obligations on its ownaccount.
An exemption may be available if over 90% of the gross revenueof the foreign affiliate from indebtedness and lease obligationscame from the indebtedness and lease obligations of non-residentpersons whom the affiliate deals with at arm's length.
Income from Services Deductible by a Non-Arm's LengthCanadian Resident
If a foreign affiliate earns income by charging a fee for aservice it provides, and that fee is deductible in computing theCanadian business income of a taxpayer with respect to whom theaffiliate is a foreign affiliate or any person non-arm's lengthfrom the taxpayer or the foreign affiliate, then that income willbe included in FAPI. This is another measure intended to prevent"erosion" of the Canadian income tax base by movingprovision of services related to a Canadian business to a foreignaffiliate.
A similar rule applies with respect to charges for services thatare deductible from the FAPI of another foreign affiliate. If aforeign affiliate earns income by charging a fee for a service itprovides, and that fee is deductible in computing the FAPI of asecond foreign affiliate of the same Canadian resident taxpayer,then that income is itself FAPI. This rule also applies if thesecond foreign affiliate is a foreign affiliate of a differentCanadian taxpayer which does not deal at arm's length witheither first foreign affiliate or the first Canadian residenttaxpayer.
Income from Services Performed by Canadians
Income from services provided by a foreign affiliate is includedin FAPI to the extent the services are actually performed by:
- A Canadian resident taxpayer with respect to which the foreignaffiliate is a foreign affiliate,
- A relevant person who does not deal at arm's length withthe foreign affiliate or a taxpayer of whom the foreign affiliateis a foreign affiliate,
- A partnership any member of which is a person described above,or
- A partnership in which any person or partnership describedabove has a partnership interest.
A "relevant person" is:
- A Canadian resident taxpayer, or
- A non-resident person who performs the relevant services in thecourse of a business carried on in Canada.
Capital Gains
Capital gains from the sale by a foreign affiliate of propertythat was not used in an active business and is not shares of acorporation which carries on an active business which accounts forsubstantially all of the fair market value of the shares are alsoincluded in FAPI.
FAPI Exclusions
Active Business Income
Income from an active business is excluded from FAPI so long asit falls outside of the "investment business" or otherspecial rules designed to prevent tax base erosion as describedabove.
Intra-group Payments and Transactions
Some income from property earned by a foreign affiliate isexcluded from being FAPI due to rules that deem some intra-grouppayments to be active business income for FAPI purposes. Incomefrom property earned from another member of the same corporategroup where that income ultimately originated from an activebusiness carried on by a different member of the corporate group istypically excluded from FAPI. This is to prevent intra-grouppayments converting active income not intended to be included inFAPI into income that would otherwise be included in FAPI.Typically, this treatment is available to the extent that theproperty income earned by the foreign affiliate is deductible whencomputing the income from an active business of another foreignaffiliate.
Active Business Carried Out by Two Related ForeignAffiliates
When two foreign affiliates carry out separate aspects of anactive business in a collaborative fashion, income earned by aforeign affiliate that would otherwise be classified as income fromproperty may be classified as active business income instead. Thisincome should be such that if it is directly related to the activebusiness activities of the other foreign affiliate and would beincluded in computing the active business income of the otherforeign affiliate if it had been earned by the other foreignaffiliate.
Pro Tax Tips – Foreign Affiliates and Controlled ForeignAffiliates
The foreign affiliate system and foreign accrual property incomeare highly complex and is essential to get advice from an expertToronto tax lawyer before setting up any structure or business towhich this system may apply. Some structures for your business maybe significantly better or worse than others and it is essential tounderstand the income tax compliance requirements associated withyour business. If you inadvertently have FAPI which you have notreported, you should consult with an experienced Canadian taxlawyer about filing a voluntary disclosure application. This mayallow you to eliminate the penalties and reduce the interestassociated with your non-compliance if you have not already beencontacted by the Canada Revenue Agency.
Related Post
Components ofForeign Accrual Property Income – Canadian Income Tax –Toronto Tax Lawyer Guide
ForeignAffiliates and Controlled Foreign Affiliates – CanadianIncome Tax – Toronto Tax Lawyer Guide
T1134 Formfor Foreign Affiliates
The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.
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