Advisory Panel on Canada's System of International Taxation

2. Taxation of Outbound Direct Investment

Active Business Income of Foreign Affiliates

2.1   Outbound taxation generally refers to the Canadian tax rules that deal with income earned from foreign investments by Canadian residents. These investments can be categorized as follows:

  • Foreign portfolio investments: These are passive investments in shares, debt and similar instruments of foreign corporations and entities.
  • Foreign direct investment: Direct investments constitute ownership or controlling stakes granting the investor significant influence over the management of the business activities of the foreign entity. The focus of this paper is on foreign direct investment.

2.2   Canada’s tax system is designed to tax Canadian residents on their worldwide income. As a result, foreign-source income may be subject to tax twice: once in the foreign jurisdiction where the income is earned, and again in Canada. To alleviate possible double taxation, Canada’s tax rules allow for a foreign tax credit to offset the Canadian tax otherwise payable on foreign-source income earned by Canadian taxpayers.

2.3   In the case of portfolio investments, the foreign tax credit provides some relief for foreign withholding taxes paid on the income. For example, a $100 dividend received by a Canadian taxpayer in respect of a portfolio investment in shares of a foreign corporation may be subject to 15 percent or $15 of foreign withholding tax. The $15 of tax is eligible for a foreign tax credit against the Canadian tax otherwise payable on the dividend received.

2.4   Continuing this example, the foreign corporation paying the dividend was probably subject to foreign income tax. If the $100 dividend was derived from earnings that were subject to a 30-percent corporate income tax rate, the pre-tax earnings needed to pay the $100 dividend would be approximately $143 [$143 – ($143 x 30%) = $100]. For income from portfolio investments, there is no Canadian income tax relief for the $43 of foreign tax.

2.5   Most international tax systems, including Canada’s, tax dividends from foreign direct investments differently, by attempting to provide some relief for foreign tax that has already been paid on the earnings from which the dividend is paid (i.e., the $43 of foreign tax in the above example). This tax is generally referred to as “underlying foreign tax.”

2.6   In broad terms, domestic tax relief for underlying foreign tax is provided in one of two ways: by credit or by exemption. While there are many variations and special rules governing how the credit or exemption is provided or computed, all systems are generally based on one or the other. Canada’s system features elements of both, as described in more detail below.

2.7   Under a foreign tax credit system, if the underlying foreign tax paid is equivalent to or higher than the domestic tax that would otherwise be payable, no additional domestic tax would be paid when the dividend is received by a domestic shareholder. If the underlying foreign tax is less than what the domestic tax would otherwise be, then additional domestic tax would be payable. For example, if the foreign tax rate is 20 percent and the domestic tax rate is 30 percent, then an additional domestic tax of 10 percent would generally be payable on the dividend.

2.8   In an exemption system, the foreign dividend is simply exempt from domestic tax when it is received, thus eliminating the need for foreign tax credit calculations, which are sometimes quite complicated. For example, in Canada, the exemption system applies to certain dividends paid from “active business income.” In some countries, other conditions such as a required holding period of the foreign corporation shares may also apply.

2.9   The choice between an exemption system and a foreign tax credit system involves considerations beyond the complexity of foreign tax credit calculations. Some of the economic theories that may influence the choice of one system over another are described in the accompanying box.

Economic Approaches to the Taxation of Foreign Direct Investment Income

Besides being fair and simple, a good tax system should be economically efficient: it should impose the least possible burden on the economy while generating its target revenue.

A tax imposed on foreign-source business income not only affects the competitiveness of multinationals but also may distort the investment and saving decisions of taxpayers and may affect the pattern of ownership of business assets among corporations. Economists have identified three possible objectives that countries might pursue to ensure neutrality in designing their systems for taxing income from outbound direct investment:

  • “Capital Export Neutrality” (CEN): If CEN is the chosen objective, a tax system is designed to be neutral regarding resident investor preference for investment at home or abroad, so the more profitable investments (on a pre-tax basis) are made first.
  • “Capital Import Neutrality” (CIN): If CIN holds, investors from different countries face the same level of tax when doing business in a given country, so there is neutrality with respect to the investment decisions made by residents of different countries.
  • “Capital Ownership Neutrality” (CON): If CON is the objective, a tax system is designed to be neutral regarding which corporations own and exploit capital assets, so the corporations that exploit a given asset most efficiently are willing to pay the most to own that asset.

