The New Reality: Taxation of FAPI and Other Distributions Earned by CCPCs

On April 7, 2022, Deputy Prime Minister and Minister of Finance Chrystia Freeland tabled the federal budget, which includes rules that will have a significant impact on how CCPCs or substantive CCPCs that earn foreign accrual property income (FAPI) will be taxed. These rules will be effective for taxation years ending on or after April 7, 2022. The budget also contains some measures that will mean negative results for the distribution of taxable surplus and, potentially, advantages for the distribution of hybrid surplus.

The rules on substantive CCPCs were introduced in part to address tax planning that shareholders of private corporations had undertaken—planning that involved changing the status of a private corporation from a CCPC to a non-CCPC, often as part of a sale-planning process, in order to achieve a deferral on proceeds or to reduce the current tax cost of other investment income. In response to this planning, the government has also targeted CCPCs with foreign affiliates. The budget measures, if enacted, will result in a significant change to the taxation of FAPI and foreign affiliate distributions. To address this change, shareholders of CCPCs may (1) engage in tax planning to restructure their affairs to avoid FAPI, (2) ensure that active business earnings are treated as exempt surplus, or (3) enter into transactions that generate hybrid surplus.

This article provides a brief overview of the federal budget measures, outlines a few situations where the rules are problematic, and speculates about how CCPCs may respond to the measures.

Background and Context

There has always been considerable debate on how foreign-source income earned by a CCPC should be taxed. The Canadian tax system has been developed on the basis that, according to a concept referred to as “integration,” the taxation of investment income should be neutral as to whether it is earned personally or through a corporate structure. While the Canadian tax system is not perfect, it strives for “fairness.” Integration is achieved through the refundable tax on hand (RTOH) rules and the capital dividend account rules. The federal budget measures will pose many challenges for CCPCs conducting business outside Canada. As tabled, the draft legislation will require CCPCs to fund significant additional income taxes in respect of FAPI earned by a controlled foreign affiliate (CFA) in a number of situations.

Taxation of FAPI Earned by a Controlled Foreign Affiliate

Under the FAPI rules, Canada reserves the right to tax the income earned by a CFA if the entity earns income that is or is otherwise deemed to be passive. When a CFA earns FAPI in a taxation year, the CCPC must include that amount in taxable income on a current basis, computed in accordance with Canadian rules. To avoid double taxation, Canada provides a deduction from FAPI for any foreign taxes paid that are attributable to the FAPI. A corporate taxpayer is entitled to deduct an amount equal to the grossed-up foreign income or profits tax (“foreign accrual tax” [FAT]) paid by the CFA in respect of the FAPI. The deduction is calculated by multiplying the FAT by the “relevant tax factor” (RTF), which is generally the inverse of the federal corporate tax rate. Under the currently enacted rules, the RTF is 4 for a corporate taxpayer. This results in the taxation of FAPI at a combined foreign and Canadian rate that is at least equal to an acceptable corporate income tax rate, which is 25 percent. If FAPI has been subject to tax in the foreign jurisdiction at a rate of at least 25 percent, no incremental Canadian taxation should result because such income is considered to be fully taxed.

Currently, with regard to FAPI, the tax system does not distinguish between a corporate taxpayer that is a CCPC and a corporate taxpayer that is a non-CCPC. As a result, a shareholder of a CCPC is able to defer taxation on passive income earned by a CFA, provided that such income has been taxed at a rate of at least 25 percent. To eliminate the deferral, the federal budget proposes to reduce the RTF, which would otherwise gross up the FAT by a factor of 4, to 1.9 for a CCPC. This change ensures that the shareholder of a CCPC will pay a comparable rate of tax once the FAPI has been distributed to the individual shareholder. The accompanying table illustrates the results. On a fully distributed basis, the net after-tax funds received by the individual are comparable to a portion treated as a tax-free capital dividend. This comparison assumes, however, that cash is available to make the distribution.

Comparison of Canadian Tax on FAPI and After-Tax Funds Received by an Individual Shareholder, Calculated at 2022 Ontario Tax Rates, Under Current and Proposed Law
  Current law (2022)   Proposed law (2023)
Income earned in foreign affiliate (year 1)  
  Net FAPI earned in foreign affiliate 10,000   10,000
  Foreign income taxes (FAT) 2,500
  Net income after tax in foreign affiliate 7,500
  FAPI in Canadian parent company 10,000   10,000
  FAT × RTF (10,000)
  Canadian FAPI earned in year 0   5,250
  Canadian tax on FAPI 0
Distribution of funds to individual shareholder  
  Tax-free capital dividend na   2,250
  Taxable dividend to individual shareholder 7,125   3,634
  Tax on dividend at top Ontario tax rate (39.34% under current law; 47.74% under proposed law) 2,803
  Net funds to individual 4,322
FAPI = foreign accrual property income; FAT = foreign accrual tax; RTF = relevant tax factor; na = not applicable.
Note: Calculations assume that refundable tax is fully recovered.

The policy reasons for eliminating the deferral when a CFA earns passive income with no substantial employment base are understandable. However, there are cases where the result of this measure may be inappropriate. Below, we describe two such cases.

Consider a scenario where a CCPC forms a CFA in India. The CFA hires local software developers to support the Canadian head office’s efforts to develop software. The only source of income for the CFA is service fees from Canada. The net income realized by the CFA would likely be FAPI, pursuant to paragraph 95(2)(b). This type of structure is common for mid-market companies that need to outsource such functions in a cost-effective manner. In our view, having such income caught by the federal budget measures is punitive. We do not believe that this service arrangement is detrimental to the Canadian tax base: the CCPC would normally recognize the third-party revenue or realize revenue from licensing fees because it is the beneficial owner of the software (leaving aside the impact of the OECD pillar 2 proposals). We recommend that the federal budget measures include a specific carve-out from the rules when the CCPC utilizes its CFA for good commercial purposes that are, for example, tied to a certain employment base or activity in the foreign country.

