Overview – Foreign Affiliates and Controlled Foreign Affiliates
Canadians who invest in a foreign corporation can be subject to special income inclusion and reporting rules if they own a big enough stake in the foreign corporation. These rules are among the most complicated in Canadian Income Tax law and can have dramatic consequences.
If a Canadian person owns 10% of a foreign corporation, that corporation will qualify as a foreign affiliate. Having a foreign affiliate means a Canadian taxpayer is required to file a special information return, form T1134, each year along with the Canadian taxpayer’s T1 or T2 tax return, which provides the Canada Revenue Agency (CRA) with information about the foreign affiliate.
Canadian corporations that have a foreign affiliate are subject to a distinctive tax regime on the dividends they receive from their foreign affiliate where the foreign affiliate’s income is categorized into different surplus accounts and the tax treatment of the dividend is dependant upon which surplus account it is paid out. This distinct dividend taxation regime is often significantly more favorable than the one that applies to non-foreign affiliates.
When a Canadian controls a foreign corporation (generally but not exclusively by owning more than 50% of its shares) then the foreign corporation is a controlled foreign affiliate of the Canadian taxpayer. A foreign corporation can also be a controlled foreign affiliate if the Canadian taxpayer and a distinctly specified small group of other Canadian taxpayers collectively own sufficient shares to control the foreign corporation. When a controlled foreign affiliate earns passive investment income, it will give rise to foreign accrual property income for its Canadian owners with respect to which it is a controlled foreign affiliate even though the controlled foreign affiliate has not paid a dividend or any other amounts to its Canadian owners.
What is a Foreign Affiliate – Foreign Affiliates and Controlled Foreign Affiliates
For an entity to be a foreign affiliate of a taxpayer resident in Canada:
- the entity must be a corporation,
- the entity must not be a tax resident of Canada, and
- the taxpayer must meet an equity ownership requirement with respect to the entity.
Note that foreign affiliate status is a relational attribute, an entity is only a foreign affiliate or not with respect to a particular taxpayer resident in Canada. An entity can have multiple Canadian owners and be a foreign affiliate with respect to some of them but not others.
Classifying Foreign Entities as Corporations
The Canadian Income Tax Act does not provide detailed guidance as to what entities count as corporations so the advice of an expert Canadian tax lawyer is required. As potential foreign affiliates are typically entities defined under the law of a foreign jurisdiction which do not correspond exactly to the sort of business entities that exist under Canadian law, it can be quite complicated to determine if a particular foreign entity counts as a corporation.
The existing caselaw regarding classifying foreign entities have generally followed a two-step approach. The first step is to determine the characteristics of the foreign entity under the relevant foreign law. The second step is to then compare these characteristics with those of recognized Canadian entities and identify whether the foreign entity has the essential characteristics of a particular recognized Canadian entity.
The relatively recent case law which establishes the two-step test described above has dealt with the essential characteristics of partnerships and trusts but not corporations. However, other caselaw, Canada Revenue Agency publications, and the secondary Canadian legal literature have indicated that the following are some of the key characteristics of corporations:
- corporations are artificial separate legal persons whose existence is enabled by a statute,
- corporations must register their constating documents (e.g. articles of incorporation) with the government in order to come into existence,
- corporations can exist indefinitely,
- corporations can own property separately from the owners of the corporation,
- corporations can have liability and obligations separate from their owners, and their owners are not liable for the debts of the corporation,
- corporations can engage in a wide variety of activities such as entering into contracts, carrying on a business, suing and being sued.
Canadian Corporate Tax Residence
Unless a statutory rule applies, the Canadian income tax residence status of a corporation is determined by a common law test which provides that a corporation is resident in Canada if that is where its actual place of central management and control is. Typically, this is where its board of directors meets or otherwise exercises its responsibilities. However, in circumstances where the central management and control is exercised by a shareholder resident and making decisions in another country, the corporation will be found to be resident where the shareholder resides.