Different countries, however, tax foreign direct investment income at different rates, so fulfilling the three neutrality standards with a single set of tax rules is impossible. For example, taxing foreign business income on an accrual basis with a credit for foreign taxes paid on that income would conform with the CEN standard but not with CIN or CON. In contrast, providing an exemption for foreign business income could conform with CIN and CON but maybe not with CEN, as it could create a bias in favour of foreign investment.

Of course, countries will consider many other factors beyond neutrality in designing their tax systems, including competitiveness.

Alternatives for Taxing Active Business Income Earned Indirectly through Foreign Corporations

2.10   Broadly speaking, countries have four principal choices in how they tax active business income earned indirectly by resident taxpayers from foreign corporations:

  • accrual or worldwide basis of taxation
  • deferral with credit
  • partial exemption and partial deferral with credit (the “Canadian System”)
  • full exemption.

2.11   Generally, passive income earned indirectly through controlled foreign corporations is taxed on an accrual basis. The meaning of “accrual” in this context is discussed in the following subsection. The Canadian taxation of such income, for example under the rules for foreign accrual property income (FAPI), is discussed in more detail below starting at paragraph 2.41.

Accrual or Worldwide Basis of Taxation

2.12   Under the Accrual or Worldwide Basis of Taxation, in its purest form, all domestic and foreign-source income earned directly and indirectly is taxable in the country of residence on an accrual basis (i.e., as it is earned), whether or not it is repatriated to the home country. A credit is provided for any underlying foreign tax paid in respect of such income.

2.13   As compelling as this alternative may appear, no member country of the OECD or the European Union (EU) employs this system in its purest sense for taxing foreign business income. The country that comes closest is New Zealand, although it maintains exceptions for foreign corporations located in countries included on a so-called “grey list.” Moreover, New Zealand is engaged in a major international tax reform aimed at making its international tax system more competitive for its domestic companies investing abroad, and therefore will likely move closer to an exemption system.3

Deferral with Credit (the “Credit Method”)

2.14   The Credit Method defers the taxation of foreign active business income until such income is repatriated to domestic shareholders, and allows for a tax credit for foreign income tax paid on the income. This alternative is employed by the U.S., the United Kingdom and Japan, among others.

2.15   The Credit Method appears to have certain merits. Notably, from an economic policy perspective, Canadian businesses would be more neutral in evaluating whether to invest domestically or outside Canada (see earlier box describing CEN). However, this method also has disadvantages: it is more complicated than the exemption system and would create a more onerous compliance burden for taxpayers and the CRA. The Credit Method also discourages repatriation of business profits, as domestic taxation is deferred so long as those profits remain outside Canada. The additional Canadian tax that would be collected on repatriated foreign profits may not be significant, and so capital export neutrality may not be achieved.4

The “Canadian System”

2.16   The Canadian foreign affiliate rules were introduced as part of the 1972 tax reform and have been in effect since 1976. Although changes have been made over the years, the rules’ basic premise remains the same: active business income earned by a foreign affiliate of a Canadian resident will not be taxed in Canada until the profits are repatriated to Canada. Generally, a foreign affiliate is a foreign corporation in which a Canadian resident owns 10 percent or more of a class of shares, while a controlled foreign affiliate is a foreign affiliate that is controlled by a Canadian resident or a small group of Canadian residents. For these definitions, there are additional rules that include shares owned by related or non-arm’s-length persons in determining whether a foreign corporation is a foreign affiliate or a controlled foreign affiliate.

2.17   The key features of the Canadian System are as follows:

  • Foreign active business income earned through a foreign affiliate is exempt from Canadian tax when such income is paid as a dividend to Canadian corporate shareholders if the affiliate is resident and the business is carried on in a country with which Canada has a tax treaty (a “Treaty Country”). Under recently enacted changes, the same treatment applies to active business income earned in a country with which Canada has a comprehensive Tax Information Exchange Agreement (TIEA).
  • If an affiliate is not resident or if its business is not carried on in a Treaty Country or a country with which Canada has entered into a TIEA, the Credit Method applies to the income. If Canada offers to negotiate a TIEA with a country and if an agreement is not reached within five years, the active business income earned by a controlled foreign affiliate in that country is taxed in Canada on an accrual basis.

