Maroof HS CPA Professional Corporation, Toronto

Foreign Accrual Property Income

Canadian resident taxpayers with passive investments in controlled foreign affiliate are subject to complex FAPI rules

Foreign Accrual Property Income, a.k.a. FAPI in its short form, is defined in subsection 95(1) of the Income Tax Act (ITA). The definition itself is very long and complex.

If one must oversimplify, one can say that FAPI is the inclusion of passive income earned through foreign (Non-Resident) corporations into the income of a Canadian resident taxpayer on an accrual basis.

ITA provides specific definitions of types of income Passive income for the purpose of FAPI. Nonresident corporations are generally referred to as foreign affiliates, and there are rules when a corporation is a foreign affiliate or a controlled foreign affiliate of a Canadian resident taxpayer.

For the sake of simplicity, the terms presented in this article may be different from the ones mentioned in subsection 95(1) of subdivision i of the Income Tax Act. Please read the full definition there.

Quick Facts about FAPI

The actual purpose of FAPI is to avoid a tax deferral by Canadian tax residents, potentially indefinite on most foreign passive investments. Before we go to the overview of different income types included in FAPI, let’s have some quick facts:

  • FAPI is included in the income of the Canadian shareholder when earned by its Controlled Foreign Affiliate (CFA) not when distributed. It’s on a current and accrual basis and included based on a term specifically defined as a participating percentage. 
  • Foreign taxes do not provide a direct foreign tax deduction or credit, instead, an income deduction is available for a term defined as Foreign Accrual Tax times relevant factor. See further below. 
  • Active business income may be recharacterized as FAPI in certain cases and vice versa. 
  • It is calculated on an affiliate-by-affiliate basis in a way that it cannot be a negative number.
  • Net losses from CFA  cannot be used to offset income from other sources of a Canadian corporation or the FAPI from another CFA. However, FAPI can offset a corporation’s non-capital losses from other sources. 
  • If the income inclusion under FAPI is less than $5,000, it does not need to be included in the income of its shareholder. 
  • FAPI is calculated using the Canadian income tax rules in Canadian dollars. 
  • FAPI affects the ACB of shareholders in the shares of CFA and negative ACB can trigger capital gains in Canada.
  • Repatriation of the income already taxed as FAPI is not taxed again in Canada.

6-Steps Approach to FAPI determination

FAPI rules are very complex – a big thanks to lengthy, complex and confusing definitions and terms in relevant sections of ITA. Adopting the below systematic approach may help in determining the FAPI and its tax effects on the Canadian taxpayer with lesser pain. 

  1. Identify foreign affiliates and determine if there are any Controlled Foreign Affiliates.
  2. Calculate the FAPI as per subsection 95(1) of ITA. (Summarized next)
  3. Determine the participating percentage of the Canadian shareholder as per subsection 95(1), and include in the income of Canadian shareholder’s income as per para 1291)(k) and subsection 91(1).
  4. Determine the Foreign taxes already paid by the CFA and calculate the deduction allowed as per subsection 91(4). 
  5. Calculate Canadian income tax on FAPI
  6. Calculate the Adjusted cost basis for the shares of the CFA. If any negative ACB, determine if it triggers capital gains. 

1. Controlled Foreign Affiliate

A Canadian shareholder of a foreign affiliate (FA) includes FAPI in its income only if it is a Controlled Foreign Affiliate (CFA). A CFA is always a FA, however, FA does not have to be a CFA. Therefore, the first step is to determine whether the foreign affiliate is a CFA or not. If it’s not a CFA, no need to go to the next steps. 

In general, not always, a foreign affiliate is a CFA if the Canadian shareholder owns more than 50% of the shares. The De Jure Control is an ability to elect members of the board of directors and can exist even if the equity percentage is less than 50%. Subdivision i of ITA provides the definition of FA and CFA. The definition seems to be straightforward but it may not be the case always. Subsection 95(1) also provides that if the Canadian shareholder and a specified number of other Canadian shareholders control the foreign affiliate, it is a Controlled Foreign Affiliate! 

2. Calculation of FAPI

The calculation of FAPI is defined in the ITA subsection 95(1) in a very complex way. A simplified summary of different variables making up FAPI (not all in 95(1)) is below:

(A) Certain Incomes

Income from Property 

+

Income from Non-qualifying business
+

Income from a business other than an active business

minus

(D) Corresponding losses 

Loss from property 

+

Loss from Non-qualifying business

+

Loss from a business other than an active business

Plus
(B) Income or taxable capital gains from the disposition of property other than the excluded property. Check exclusions and exceptions  minus

(E) Corresponding Losses

i.e. lesser of:

allowable capital losses from the disposition of property 

or

taxable capital gains included in (B) on left side of this table

minus

(F) Foreign accrual property (FAPL) losses carryovers 
ITR Section 5903

minus
(F.1) Foreign accrual capital loss carryovers
ITR Section 5903.1

Please calculate the FAPI for each CFA using the above. Though, I strongly recommend reading subsection 95(1). So as not to confuse further, a brief (very brief) overview of some of these variables may help simplify the concept. Many of the items on the right above are related to the left.