Notwithstanding the common law test, a corporation whose jurisdiction of incorporation is in Canada will deemed to be a tax resident of Canada. If a corporation would otherwise be a tax resident of both Canada and another country with which Canada has a tax treaty, tie-breaker rules will apply which designate the corporation as a resident of only one of the two countries. If these tie-breaker rules designate the corporation as not a tax resident of Canada for the purposes of the treaty, the corporation will also be deemed not to be a tax resident of Canada. This tie-breaker deeming rule will override both the common law test and the jurisdiction of incorporation deeming rule.
The Equity Ownership Requirement
For a non-resident corporation to be a foreign affiliate of a Canadian resident taxpayer:
- the Canadian resident taxpayer’s equity percentage in the non-resident corporation must be at least 1%; and
- the total of the equity percentages in the non-resident corporation of the Canadian resident taxpayer and of each person related to the Canadian resident taxpayer must be at least 10%.
The idea behind this requirement is, loosely speaking, that for a non-resident corporation to be a foreign affiliate of a Canadian resident taxpayer, the Canadian resident taxpayer needs to own 10% of the non-resident corporation. The actual requirements however allow for the 10% ownership threshold to be spread out across multiple persons so long as they are sufficiently closely connected (i.e. are “related” persons). The Income Tax Act also uses the notion of “equity percentage” to track ownership to account for the fact that shares of non-resident corporations are often owned indirectly through other corporations.
A person’s “direct equity percentage” in a corporation is intended to capture the percentage of the shares of the corporation that person owns directly (i.e. not through holding shares in other corporations).
A person’s “equity percentage” in a corporation includes that person’s direct equity percentage in that corporation but also includes indirect ownership through other corporations proportionate to the persons ownership of the intermediate corporations. This is effectively done by multiplying the direct equity percentage of each intermediate corporation in the potential foreign affiliate by the person’s equity percentage in the intermediate corporation and adding up the resulting percentages. If there is more than one layer of intermediate corporations then the equity percentage definition needs to be applied recursively to the intermediate corporations.
As noted above, the 10% equity percentage can be spread out over multiple persons so long as those persons are “related”. The Income Tax Act contains highly detailed rules specifying when two persons are related to each other. Below is a non-exhaustive list of the rules which establish when two persons are related:
- Individuals connected by blood relationship, marriage, common law partnership, or adoption are related;
- A corporation and the person who controls it are related;
- A corporation and a person who is a member of a group of related persons that controls the corporation are related;
- Two corporations are related if they are controlled by the same person or group of persons; and
- If two corporations are each related to a third corporation, then they are deemed to be related to each other.
Applying these rules correctly is highly technical, so it is necessary to consult with an experienced Toronto tax lawyer in situations where these rules become relevant.
Consequences of Foreign Affiliate Status – Foreign Affiliates and Controlled Foreign Affiliates
T1134 Reporting Requirement
Canadian resident taxpayers who have a foreign affiliate are generally required to file a T1134 information return every year with their income tax returns. The form T1134 information return provides CRA with various information to the filer’s foreign affiliates including their names, the country in which they reside, and whether they are controlled foreign affiliates. Failure to file form T1134 with your tax return as required will result in substantial tax penalties.
To prevent duplicative filings, the rules requiring taxpayers to file T1134 information returns effectively restrict the requirement to file to the lowest tier of Canadian taxpayers with foreign affiliates in a holding structure. This done by only requiring T1134s from Canadian taxpayers with foreign affiliates using a modified version of the equity ownership requirement which effectively means that ownership of a potential foreign affiliate that runs through a Canadian resident intermediate corporation does not count towards the 10% equity percentage requirement.
Foreign Affiliate Dividends
Where a Canadian resident corporation receives a dividend from a foreign affiliate, a special tax regime applies. Under tax rules, the foreign affiliate needs to keep track of a number of different surplus accounts. When a dividend is paid, it is then treated as coming out of a particular surplus account with correspondingly different tax treatment.
