Investing in Foreign Businesses – A Canadian Perspective – Part 1

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The Section 84 Deemed Dividend Rules

What to do to avoid the deemed dividend trap.

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Taxation Issues for Canadian Corporations with Foreign Affiliates

An overview.

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Using Joint Ventures To Capitalize On Real Estate Investments

Research tax-efficient structures to facilitate real estate investing.

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The Replacement Property Rules

Using the Income Tax Act to avoid tax.

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Corporate Tax Planning:

Utilizing the butterlfy.

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The Corporate Attribution Rules

Navigating through the delicate nature of non-arms length transactions.

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Investing in Foreign Businesses – A Canadian Perspective – Part 1

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International competitiveness is a rather ill-defined term since it could have a variety of meanings. It might mean how competitive a country might be as a place of location for investments and production compared to other jurisdictions. It could also imply how competitive a home-based multinational resident is relative to other multinationals operating at a worldwide scale. These concepts are not the same.

An important element in attempting to maintain Canada as a desirable country to attract foreign investment from is the efficiency of it’s tax structure.  Efficiency implies that the tax system should distort economic decisions as minimally as possible so that individuals and businesses make choices based on economic gains that are not influenced by tax considerations.

To this end the Department of Finance strives to maintain a foreign affiliate tax regime that facilitates tax-efficiency.  If a Canadian resident earns income abroad, Canada has a tax credit and deduction system that, in theory, offsets the foreign tax paid so that the ending tax obligation of that resident is consistent with Canadian personal tax rates.  Perfect integration of course is not always realized, but the intention remains.

The foreign affiliate regime is designed to ensure Canadian companies are not at a disadvantage when expanding their active business abroad through foreign subsidiaries by permitting, in general terms, earnings of an active business of a "foreign affiliate" ("FA") to not suffer Canadian tax when earned, or when distributed as a dividend to its Canadian corporate (not individual) shareholder provided certain conditions are met. Further, it permits planning to reduce foreign tax applicable to active income by shifting income from one FA to an FA in a lower-tax jurisdiction.


Canadians Considering Outbound Investment to a foreign business

Canadian tax liability generally turns on whether a person is a resident or a non-resident of Canada. A person who is resident in Canada during a tax year is subject to Canadian income tax on his or her worldwide income from all sources, which includes income from an office, employment, property, or business.  Accordingly, an individual who is a resident of Canada is subject to Canadian tax on any income earned directly from a source outside Canada. This includes dividends received on shares of non-resident corporations, which would generally be characterized as income from property and included in a taxpayer's income for the year in which the dividends are received (or in which the taxpayer becomes entitled to receive the amount).

There is one exception to the general rule that income is recognized in the year in which it is received or receivable by a taxpayer. Canadian taxpayers are subject to current taxation on FAPI (Foreign Accrued Property Income)  earned by Controlled Foreign Affiliates (CFAs)  regardless of whether the FAPI is repatriated to Canada in the year income or profits are realized by the CFA. Specifically, in computing taxable income for a taxation year, taxpayers are required to include their "participating percentage" (ie: the percentage of the FAPI that they have entitlement to through their ownership) of the FAPI earned by each of their CFAs pursuant to subsection 91(1) of the Income TaxAct (ITA). The amount corresponding to the taxpayer's FAPI inclusion for the year is added to the adjusted cost base (ACB) of its shares in the CFA.



A Canadian-resident taxpayer is required to include in its income for a particular taxation year all dividends received from non-resident corporations. A Canadian-resident corporate taxpayer receiving a dividend on a share of an Foreign Affiliate (FA) owned by the taxpayer may be entitled to a full or partial deduction in computing its taxable income under section 113 of the ITA. The amount of the deduction available under section 113 depends in part on the surplus account of the FA in respect of the taxpayer from which the dividend is prescribed to have been paid.


Canadian Taxation of Foreign Affiliate Income

Active Business Income (ABI)

Active business income (including amounts deemed to be active business income) of a controlled foreign affiliate, and all income of a non-controlled foreign affiliate, is taxed on a territorial basis and is therefore not included in the income of the Canadian shareholder(s) of the foreign affiliate or controlled foreign affiliate until dividends are paid.

For the purposes of the foreign affiliate regime, an active business of a foreign affiliate is a business carried on by the foreign affiliate other than an investment business (ie: a business investing in property and earning income such as rents, interest, royalties, etc…), a business that is deemed not to be an active business, or a non-qualifying business.  A foreign affiliate’s income from an active business includes amounts that are incident to or pertain to the active business, but does not include income that is FAPI, income from a business that is deemed to not be an active business, or income from a non-qualifying business.

