Foreign Affiliate Issues: Understanding FAPI and Optimal Cross-border Structuring

 

 

 

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FOREIGN AFFILIATE ISSUES

1. UNDERSTANDING THE CALCULATION OF FAPI

2. CROSS BORDER STRUCTURE TO REDUCE COMBINED TAX

 

Canada and the US are each other’s largest trading partner, and many Canadian corporations have extended their domestic operations to the US in hopes of securing market share for the products and/or services they provide. Similarly, US corporations have ventured into the Canadian market to likewise grow their own brands.

Both jurisdictions provide options regarding the structures within which these business interests are held; however, the tax and filing consequences arising from these various structures can vary.  In order to structure cross-border activities in a manner that minimizes tax exposure and sufficiently protects assets, the various possibilities available to structure such activities must be considered to make sure that businesses on both sides of the border are able to operate effectively.

In addition, care must be taken to confidently understand the tax treatment of income travelling across the Canada - US border.

This article deals primarily with Outbound investment by a Canadian corporation with a US subsidiary.  A future article will deal with relevant Inbound structures and issues from a Canadian perspective.

FAPI

 

Canadian corporations owning controlling interests in corporations operating in foreign jurisdictions – termed controlled foreign affiliates (CFA’s) - have a substantial reporting and administrative responsibility to ensure that they stay compliant with the Canada Revenue Agency’s (CRA) disclosure requirements regarding transaction activity with and interests in those respective foreign entities.

While the repatriation of income from a CFA engaged in an active business[1] can be carried out without any additional tax applied at the corporate level, the mechanism behind the repatriation of income and capital when the CFA  is not an active business, and the tax consequences thereof, is much more complicated.

Income from a CFA that is not considered for Income Tax Act (“ITA”) purposes to be active business income is defined as Foreign Accrual Property Income - or FAPI, and includes, but is not limited to, such non-active business income as interest, dividends and rent.  The department of Finance’s intention behind the FAPI scheme is, in part, to prevent the permanent deferral of Canadian corporate-level taxation on income earned by a parent Canadian corporation (also called a corporation resident in Canada, or CRIC) through a CFA.

For example, consider the following scenario:

1. A CRIC owns 100% of the outstanding shares of a CFA;
2. The CFA is domiciled in a jurisdiction with which Canada has entered into a Tax Treaty or a Tax Information Exchange Agreement (TIEA);
3. The CFA earns net income of $10,000 that does not fit the definition of Active Business Income (ABI) as defined in the ITA.
4. The tax rate of the CFA is 25%, resulting in retained earnings remaining in the CFA - which can be repatriated back to the CRIC - of $7,500.

 

Simplifying the scenario by assuming that there are no material differences in the computation of taxable income between Canada and the CFA, and that there are no foreign exchange differences, without the FAPI tax regime in place, the CRIC would be able to defer $7,500 in income subject to Canadian taxation by leaving it in the CFA’s bank account indefinitely.

 

The FAPI regime exists to tax FAPI income on a current basis, meaning that applicable Canadian tax must be paid on the FAPI income whether or not the income is repatriated back to Canada.

 

Subsection 91(1) characterizes the inclusion of FAPI as “income from a share”, meaning that FAPI is considered to be income from property under the Income Tax Act.  As a result, FAPI included in the income of a Canadian-Controlled Private Corporation (CCPC) is also considered to be Aggregate Investment Income (AII)[2].  AII earned by a CCPC is subject to the refundable dividend tax on hand (RDTOH) regime, which results in AII being taxed at between 48.50% to 53.5%, depending on which province in Canada the CRIC has its management.

 

Proposed rules to effectively decrease the tax deduction under subsection 91(4) for the foreign tax paid by the CFA will increase the amount of income subject to tax by the CRIC, and, because that income is subject to the Non-eligible / Eligible Refundable Dividend Tax On Hand (RDTOH) tax regime (assuming the CRIC is a CCPC), will effectively increase the amount of tax paid by the CRIC on FAPI income earned by the foreign affiliate. This is because the tax deduction calculated under subsection 91(4) is based on a Relevant Tax Factor[3].

The Relevant Tax is a multiplier that, when multiplied by the Canadian equivalent of the foreign tax paid (also called Foreign Accrual Tax, or FAT), seeks to simulate the Canadian corporate tax that would be paid had the income been earned in Canada.

 

The Department of Finance, in its 2022 Budget, has proposed to reduce the Relevant Tax Factor applicable in the calculation of the tax deduction available from 4 to 1.9 to simulate the tax deduction available to Canadian individuals investing in a CFA directly.  This is reflected in the “Proposed” column on the chart below.

[1] The term “Active Business” is defined in Income Tax Act (“I.T.A”) subsection 125(7) as “any business carried on…and includes an adventure or concern in the nature of trade”.

[2] Defined in ITA subsection 129(4)

[3] Defined in ITA subsection 95(1)

With the current FAPI regime, tax on the CFA’s income of $10,000 is calculated as follows:

 

 

The ending combined tax rate of 51.60% in the proposed column is marginally higher than the investment income rate of 50.67% payable by a CCPC resident in B.C on passive investment income, proving that, despite the reduction in the Relevant Tax Factor proposed, full integration is not yet achieved, at least not yet in B.C.

 

The main purpose behind the reduction in the tax deduction under 91(4) is to replicate, as closely as possible, the combined Canadian and foreign tax consequences to an individual of earning FAPI income. In effect, the Department of Finance has taken away the deferral advantage of holding FAPI income in a CCPC.