The exempt surplus account tracks the active business income earned in a designated treaty country (i.e. a country with a tax treaty or tax information exchange agreement with Canada). When a dividend is paid out of exempt surplus of a foreign affiliate, the Canadian corporation is entitled to a deduction for the entire amount of the dividend, but no deduction or credit is available for any non-resident withholding tax paid on the dividend. This treatment is usually very favorable for the taxpayer since Canada is effectively choosing not to tax the dividend at all.
The hybrid surplus account tracks gains realized from the sale by the foreign affiliate of shares of another foreign affiliate or certain other types of property. The treatment of hybrid surplus is intended to mimic how under Canadian income tax, only half of a capital gain is subject to income tax. A deduction is available to the Canadian resident corporation for half of the amount of the dividend (i.e. for the “non-taxable” half of the dividend) plus a deduction intended to offset the foreign income tax paid on the “taxable” half of the dividend. No deduction or credit is provided for non-resident withholding tax.
This account tracks non-active business income or active business income earned by the foreign affiliate in a country that is not a designated treaty country. A deduction is provided intended to offset foreign income tax paid on this income. Another deduction is provided to offset non-resident withholding tax paid on the dividend.
This account effectively tracks the Canadian corporation’s capital investment or the cost of the shares of the foreign affiliate. A full deduction is available for amounts paid out of pre-acquisition surplus, although the Canadian corporation’s adjusted cost base in the shares of the foreign affiliate will be reduced by a corresponding amount.
An ordering rule governs out of which surplus account a dividend is treated as being paid. When a foreign affiliate pays a dividend, if there is exempt surplus available, the dividend will be considered to be paid out of exempt surplus. If no exempt surplus remains, the dividend will be considered to be paid out of hybrid surplus, then taxable surplus, and then finally pre-acquisition surplus. In some circumstances a top Canadian tax planning lawyer may advise that elections be made to opt for a dividend that would be paid out of exempt surplus to be paid out of taxable surplus or hybrid surplus instead (e.g. to take advantage of losses).
What is a Controlled Foreign Affiliate – Foreign Affiliates and Controlled Foreign Affiliates
There are two tests that determine whether a foreign affiliate also counts as a controlled foreign affiliate of a Canadian resident taxpayer. Either test, if satisfied, is sufficient for qualifying as a controlled foreign affiliate. The first test examines whether the Canadian resident taxpayer directly or indirectly owns sufficient shares to be able to control the foreign affiliate. The second test examines whether the Canadian resident taxpayer together with a detailed specified group of other taxpayers directly or indirectly own enough shares to control the foreign affiliate.
Control Test for Foreign Affiliates
If the foreign affiliate is controlled by the Canadian resident taxpayer, then the foreign affiliate is a controlled foreign affiliate.
For the purposes of controlled foreign affiliate status, “control” means de jure control (i.e. formal legal control) not de facto control (i.e. control in fact as assessed by looking beyond the corporation’s share register and constating documents). Typically an entity has de jure control of a corporation if the entity has sufficient shares to elect a majority of the corporation’s board of directors. Typically owning more than 50% of a corporation’s shares is sufficient to do this.
In the Canadian context the board of directors of the corporation by default will be responsible for and have the power to supervise the management and affairs of the corporation. This is why control of the board of directors typically results in de jure control. However, in some circumstances the constating documents of a corporation can change this, such as a unanimous shareholder agreement (which is a constating document of a corporation under many Canadian corporate statutes) which allows the shareholders of a corporation to manage it directly. In such circumstances, de jure control is analysed in terms of the specific corporate statutes and constating documents involved in that situation. Similarly, to the extent that a corporation incorporated in a foreign jurisdiction has a substantially different corporate law than Canada, the conditions necessary for de jure control will change accordingly.
