As a general rule, every Canadian resident who is a shareholder of a “controlled foreign affiliate” (“CFA”), will be subject to tax in Canada on that person’s share of the “foreign accrual property income” (“FAPI”) of that CFA[1].
In general, the FAPI of the CFA will consist of income and taxable capital gains from investments. However, certain types of business income may be deemed to be FAPI, and, conversely certain types of investment income and gains may be deemed not to be FAPI.
This will be the case regardless of whether or not any FAPI is actually distributed by the CFA to the Canadian resident in the relevant year. If and when the FAPI is distributed as a dividend, double tax is avoided by allowing a deduction for previously taxed FAPI[2].
FAPI can be taxed in the hands of any Canadian resident, whether individual or corporate.
However, most accountants do not realize that, in any situation where the FAPI has been subject to significant taxation in the hands of the CFA, either in its country of residence, or the country in which the FAPI is earned, there can be a substantial tax savings benefit by holding the CFA shares in a Canadian holding corporation (“Holdco”), as opposed to in the hands of a Canadian resident individual. For individuals who currently own shares of a CFA personally, it is likely that they could begin to enjoy such benefits simply by rolling over the shares in that CFA to a Holdco under subsection 85(1).
Often, when I mention this to fellow accountants, they find it hard to believe. The structure of our tax system is designed so that one is not supposed to enjoy any significant tax deferral or savings benefits with respect to investment income by using a Holdco, assuming it is a “Canadian-controlled private corporation” (“CCPC”).
I try to explain that it relates to the way credit is given for the underlying tax paid by the CFA on the FAPI (“foreign accrual tax” or “FAT”). Even then, they often still don’t get it, and wrongly suggest that the Holdco would just have to pay additional taxes equal to the excess of the relevant CCPC investment income tax rate[3] and the tax rate paid on the income by the CFA.
Well, the fact of the matter is, that is not the way it works.
Let me explain in an example that relates to an actual situation regarding a new Ontario-resident client of mine who had a wholly-owned Australian corporation (“Ausco”) earning nothing but FAPI.
She was quite upset about the fact that she was paying a lot of tax each year on the FAPI earned by Ausco, even though she was not actually taking a cent in dividends.
I explained to her that such was the way FAPI works, but I then asked whether her regular accountants (a big, national accounting firm) had ever explored with her the possibility of rolling over her Ausco shares to a Holdco. She said that they never had.
Here is what I found when I got the relevant information from her 2017 T1 return, and T1134 information return:
| FAPI of Ausco |
$103,000 |
| Tax paid by Ausco (FAT) |
29,000 |
| FAPI included in income (net) |
47,900 |
| Tax paid by client (at top tax bracket-53.5%) |
$25,627 |
What if, instead, the Ausco shares had been rolled-over to Holdco before the end of 2017? How much FAPI would have been taxed, and how much tax would be payable?
The answer: zilch!, nada!, nothing!
How can that be? It all relates to the different amount used as the relevant tax factor (“RTF”) in determining the way credit is given for the FAT[4].
For an individual, the RTF is currently 1.9, whereas for a corporation it is 4[5]. Or, to look at it another way, if the shareholder is an individual, the CFA has to pay taxes at a rate of at least 52.6% on its income for the shareholder to be spared from paying tax on any FAPI; in contrast, with a corporate shareholder, as long as at least 25% is paid, there is no net inclusion.
So, to go back to my client with the Aussie company, as an individual shareholder, she included the $103,000 in income, and deducted 1.9 times the FAT of $29,000, which is $55,100. That left $47,900 to be included in income, giving her an extra tax cost of $25,627.
On the other hand, Holdco as a shareholder would have been able to fully offset the FAPI inclusion because 4 times the FAT exceeds the FAPI.
But, that is not the end of it, the use of a Holdco in the scenario above is not just a corporate-level tax deferral. It can also lead to an absolute
savings in tax. This is because of the fact that, if and when the FAPI is paid to the Holdco as a dividend, it passes through Holdco free of Canadian tax[6], and out to the individual shareholder as an “eligible dividend”[7], which currently bears a top tax rate of less than 40% in Ontario. In contrast, if the dividend had been paid directly to her, it would have been taxed at a rate as high as 53.5%[8].
[1] As income from the shares owned, under subsection 91(1) of the
Income Tax Act (“the Act”). All statutory references are to the Act.
[2] Subsection 91(5)
[3] Generally around 50%-in Ontario 50.16%.
[4] Actually, via a deduction under subsection 91(4)
[5] See RTF definition in subsection 95(1)
[6] It would be fully offset by a deduction under paragraph 113(1)(b). Since rate of underlying tax exceeds 25%, three times that tax would exceed amount available for dividend.
[7] See paragraph “b” of item “E” in the “general rate income pool” definition in subsection 89(1).
[8] However, with the dividend passing through Holdco, no credit may be obtained for the 5% Australian tax paid. In contrast, an individual shareholder would have been able to claim a foreign tax credit for the 15% Australian tax that would be payable.