2.18   The exemption system applies to a significant amount of active business income earned by foreign affiliates because Canada has tax treaties with 86 countries. However, there are still countries with which Canada has not entered into either a tax treaty or a TIEA. These include, for example, certain developing countries where Canadian mining and resource companies have significant investments. The table below, provided to us by the Department of Finance, reports dividends received by Canadian taxpayers from their foreign affiliates for the years 2000 through 2005 (see also paragraph 2.23).

Dividends Received by Canadian Taxpayers from their Foreign Affiliates, by Surplus Account, 2000–2005 ($millions)
  2000 2001 2002 2003 2004 2005

Exempt

5 531

8 320

8 990

11 731

9 676

10 609

Taxable*

177

1 016

527

765

688

1 288

Other**

1 770

3 786

1 289

1 918

1 924

2 167

Total

7 478

13 122

10 805

14 414

12 289

14 064

*   Canadian taxes paid on taxable dividends received from foreign affiliates, including those contained in the “Other” category, depend on the taxpaying position of the recipients and the extent to which they are eligible to claim relief in respect of taxes paid on the underlying active business income. Currently available data do not allow for a reliable estimate of Canadian taxes on taxable dividends received from foreign affiliates. Work is under way to refine these data further.

**   Includes dividends received by firms that have indicated that the dividends were paid out of more than one type of account (i.e., exempt surplus, taxable surplus and pre-acquisition surplus), or have not indicated the type of surplus account that dividends were paid out of.

Source: Canada Revenue Agency, T1134 Information Return.

2.19   All foreign income earned by a foreign branch of a Canadian company, including foreign active business income, is generally subject to Canadian tax on an accrual basis, with credit for any foreign tax paid.

Full Exemption

2.20   Under a full exemption system, all foreign active business income is exempt from domestic taxation when paid as a dividend to domestic shareholders, including any income derived from the sale of assets or shares of foreign companies. In simple terms, under a full exemption system, there is generally no need to track foreign earnings and underlying foreign tax as there is under the current Canadian System: the income earned indirectly through foreign companies is either taxed domestically on an accrual basis when it is earned or it is never subject to domestic tax.

Evaluating the Canadian System

2.21   Refinements have been made to the Canadian System over the years. Given today’s competitive global environment, it is appropriate to consider whether further refinements or substantive changes are needed. Issues to consider are its ongoing effectiveness in supporting the competitiveness of Canadian businesses operating abroad as well as safeguards against the erosion of the Canadian tax base. Achieving these objectives should not come at the expense of complex rules that create difficulties in compliance for taxpayers and administration for the CRA.

2.22   An added incentive for Canada to evaluate its current system at this time is the number of countries engaging in similar reviews for similar reasons. These countries are considering adoption of features that would either enhance their existing exemption system for active business income or move them to an exemption system and away from an accrual or credit system (for example, New Zealand and the United Kingdom).

2.23   As noted, the Canadian System has elements of both an exemption and a credit system. This requires Canadian corporate shareholders to track the “exempt surplus” and “taxable surplus” balances of each foreign affiliate to determine how dividends will be taxed when received (dividends from exempt surplus are exempt and dividends from taxable surplus qualify for the Credit Method). The Department of Finance has proposed rules that, among other things, aim to prevent taxpayers from creating exempt surplus in certain types of inter-affiliate transactions. These proposed rules will likely increase the complexity of these surplus computations.

Options for Consideration

2.24   In 1998, the Report of the Technical Committee on Business Taxation (commonly referred to as the “Mintz Report”) concluded that “[o]n balance [. . .] the existing regime is fundamentally sound and should be maintained.” In particular, the Mintz Report ruled out pursuit of the Credit Method for essentially the same reasons noted in paragraph 2.15. While the Panel recognizes there are possible advantages to the Credit Method, its initial view is that there is no compelling reason to believe that the conclusion reached by the Technical Committee does not still apply today. With a number of countries considering a move to an exemption system or an enhancement of their existing exemption systems, the Panel believes it is more appropriate to consider whether Canada should move to a broader or full exemption system.