Group Control Test
The second foreign affiliate test examines whether the Canadian resident taxpayer would control the foreign affiliate (in the manner described above) if the Canadian tax resident owned the following shares:+
- All the shares in the foreign affiliate that are actually owned by the Canadian resident taxpayer,
- All of the shares of the foreign affiliate that are owned at that time by persons who do not deal at arm’s length with the Canadian resident taxpayer,
- All of the shares of the foreign affiliate that are owned at that time by persons (called “relevant Canadian shareholders”), in any set of persons not exceeding four (which set of persons shall be determined without reference to the existence of or the absence of any relationship, connection, or action in concert between those persons), who
- Are resident in Canada;
- Are not the Canadian resident taxpayer or a person not at arm’s length from the Canadian resident taxpayer;
- Own shares of the foreign affiliate; and
- All of the shares of the foreign affiliate that are owned at that time by persons who do not deal at arm’s length with any relevant Canadian shareholder.
This effectively asks whether the foreign affiliate could be controlled by a small group of Canadian tax residents, specifically the Canadian resident taxpayer and any four other Canadian resident tax resident shareholders, plus any non-arm’s length persons. If this small group could control the foreign affiliate, then the foreign affiliate is a controlled foreign affiliate. This test does not require that this small group is in fact acting in concert to collectively control the corporation.
Foreign Accrual Property Income – Foreign Affiliates and Controlled Foreign Affiliates
In the absence of Canada’s controlled foreign affiliate rules, the following tax planning idea would be tempting for Canadian taxpayers with substantial investment portfolios:
- Incorporate a corporation (“ForeignCo”) in a jurisdiction no income tax or income tax rates lower than those that apply in Canada;
- Hold passive investments such as stocks, bonds, or real estate in ForeignCo; and
- Have ForeignCo reinvest the dividends, interest, rent and other investment income generated by the portfolio.
This approach would effectively allow Canadian taxpayers to defer paying Canadian tax indefinitely by only having the ForeignCo pay dividends to the Canadian taxpayer when necessary (e.g. to fund consumption). This would be a substantial tax advantage as it allows ForeignCo to reinvest and earn a return on money that would otherwise be paid to CRA.
The Income Tax Act’s way of preventing tax planning of the type described above is with the concept of foreign accrual property income (“FAPI”). Canadian income tax law will treat Canadian residents as having received income, FAPI, based on certain types of “passive” income earned by their controlled foreign affiliates even in the absence of the controlled foreign affiliate paying that money to the Canadian residents as dividends. If the controlled foreign affiliate subsequently pays dividends from income previously taxed as FAPI, an adjustment is available to prevent double taxation.
The FAPI rules only apply to “passive income” earned by controlled foreign affiliates, and not mere foreign affiliates or non-foreign affiliates in which a Canadian resident shareholder has a partial interest Canadian income tax law also allows the equivalent of foreign tax credits to reduce foreign accrual property income based on the amount of foreign taxes paid on the controlled foreign affiliates income that is included in FAPI.
The full details of what sort of income earned by a controlled foreign affiliate counts as foreign accrual property income or not are highly complex and beyond the scope of this article and will typically require guidance from a top Canadian income tax lawyer. Briefly, the main types of income included in FAPI are income from property, which includes dividends, interest, rent, and royalties, as well as taxable capital gains from the sale of property that was not used in an active business. Income earned by the controlled foreign affiliate through running an active business is generally not included in foreign accrual property income. The Income Tax Act contains many deeming rules that exclude some amounts that would otherwise be FAPI or deem amounts to be FAPI that otherwise would not be included.
Pro Tax Tips: Foreign Affiliates and Controlled Foreign Affiliates
The foreign affiliate system is highly complex and is essential to get advice from an expert Toronto tax lawyer before setting up any structure or business to which this system may apply. Some structures for your business may be significantly better or worse than others. For example, it is generally better for the shares of a foreign affiliate to be held by a Canadian resident corporation rather than an individual so as to qualify for the surplus regime summarized above.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."