Income from property 

Generally, income from the property is passive income such as rent, royalties, dividends, and royalties.

  • ITA 95(1) specifically includes “Income from an investment business”. It also provides the definition of investment business and related exceptions. Again, in general, income is from rents, royalties, interest and dividends. 
  • An important inclusion under Income from property for FAPI purposes is income from “an adventure or concern in the nature of trade”. This is important to mention here that though this income is a business income for other parts of the income taxes otherwise. 

Income from Non-Qualifying Business

Canada has tax treaties with the majority of countries across the world. Canada discourages business with the countries that do not have a tax treaty with it, have not signed a tax information exchange agreement (TIEA), or have not started negotiation of a TIEA for less than 60 months. Active income from business in such a Non-Designated Treaty Country (Non-DTC) is FAPI. 

Income from an Active Business 

Income from an active business from a Designated Treaty Country (DTC) in most cases is not FAPI. There are situations where this active income might be recharacterized as FAPI or situations where foreign-affiliated dumping rules apply. Similarly, there are certain situations where income from the property might be recharacterized as active business income. 

If you are a corporate income tax accountant or professional income tax preparer, active business income, in most cases, is the same as we see in the practice of Corporate income tax. If you are not an accountant, it is highly recommended to consult a professional accountant who works in the area of international tax. 

Excluded Property 

As mentioned in the definition of FAPI, taxable capital gains from the disposition of property add to FAPI unless they are from Excluded Property. 

The spirit of the law is that the property used in the active business of a foreign affiliate is very closely related to running an active business, the gains from the disposition of such properties do not give rise to FAPI inclusion. Three important types of properties are excluded from FAPI:

  1. Property of a foreign affiliate that is used in active business. 
  2. Share of a foreign affiliate that carries on an active business 
  3. Hedging activities on excluded properties that give rise to a property. 

Look-through partnership rules apply, and modify the definition and direct equity percentage of a foreign affiliate, for the determination of excluded property status.

Investment Property

An investment property is not an excluded property. Gains on the disposition of an investment property are included in FAPI. Investment property includes shares, partnership interests, trust interests, annuities, indebtedness real property or immovable property, resource properties, interests in funds and entities, and interests or options in any of the above. 

Income from an Adventure or Concern in the Nature of Trade

ITA 248(1) specifically provides that this income is business income. For CCPCs, this income is ABI for the purpose of small business deduction. It usually involves business activities that are more of speculative nature. ITA 95(1), on the other hand, adds such income from an Adventure or Concern in the Nature of Trade into the FAPI of the Canadian resident taxpayer. 

If a taxpayer is making occasional speculative transactions using active businesses, income is added to FAPI and taxed accordingly. 

3. Participating Percentage 

FAPI is calculated on a share-by-share basis and the participating percentage is the share of this income established for Canadian shareholders of CFA. Subsection 95(4) defines and modifies the otherwise comprehensible participating percentage so that only the lowest tier Canadian shareholder includes FAPI in its income. This is important in situations with a multi-tier corporate structure all of whom may have the same CFA otherwise.

Depending on equity share in different classes of shares, either subparagraph (b)(i) applies to a single class of shares or (b)(ii) of ITR 5904 for multiple classes of shares. If the FAPI of the controlled foreign affiliate is $5,000 or less, the participation percentage is zero. Please note that this ($5,000 threshold) is the FAPI of the CFA, not the FAPI of its shareholders.

The product of participating percentage and per share FAPI of CFA is added to the income of the Canadian shareholder. 

FAPI is calculated on the last date of the fiscal year end of a CFA and added to the shareholder’s income on that date. There are provisions for short year ends and other reorganizational changes during the year.  FAPI is calculated in Canadian dollars with an exception of subsection 261(3). 

4. Income Deduction based on Foreign Accrual Taxes

The foreign taxes paid or accrued by a CFA do not give rise to an equivalent deduction from the income or income tax in Canada as one may think. The deduction is instead allowed from the income included as FAPI under subsection 91(4) equivalent to the product of Foreign Accrual Tax (FTA) and a Relevant Tax Factor. 

Foreign accrual tax is defined in ITA 95(1) and the amount is determined as per ITR 5907 (1.3) to (1.7). 

