In August 2022, the Department of Finance released draft legislation to amend and expand the service foreign accrual property income (FAPI) rule in paragraph 95(2)(b), thus providing welcome relief to taxpayers. This article provides an overview of the amendments, and it explores whether further consideration is warranted to ensure that their intended result is achieved.
Paragraph 95(2)(b) stipulates that the provision of certain services by an FA of a taxpayer is deemed to be a separate business, other than an active business, carried on by the FA, and any income from that business is deemed to be income from a business other than an active business and, as such, FAPI. Specifically, clause 95(2)(b)(i)(B) targets amounts paid in consideration for such services that are deductible in computing the FAPI of an FA of the taxpayer. The purpose of clause 95(2)(b)(i)(B) is to prevent taxpayers from converting FAPI expenses that would be deductible for one FA into active business income of another FA.
In the proposed legislation, new subsection 95(3.03) provides an exception to existing subparagraph 95(2)(b)(i). In order for the exception to apply, all of the conditions set out in subsection 95(3.03) must be met. These conditions are largely analogous to those in clause 95(2)(a)(ii)(D), which recharacterizes income from property as income from an active business. The conditions that must be met for the exception in subsection 95(3.03) to apply include the following:
The policy intent of proposed subsection 95(3.03) is not explicitly stated in the explanatory notes. However, it is thought to address the fact pattern set out in the comfort letter issued by the Department of Finance on December 23, 2016. The comfort letter provided a factual situation where an FA (“FA 1”) of a taxpayer provides management services to another FA of the taxpayer (“FA Opco”) that carries on an active business. FA Opco is held by a third FA of the taxpayer (“FA Holdco”) and other arm’s-length parties. The management fee received by FA 1 in consideration for the services it provides to FA Opco is paid by FA Holdco instead of FA Opco, because the other shareholders of FA Opco are unwilling to bear the fee. Because FA Holdco does not carry on an active business, the service fee paid by FA Holdco is deductible in computing FA Holdco’s income from property, which results in foreign accrual property losses (FAPLs). Existing clause 95(2)(b)(i)(B) would otherwise apply to deem the service income earned by FA 1 to be FAPI. Finance stated that to the extent that the conditions generally analogous to those in clause 95(2)(a)(ii)(D) are satisfied, clause 95(2)(b)(i)(B) should not apply to recharacterize the service fee as FAPI to FA 1. Arguably, the rationale for Finance’s position is that, if the management fee were paid by FA Opco, it would have been deductible in computing FA Opco’s active business income, and paragraph 95(2)(b) would not have applied.
Proposed subsection 95(3.03), however, seems to require that the payee FA provide services to the payer FA (as described in (b) and (c) of the conditions listed above) instead of to a third FA. Therefore, the comfort letter’s fact pattern may not meet the conditions of proposed subsection 95(3.03) because, in that fact pattern, the payee FA did not provide services directly to the payer FA. Rather, the services were rendered to a third FA, the shares of which were excluded property of the payee FA, presumably for the purpose of maintaining the third FA’s active business. Should subsection 95(3.03), therefore, be extended to situations where the payer FA directly or indirectly holds the excluded property shares of the FA that receives the services? The proposed legislation, while a welcome addition, seems to have a relatively limited scope: it appears to apply only to services provided by an FA to a second affiliate to support the second affiliate’s holding company function in respect of its investments that are shares of a third affiliate (which are excluded property). Variables A and D in the definition of “FAPI” in subsection 95(1) and regulation 5907(2.7) have, as a result, been amended to provide that any FAPLs of the payer FA otherwise resulting from the service payments are eliminated and deducted in computing that FA’s earnings from an active business, with a view to ensuring symmetry in the treatment of the payer and payee affiliates.
It will be interesting to see whether and how Finance will further expand the scope of the proposed exception in subsection 95(3.03) to encompass the situation that likely prompted the amendment.
Finally, clause 95(2)(b)(i)(B) has also been amended to ensure that service income is included in the payee affiliate’s FAPI only in proportion to the taxpayer’s participating percentage in the payer affiliate’s income. For this purpose, the participating percentage is to be read as though it applies to all FAs, not just CFAs. This change provides a fairer result when clause 95(2)(b)(i)(B) is being applied, because service fees are included in the payee’s FAPI only in proportion to the taxpayer’s economic interest in the payer’s income.
Silvia Wang and Clara Pham
RSM Canada LLP, Toronto