The amount of net income earned from the CFA, less the combined tax paid, is added to the cost basis (ACB) of the shares held by the CRIC in the CFA, and is also added to the taxable surplus balance of the CFA that the CRIC must track.  This amount of net income less combined tax can be repatriated to the CRIC without additional tax consequences.

Specifically, dividends paid to the CRIC out of the CFA’s taxable surplus balance will reduce the taxable surplus balance of the CFA, and are deducted on the CRIC’s tax return in the year in which the dividend was received under subsection 113(1)(b) and under subsection 91(5) to avoid tax payable on the repatriated dividend.  In addition, the ACB of the CRIC’s shares in the CFA is reduced by an amount equal to the repatriated dividend received.  Amounts deductible by the CCPC under section 113 are also added to its General Rate Income Pool  (GRIP)[4]; the shareholder(s) is entitled to an eligible dividend equal to the amount repatriated from the CFA.

Using Canadian corporate funds to make an investment in a foreign affiliate earning FAPI, however, is the better tax option over investing directly in a US rental property from a CCPC if there is income subject to foreign tax.

Although application of FAPI tax treatment on the income earned by the CRIC is not contingent on whether or not there is a tax treaty or TIEA between the CRIC and the CFA, such an agreement will normally reduce the applicable tax rate on non-active business income repatriated from the CFA and, combined with the calculation of the applicable tax credit the CRIC will receive under ITA subsection 91(4), may result in a refund of foreign tax, depending on the amount of foreign tax paid when earned by the CFA.

Using Canadian corporate funds to make an investment in a foreign affiliate earning FAPI, however, is the better tax option over investing directly in a US rental property from a CCPC if there is income subject to foreign tax.

Although application of FAPI tax treatment on the income earned by the CRIC is not contingent on whether or not there is a tax treaty or TIEA between the CRIC and the CFA, such an agreement will normally reduce the applicable tax rate on non-active business income repatriated from the CFA and, combined with the calculation of the applicable tax credit the CRIC will receive under ITA subsection 91(4), may result in a refund of foreign tax, depending on the amount of foreign tax paid when earned by the CFA.

 

[4] GRIP is defined in subsection 89(1).  Pursuant to paragraph (b) of element E of the definition, amounts deductible under section 113 in computing income of the corporation for a particular year are added to the corporation’s GRIP balance.

 

 

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COMMON COMBINED CANADA-US CROSS-BORDER STRUCTURE

When a Canadian corporation, or CRIC, decides to invest in a business in a foreign jurisdiction, it does so for various reasons, such as a desire to control a potential return on capital invested greater than that which can be controlled in Canada. There may be bona fide reasons to invest in a jurisdiction with which Canada has a tax treaty or TIEA, and which jurisdiction has a lower tax rate on business income than in Canada, or there may be labour or other resource advantages in the foreign jurisdiction that, when incorporated into a feasibility analysis, renders the return on investment in the foreign jurisdiction palatable to stakeholders of the Canadian parent corporation.

If the decision is made to invest, or start-up, a foreign affiliate, thought and activity focuses on how to set up the ownership structure of the foreign affiliate to facilitate (a) the ability to extract as much capital as possible on a tax-free basis from the foreign affiliate, (b) to hopefully minimize - or organize - to the extent possible filing and reporting responsibilities, and (c) to enable the extraction of equity without onerous tax and/or administrative consequences.

There are various outbound structures available when a CRIC invests in a foreign affiliate, depending on the characteristics that stakeholders in the Canadian corporation seek to prioritize in the structure.  A common structure to facilitate cross-border activity and that aims to provide:

1. Liability protection
2. Efficient tax administration

 

is as follows:

 

In this example, we assume that the Canadian corporation will be investing in a foreign affiliate in the US and will own 100%of the outstanding shares, so the LLC will be a CFA of the Canadian corporation.

Unless an LLC elects to be treated as a corporation and to be taxed as such (IRS form 8332), a single-member LLC is disregarded as an entity separate from its member.  This means that the member will report the income from the LLC on his/her US personal tax return.

By contrast Canada views LLC’s as corporations, so if you have a Canadian corporation and a US entity that elects to be taxed as a corporation, you will have a combined structure that can access available tax credits and deductions available for cross-border income scenarios.[5]  If the LLC does not elect to be taxed as a corporation, relief in Canada on foreign taxes paid is available under 126(1) and 20(11), because income generated by an LLC considered a disregarded entity is characterized as income from a share, and the tax paid is characterized as “non-business income tax”.

When the Canadian corporation reports the LLC income, depending on how the LLC has been designated, any dividends paid from the Canadian corporation to the individual sourced from the LLC will be entitled to a deduction under ss.113(1)(c) if the LLC is considered a disregarded entity, and under ss.113(1)(b) if the LLC is considered a corporation.

As you can see, there are mechanisms in place to provide integration of tax between Canada and, in this case, US business interests.  However, integration is not complete, and a careful study of proposed combined corporate structures should be undertaken to accurately assess tax treatment.

 

Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C.  He specializes in cross-border taxation and assisting clients in acquisition structures.  Check us out at:

https://www.burgesskilpatrick.com

[5] CRIC income from an LLC that has elected as a corporation will have access to a foreign tax credit based on “business and profits tax” paid in a foreign country under ss.126(2). If the LLC is considered a disregarded entity, relief is available under ss. 126(1) and ss.20(11)to account for foreign taxes paid.