Without getting into the complexity of these definitions and calculations, one can simplify the concept. 

The purpose of FAPI inclusion is to deter Canadian shareholders of foreign corporations (base companies) to get tax deferral advantage while earning FAPI-styled passive income. In the absence of these base companies, Canadian taxpayers must include such an income on accrual and current basis. The underlying concept is to allow a deduction equivalent to what would have been Canadian income if the same amount of taxes were paid in Canada. Of course, limitations apply. 

Foreign Accrual Tax includes income tax paid by CFA on the income included in FAPI, FAPI of another fiscally transparent FA, or withholding taxes paid on receiving dividends from other FAs if they are part of the FAPI inclusion. 

A Relevant Tax Factor in simple terms without getting into complexities and technicalities is one divided by the Canadian income tax rate. For the 2021 tax year, the relevant tax factor for a corporation is 4 (being 1/{38%-13%}). For individuals, the relevant tax factor is 1.9 (1/52.63%). 

The amount of deduction from FAPI included in shareholder income is equal to FAT x relevant tax factor. The deduction is not available to finance the higher taxes in foreign jurisdictions, therefore, there is a limit imposed on this deduction that it cannot be more than FAPI inclusion. The taxes must be paid in order to claim this deduction. For inter-period timing issues of payment of taxes, six years rule can help.  

5. Calculating Canadian Income Taxes 

The amount is added to the Canadian tax base after the deduction in the previous step. Canadian tax rates are applied to such income. 

This is important to know that if a Corporation resident in Canada is not in an advantaged tax deferral position simply by using a foreign subsidiary. The overall tax cost ends up the same, or almost the same, as a Canadian corporation directly generating the same income without the use of a foreign corporation. The tax paid on FAPI is final and no additional tax is payable when the same income is repatriated to Canada. 

This does not mean that the use of foreign corporations should be avoided, one must assess other factors such as liability protection! Consult a tax professional and a corporate lawyer on what suits you best. 

6. Adjusted Cost Base of Shares 

The final step is to calculate the Adjusted Cost Base (ACB) of the shares of the CFA. 

The income included under 91(1) is added to ACB and the amount deducted under 91(4) is subtracted from ACB. The FAPI calculation is never a negative number. In case of negative ACB of the shares, a Capital gain is triggered. Subsections 93(1) and 92(1) further provide mechanisms to avoid double taxes on capital gains. 

A Quick and Simple Example 

Two Canadian resident individuals own a Canadian corporation (CanCo) that owns U.S. treasury bills in a fully owned U.S. Corporation (USCO) – 100 shares. 

Step 1: Since the ownership of USCO is with CanCo and not the individuals, FAPI analysis and income inclusion need to be done for CanCo. USCO is a CFA of CanCo. 

Step 2: Assume this corporation earned interest on T-bills worth $10,000 during its fiscal year. 

Step 3: Participating percentage per share is 100%.  Therefore per share, the FAPI of CFA is $100

Step 4: Calculating income inclusion and deduction. Assume $2,000 taxes already paid in the U.S. by CFA. 

[Participating percentage x FAPI per share is $100] x 100 shares = $10,000 income as per 91(1)

[1/(38%-13%) x taxes paid of $2,000] = [4 x 2,000] = $8,000 deduction as per (91(4)

Step 5: The net amount added to the Canadian tax base is $2,000. After applying a tax rate of 25%, CanCo pays $500 tax in Canada. The total tax paid now is 2,000 in U.S. and 500 in Canada with a total of $2,500. 

Step 6: Add $10,000 to the ACB of shares and deduct $8,000 from the ACB. 

Final Word 

Foreign Accrual Property Income can get very complex and the rules are explained in a very simplified manner above. There are many other complex provisions that also come into play with foreign affiliates. 

If you are working on the corporate income tax return for a corporation with FAPI income, get in touch with us today and let us help you navigate the complexities of the rules. 

Budget 2022 Proposed Changes to FAPI for CCPCs

Budget 2022 proposed changes to lower the relevant tax factor from 4.0 to 1.9 for the CCPCs. Though it’s just a proposal at the moment and not a law yet, this should factor into any future income tax planning involved with foreign affiliates. 

Maroof Hussain Sabri

Maroof Hussain Sabri

Maroof is a CPA, CA in the province of Ontario and Alberta in Canada. He is also a licensed CPA from North Dakota in the United States. He lives in Toronto.

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Maroof Hussain Sabri

Maroof Hussain Sabri

Maroof is a CPA, CA in the province of Ontario and Alberta in Canada. He is also a licensed CPA from North Dakota in the United States. He lives in Toronto.

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