2.25   Moving to a broader exemption system for all dividends from a foreign affiliate, and possibly exempting capital gains arising from the sale of shares of a foreign affiliate, would be consistent with recent international developments. It would also simplify compliance for both taxpayers and the CRA, for example, by reducing or eliminating the need to track exempt and taxable surplus accounts. However, a broader exemption system raises considerations that may require other consequential changes to the Canadian System.

Principal Considerations in Moving to a Broader Exemption System

2.26   Three major issues need to be examined in reviewing whether or not Canada should move to a broader exemption system:

  • the conditions necessary to access the exemption regime (for example, what types of income should qualify)
  • the treatment of capital gains from the sale of shares of foreign affiliates
  • the deductibility of costs incurred in Canada that relate to earning the exempt income.

These issues and others are discussed below.

Exemption for Active Business Income

2.27   New legislation, effective for taxation years beginning after 2008, will extend the scope of foreign business earnings that can qualify for exempt treatment on repatriation to Canada to active business income earned by a foreign affiliate in a country that has entered into a TIEA with Canada. Previously, only active business income earned in a treaty country qualified for such exemption. Arguably, this is one of the more significant changes to the current Canadian System since its inception, because the exemption is no longer tied to income earned in a Treaty Country.

2.28   At the time the scope of the exemption was broadened, the scope for FAPI was also broadened because active business income earned in a country that is offered the opportunity to enter into TIEA negotiations with Canada but does not conclude a TIEA within five years will be considered FAPI. In these circumstances, active business income earned by a controlled foreign affiliate in such a country will be taxed immediately in Canada, with credit for foreign taxes paid in respect of that income.

2.29   In a broader exemption system, a link between a tax treaty or a TIEA and the exemption of the foreign business income may not be necessary. Some countries provide an exemption on the basis that the earnings are from active business income. Qualification for exemption is also often linked to criteria such as a minimum rate of tax or a minimum holding period.

Qualification as a Foreign Affiliate

2.30   Under Canada’s current rules, an investment in a foreign corporation is treated as foreign direct investment if the foreign corporation qualifies as a foreign affiliate. The benefit of foreign affiliate treatment is the availability of an exemption or relief for the underlying foreign tax paid by the foreign affiliate.

2.31   Under the current rules, a foreign corporation qualifies as a foreign affiliate if the Canadian investor has a 10-percent direct or indirect interest in any class of shares of the foreign corporation. In other countries, the threshold ownership level often requires the holding of shares in the foreign corporation that represent a certain percentage of the outstanding shares in terms of value and/or votes.

2.32   If Canada moves to a broader exemption system for dividends received from foreign affiliates, the threshold for qualification as a foreign affiliate may have to be reviewed.

Capital Gains on the Sale of Shares of a Foreign Affiliate

2.33   Many countries exempt not only the dividends received from a foreign affiliate but also the capital gains realized on a disposition of the shares of a foreign affiliate. Exempting capital gains from the sale of shares of a foreign affiliate may be viewed as appropriate if the income that would be generated by the affiliate would also be exempt from Canadian tax. The policy rationale for exempting gains on the disposition of shares of a foreign affiliate while continuing to tax capital gains arising on the sale of shares of a Canadian company would need to be considered.

2.34   In the current system, the need to maintain exempt and taxable surplus accounts to track a foreign affiliate’s earnings is important. These accounts indicate the portion of the capital gain that is attributable to previously taxed retained earnings and also the portion of the gain that is taxable and the portion that is not (see accompanying box). If capital gains from the disposition of foreign affiliate shares were no longer taxable, accounts for tracking the foreign affiliate’s earnings may no longer be needed.

Capital Gains on the Sale of Shares of a Foreign Affiliate

Under Canada’s foreign affiliate rules, where a Canadian resident corporation sells shares of its foreign affiliate, the Canadian corporation may make an election that deems an “elected amount” to be a dividend, rather than proceeds of disposition. As a result, the gain on the shares otherwise determined is reduced by the elected amount. In general terms, this deemed dividend is tax-free in Canada to the extent the affiliate has either exempt surplus or taxable surplus that has been taxed in the foreign jurisdiction at a rate at least as high as the current Canadian tax rate.