In another problematic scenario, a CFA directly or indirectly owns commercial real estate, and such income is not treated as income from an active business. (A similar scenario would be one where a CFA is required to hold residential real estate in another CFA for liability or other commercial reasons.) As proposed, the budget measures could result in the CCPC having to pay incremental Canadian tax of almost 26 percent on every dollar of FAPI if the CFA is unable to make distributions (for example, because of restrictions under debt covenants). The CCPC will need to find alternative ways to fund the taxes. To avoid this result, the CCPC may begin to shift head office functions by moving jobs to the foreign country to avoid FAPI, or it may restructure operations into a non-corporate form.

Taxable Surplus Distributions

If the taxpayer is a Canadian corporation and the non-resident corporation is a foreign affiliate, a deduction may be available under section 113, depending on the surplus account from which the dividend is paid. Another area of concern regarding the budget measures is the treatment of taxable surplus distributions. Taxable surplus includes active business income earned in a non-treaty country. However, it may also capture active business income in a “designated treaty country.” The term “designated treaty country,” which is defined in regulation 5907(11), requires Canada to have either a comprehensive tax convention or a tax information exchange agreement with the foreign country. For an amount to be included in exempt surplus rather than in taxable surplus when an active business is carried on in a treaty country, the foreign affiliate must be a resident in the treaty country both according to the common-law test of central management and control and for the purposes of the tax treaty. In a typical Canada-US cross-border context, the affiliate may earn taxable surplus if it is resident in one country under common-law principles (Canada, for example, where the majority of the board resides and key decisions are made) and resident in another country for treaty purposes (the United States, for example, on the basis of tiebreaker rules).

Under the current rules, if a foreign affiliate makes a distribution from taxable surplus, the corporate taxpayer is entitled to a deduction under paragraphs 113(1)(b) and (c) that is based on the related underlying foreign tax and withholding tax paid in respect of the dividend. Taxable surplus dividends may be tax-free depending on the tax rate in the foreign jurisdiction. In this case, the rules are designed such that interaffiliate or cross-border dividend distributions from active earnings should not be subject to income tax until distributed to the individual shareholders.

Under the federal budget measures, the RTF, like FAPI, is reduced from 4 to 1.9, which may result in a cash tax payment by the CCPC if no amount is distributed to the individual CCPC shareholder. On an after-tax basis, the individual Canadian-resident shareholder may be in a comparable position, but there may be cases where a distribution to the shareholder is not possible, resulting in an upfront cash tax payment. Moreover, such a result would not arise if the CCPC decided to conduct business through a foreign branch, because the CCPC would usually pay tax in the foreign country, and there may not be incremental Canadian tax if sufficient tax is paid and a foreign tax credit is available. The proposed rule may limit the repatriation of capital to Canada and reduce investment in domestic assets. Thus, the CCPC may have a bias toward investing in business operations outside Canada and permanently defer the distribution of taxable surplus earnings to Canada.

It is not clear why active business income included in taxable surplus should be treated in this manner. It is often not possible for smaller organizations to have local management or directors in a foreign country. To avoid any risk of taxable surplus, a CCPC may move or hire employees in the foreign country or, if possible, begin to conduct business through a non-corporate entity.

Hybrid Surplus Distributions

Hybrid surplus arises from the disposition of foreign affiliate shares or partnership interests by the shareholder affiliate, provided that the gain on disposition does not give rise to FAPI (that is, provided that the assets sold are excluded property). If a gain is realized by a foreign affiliate on a qualifying transaction, the entire amount is included in hybrid surplus. When there is a distribution of hybrid surplus, a deduction is provided under paragraph 113(1)(a.1) based on the amount of hybrid underlying tax (HUT) applicable to the dividend. If the foreign tax rate on capital gains is greater than Canada’s effective tax rate for capital gains (that is, 50 percent of the ordinary tax rate), any dividends paid out of hybrid surplus should generally have full HUT available as a deduction in Canada, so there is no additional Canadian tax.

The federal budget proposals appear to result in slightly higher taxation at the corporate level; on a fully distributed basis, however, the overall tax paid may be less. Although the RTF is reduced from 4 to 1.9, which results in slightly higher corporate taxation, it may—because of the potentially larger addition to the capital dividend account being equal to the section 113 deductions—result in lower overall tax when the cash is distributed to the shareholder as a dividend where the capital gain is taxed at a preferential rate in the foreign jurisdiction. It is unclear whether this is the intention behind the proposals because there is no legislation, although such a result would be consistent with the treatment of a capital gain realized directly by the CCPC.

Final Observations

The federal budget proposals could be problematic for CCPCs with international operations. Although it may be appropriate to eliminate the deferral on purely passive investment income for a CFA with a nominal operations or employment base, there are several commercial situations where this is not the case. Finally, it is not clear why the budget measures should target CCPCs that generate taxable surplus from active business operations. We hope that the Department of Finance will consider possible amendments to the rules to eliminate some of the challenges that CCPCs with international operations may encounter.

Hetal Kotecha
BDO Canada LLP, Toronto

International Tax Highlights

Volume 1, Number 2, August  2022

©2022, Canadian Tax Foundation and IFA Canada

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