Expanding into the US – is it a good idea?

There are many variables to consider prior to making the decision whether or not to expand your Canadian company into the US.  Will your product / service be successful?  How much do you have to risk up front to see if the concept will work? What are the operational and tax implications of going into the US?

In this and future articles, we go into the various issues that must be considered before expanding your business operations into the US.


Key Considerations

While any expansion to either the US or any other jurisdiction will require significant analysis in order to determine the appropriate structure, below are a few key considerations:

1) In general, shares of an FA should be owned through a Canadian corporation and not directly by individuals, unless no dividends are anticipated and the sale of the FA on capital account is the exit strategy, since in this limited circumstance on a fully distributed basis, individual ownership may provide the most efficient structure.




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2) It is almost always most tax efficient, to the extent commercially possible, to leverage a foreign subsidiary's operations with interest bearing debt, and seek to maximize the interest charged, as supported using transfer pricing principles.

3) Failure to maintain residency of an FA outside of Canada may result in adverse tax consequences.

4) Non-interest bearing debt may result in imputed income to a Canadian lender or shareholder.

5) It is generally preferable to have the shares of an FA held in a separate corporate group from the Canadian operating companies if access to the lifetime capital gains exemption is contemplated.

6) Care must be taken to ensure, to the extent possible, integration is maintained, which often requires modelling to consider the combined ETRs of the foreign tax, Canadian corporate tax and if applicable individual personal tax once the profits are distributed to the individual shareholders.


Type of Entity

The use of LLCs is common but, as discussed further below, LLCs may lead to undesirable tax results if transparent for US tax purposes (with member(s) of the LLCs being taxable in the US on the LLC's income). When using an LLC, it is essential that central management and control reside outside Canada; otherwise, the LLC is taxable in Canada similar to a Canadian formed company.

In contrast, similar residency issues do not arise with US C-corporations ("USCo"), which are opaque for both Canadian and US tax purposes. An USCo, as opposed to its shareholder(s), is taxable on its income. Although often preferred to access exempt surplus treatment for distributions, central management and control is not as crucial where the USCo is eligible to claim the benefits under the Canada-United States Tax Convention (the "Treaty") and sufficient US tax is paid by USCo. The Treaty has a rule that deems a US incorporated company with central management and control exercised in Canada to be a resident of the US.

Non-corporate business forms include branches and partnerships. Limited partnerships ("LP") are generally favoured as they offer liability protection for partners. LPs are fiscally transparent for both Canadian and US tax purposes, with LP partners being subject to both US and Canadian tax on their respective shares of LP income. More specifically, a Canadian partner of an LP that carries on business in the US through a permanent establishment ("PE") is required to file a US tax return to report its share of LP income (as computed under US tax rules) and liable to US tax on such income. Similarly, the Canadian resident partner is also taxable on its share of LP income (as computed under Canadian tax rules and in Canadian dollars) with relief for US tax paid.  The computation of income under US rules will differ from the Canadian computation primarily because of depreciation rates, timing of income recognition, deductibility of various expenditures, etc.

It is important to note that while LPs are considered fiscally transparent for both Canadian and US tax purposes, the CRA has recently taken the position that certain other US partnerships (limited liability partnerships and limited liability limited partnerships formed under Florida or Delaware law) should be treated as corporations for Canadian tax purposes.  This new position results in a different tax treatment



of these vehicles for US and Canadian tax purposes and, therefore, significantly increases the potential for undesirable tax results, including double taxation in certain circumstances.

Canadian-Controlled Private Corporations (“CCPCs”) may expand into the US through branches. Branch profits attributable to a (PE)  are subject to US tax but such profits are also taxable in Canada as a CCPC is a resident of Canada and subject to tax on its worldwide income. The CCPC is required to file a US branch return to report branch profits, which must be calculated under US tax law and in US dollars and must also file a Canadian corporate tax return to report the profits for Canadian tax purposes which must be calculated based on Canadian tax rules and in Canadian dollars. Relief for US taxes paid should be available to reduce Canadian tax payable. A Foreign Tax Credit  (“FTC”) is only available to the extent of the Canadian income tax otherwise payable on that income.  Similar to the LP scenario, there is no FA in the structure, which means that the surplus and FAPI regimes are not applicable.


Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients.  Please visit our website at


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