For example, assume a Canadian corporation sells shares of a foreign affiliate for $10 million and the cost base of those shares is $6 million. Also assume the foreign affiliate has exempt surplus of $1.5 million. By electing to have $1.5 million of the sale proceeds treated as an exempt dividend, the gain, which would otherwise be $4 million, is reduced by $1.5 million to $2.5 million.

2.35   If Canada chooses to adopt a broader exemption system under which dividends from a foreign affiliate are exempt but capital gains on the disposition of foreign affiliate shares are not, it would be necessary to retain some form of tracking the earnings of a foreign affiliate. In a tax system where dividends are exempt and capital gains are taxable, a taxpayer will generally seek to reduce the taxable capital gain by stripping the value of the company being sold through the payment of exempt dividends by the target company.

2.36   There is a rationale for Canada to have robust FAPI rules to deal with passive income and for Canada to continue to tax the capital gain arising on the sale of shares of a foreign affiliate where a significant part of the value of the shares is derived from passive activity. Under the current rules and in the context of shares of a foreign affiliate held by another foreign affiliate, the concept of “excluded property” determines what is and what is not taxable as FAPI (see accompanying box). Analysis would be required to determine what modifications, if any, would need to be made to this test if Canada adopts a system that exempts all capital gains from the sale of shares of a foreign affiliate.

Excluded Property

A foreign affiliate’s “excluded property” is its property used to earn active business income or shares of another foreign affiliate where all or substantially all of the fair market value of the property of the other foreign affiliate is attributable to excluded property. The definition is relevant, for example, where a foreign affiliate realizes a capital gain on the sale of shares of another foreign affiliate. Generally, any capital gain arising on the sale of foreign affiliate shares that are excluded property is not FAPI. If the shares are not excluded property, 50 percent of the gain is FAPI.

Allocable Costs

2.37   The proper measurement of foreign-source income is an important aspect of an exemption system. Certain countries that employ an exemption system have special rules to deal with domestic costs attributable to foreign income that is exempt from domestic taxation. Some of these countries deny the deduction of such costs while others do not fully exempt the income (for example, only 95 percent of the income is exempt) to reflect the costs incurred to earn the income.

2.38   Some countries continue to allow a full deduction of the interest expense incurred to acquire shares that would produce exempt dividends or that are exempt from capital gains tax upon their disposition.

Other Returns from Foreign Affiliates

2.39   Dividends are one way in which shareholders receive returns from their investments in foreign corporations. Shareholders may also make loans to the corporation and receive a return in the form of interest. Shareholders may also rent or license property (tangible or intangible) they own to the foreign corporation, and these rents or royalties also represent a form of return from the investment. Interest, rents and royalties are fully taxable to Canadian recipients and are generally deductible by foreign payers.

2.40   Equity and debt instruments held by shareholders in respect of their non-portfolio investments are often substitutable. Therefore, absent tax considerations, shareholders of wholly owned subsidiaries could be indifferent to whether they receive their returns in the form of dividends, interest, royalties or any combination of such income.

Questions on Active Business Income of Foreign Affiliates

  1. Should Canada’s foreign affiliate regime for active business income be retained in its current form, or should changes be introduced to make it a broader exemption system?
  2. What are the conditions that taxpayers should meet in order to access a broader exemption system?
  3. If the exemption for active business income earned by an affiliate is expanded, is the new TIEA exemption the most appropriate way of achieving this goal? Should the accrual basis of taxation or some credit system apply to active business income earned by a controlled foreign affiliate in a non-Treaty Country that has failed to negotiate a TIEA with Canada?
  4. Should Canada exempt the capital gain on the disposition of shares of foreign affiliates? If so, under what conditions?
  5. If Canada adopts a broader exemption system, are additional rules needed to deal with expenses allocable to exempt foreign income?
  6. Should Canada treat other returns (such as interest and royalties) from a foreign affiliate in the same manner as dividends?
  7. Should Canada consider providing an exemption for active business income earned through a foreign branch to the same extent as it does for dividends paid from active business income earned through a foreign affiliate?
  8. Does the increased significance of tax-exempt entities as outbound investors raise any particular issues regarding Canada’s foreign affiliate regime?
  9. How can the foreign affiliate rules be amended to reduce the compliance and administrative burden for taxpayers and the CRA while maintaining the tax policy objectives of these rules?
  10. Are there other issues or options related to the taxation of active business income earned indirectly through foreign corporations that should be reviewed and considered?

