Taxation Issues Facing Canadian Parent Corporations With Foreign Affiliates
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The prospect for Canadian parent corporations to invest in foreign subsidiaries can provide multiple business opportunities that otherwise may not exist in Canada. For example, the Canadian market for a company’s existing product line may be saturated, while competition may be low in foreign jurisdictions. Or established business connections or relationships may facilitate expedited insertion of the company’s products or services into a foreign market.
If a Canadian corporation establishes or purchases a foreign subsidiary and generates profit from that subsidiary, the repatriation of profits from the foreign subsidiary to the Canadian parent presents various taxation issues – and international tax planning opportunities – that need to be considered in order to determine the viability of any proposed investment into any foreign jurisdiction.
Definition of “Foreign Affiliate” and “Controlled Foreign Affiliate”
A non-resident corporation is a foreign affiliate of a Canadian parent corporation if the Canadian parent (i: “taxpayer”) owns, either directly or indirectly, at least 1 percent of any class of shares, and the taxpayer, together with related persons (whether residents or non-residents of Canada) owns, directly or indirectly, at least 10 percent of any class. The threshold for foreign affiliate status is therefore fairly low, and qualifying as a foreign affiliate can be either good or bad. If the affiliate is carrying on an active business, foreign affiliate status will give a Canadian corporate shareholder access to deductions under the exempt/taxable surplus regime. However, if the foreign affiliate is also a “controlled foreign affiliate,” any Canadian shareholders (individuals as well as corporations) will be subject to annual taxation on their pro rata share of any FAPI. A controlled foreign affiliate (CFA) of a taxpayer resident in Canada means a foreign affiliate that is controlled by the taxpayer or the taxpayer and a person or persons with whom the taxpayer does not deal at arm’s length.
Dividends from Active Business Income
Dividends paid from active business income by a foreign affiliate to a Canadian corporate shareholder may be out of “exempt surplus,” “taxable surplus,” or “pre-acquisition surplus.” Exempt surplus generally includes after-tax, active business income earned in a treaty country, provided that the affiliate is also resident in a treaty country, both under the common law principle of management and control and as defined in the applicable treaty. Active business income earned by a foreign affiliate in a non-treaty country, or by an affiliate that is not resident, as defined, in a treaty country, is included in taxable surplus.
Dividends paid by a foreign affiliate that exceed its exempt and taxable surplus accounts are deemed to come out of pre-acquisition surplus, a notional account for which no actual computations are made. Dividends received by a corporation resident in Canada from foreign affiliates are initially included in income, but deductions are then allowed for all or a portion of the dividends in computing taxable income, depending on the surplus account from which the dividend is prescribed to have been paid.
Dividends out of exempt surplus are deductible in computing taxable income, irrespective of the foreign tax burden that has been incurred. Where a dividend is out of taxable surplus, deductions related to the underlying foreign tax applicable to the earnings being distributed, as well as to any foreign withholding taxes applicable to the dividends, are available. The general policy rationale is that Canadian tax will be payable on dividends out of taxable surplus only to the extent that the total foreign tax burden is less than the basic Canadian corporate tax rate. While the underlying foreign tax applicable to a dividend received
While the underlying foreign tax applicable to a dividend received out of taxable surplus is generally determined on a pro rata basis according to the proportionate amount of the taxable surplus being distributed, a taxpayer can claim more than a pro rata amount if prescribed tests are met. Dividends received out of pre-acquisition surplus are deductible in computing taxable income, but the amount of such dividends, net of any foreign withholding tax, reduces the tax basis of the shares on which the dividends were paid. Dividends paid by a foreign affiliate are deemed to come first out of the affiliate’s exempt surplus to the extent available, and next out of taxable surplus. However, a taxpayer may elect to have all or part of a dividend received from a foreign affiliate treated as having been paid out of taxable surplus rather than exempt surplus. This election may be desirable where, for example, the dividend is out of low-taxed taxable surplus, and the Canadian corporation has a non-capital loss carryforward expiring in the year. Any dividend payments that exceed an affiliate’s exempt and taxable surplus balances are generally deemed to be paid out of pre-acquisition surplus.
Taxation of FAPI
Taxpayers resident in Canada must include their proportionate amount of any FAPI earned by a CFA in income on a current basis (subject to deductions in respect of underlying foreign tax), whether or not the income is distributed by the affiliate as dividend payments. These rules apply to Canadian-resident individuals as well as to corporations, and to affiliates in treaty as well as non-treaty countries. The allocable amount is based on the taxpayer’s participating percentage,10 determined at the end of each taxation year of the affiliate. If a Canadian taxpayer has an interest in a CFA at the end of a particular taxation year, there is an attribution of FAPI earned by the affiliate during the entire year; conversely, there is no attribution if the Canadian shareholder does not have an interest in a CFA at the end of a year. Generally, no further Canadian tax is imposed when FAPI is repatriated to Canada as dividend payments, although deductions may be available at that time for foreign withholding tax imposed on the dividends. Income characterized as FAPI is included in taxable surplus and, to the extent that FAPI is earned by a foreign affiliate that is not a CFA of a Canadian taxpayer, the income is subject to potential Canadian tax when it is ultimately paid to Canada as dividends.
Determination of FAPI
FAPI, as defined, includes an affiliate’s income from property and businesses other than active businesses, and taxable capital gains from dispositions of property other than “excluded property,”less the affiliate’s losses from property and businesses other than active businesses and allowable capital losses from dispositions of property other than excluded property. There is a five-year carryforward of any net FAPI losses incurred by an affiliate in a particular year. Interaffiliate dividends are specifically excluded from the definition of “FAPI.”
In addition to property income that is purely of a passive nature, FAPI includes income from an adventure or concern in the nature of trade, as well as
- income from an “investment business
- income from trading or dealing or indebtedness; and
- various types of income earned by a foreign affiliate, where the corresponding deduction erodes the Canadian tax base.
Income from an Investment Business
Income from an investment business is included in the definition of “income from property.” Under the investment business rules, where the principal purpose of a business is to earn interest, dividends, rents, royalties, or similar returns or substitutes therefor, insurance income, income from factoring accounts receivable, or profits from the disposition of investment property, the income is FAPI unless specifically exempted. Exemption generally applies if the affiliate employs more than five employees (or the equivalent thereof) full-time in the active conduct of the business, and the business is conducted principally with arm’s-length persons
There are many taxation issues that exist when a Canadian parent corporation invests in a CFA, and the above is not an exhaustive discussion of all the prevalent issues. One must consider and analyse the business and tax issues to determine if the prospective purchase of start-up of the foreign subsidiary is in the Canadian parent’s best interests.
If you have any questions or want to speak further about your corporation or estate planning matters, contact Nicholas Kilpatrick at firstname.lastname@example.org
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 www.burgesskilpatrick.com or on Facebook at www.facebook.com/Burgess Kilpatrick for more information on our firm. This article has been paraphrased from an article by Allen R. Lanthier of Ernst & Young.
 Lanthier, Allen R., Ernst & Young, Canadian Tax Journal, Vol 43, No. 5.