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.
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.
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.
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 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.
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.
BDO Canada LLP, Toronto