Foreign Accrual Property Income

Current Rules

2.41   Regarding passive income, Canada’s tax rules are similar to those of many other countries. Canada’s tax rules require a Canadian resident shareholder to include in income on an accrual basis amounts related to certain types of income earned by its controlled foreign affiliates, with relief provided for any foreign tax paid on the income. These rules, referred to as the foreign accrual property income (FAPI) rules, have been a fixture of the Canadian tax system since the early 1970s.

2.42   FAPI includes passive income such as interest, dividends (except dividends from other foreign affiliates), royalties, 50 percent of capital gains realized from the sale of property that is not excluded property, and, as a result of the so-called “Base Erosion Rules,” certain other specific types of income earned by a foreign affiliate. In addition, certain passive income that would otherwise be FAPI is considered active business income where the business generating the income is conducted principally with arm’s-length persons and employs more than five full-time employees. A special exception to the FAPI rules applies to certain payments between related foreign affiliates (see accompanying box).

FAPI Exception for Inter-affiliate Payments

Special exceptions to the FAPI rules may apply in the case of interest, royalties and certain other payments. For example, interest income of a foreign affiliate (FA1) resulting from payments from another foreign affiliate (FA2) generally is not considered FAPI if, among other conditions, FA2 deducted the interest in computing its active business income. This exception is generally referred to as the “inter-affiliate payment exception.”

2.43   The FAPI rules are designed to ensure that the Canadian tax base is not eroded by Canadian residents transferring passive investments and certain business activities to foreign affiliates to avoid or defer Canadian tax. Accordingly, there appears to be little debate that taxing FAPI on an accrual basis is appropriate. Because passive income is highly mobile, in the absence of such rules, Canadian businesses could easily convert domestic passive income into foreign income that is unrelated to its foreign business operations, and so escape domestic tax. However, a key issue is the determination of what constitutes passive versus business income, and how each type of income should be computed.

2.44   As an example of how the FAPI rules work, assume a Canadian corporation has excess funds, which it invests in marketable securities. The return on those funds will attract Canadian income tax. Funds invested in marketable securities are a highly mobile form of capital. Therefore, it is relatively simple for the Canadian corporation to set up a subsidiary in a country with a very low tax rate, contribute the funds to that subsidiary and have that subsidiary invest the funds in the marketable securities. Absent the FAPI rules, the income from the marketable securities would be subject to little tax until the time (if ever) it is paid as a dividend to the Canadian corporation. If such income is not treated as FAPI, the deferral and possible permanent avoidance of Canadian tax in this way could erode the Canadian tax base and represent a loss of tax revenue to the government.

2.45   Currently under the FAPI rules, passive income earned by a foreign affiliate that is not a controlled foreign affiliate is not taxed on an accrual basis in Canada (because the affiliate is not “controlled” by the Canadian group). Such income is still considered FAPI and is subject to the Credit Method on repatriation. This treatment reflects the view that, if the foreign affiliate is not controlled by the Canadian shareholder, the foreign affiliate’s income should not be included in the Canadian shareholder’s income until the income is repatriated as a dividend.

2.46   In addition to the FAPI rules, Canada also has existing and proposed “Foreign Investment Entity” (FIE) rules, which attribute passive income in much the same way as the FAPI rules and are intended to apply to certain circumstances that are outside the scope of the FAPI rules. For example, the FAPI rules only attribute passive income to Canadian shareholders on an accrual basis if the affiliate is a controlled foreign affiliate. One intent of the FIE rules is to tax, in certain circumstances, passive income that would not otherwise be taxed on an accrual basis under the FAPI regime because the foreign corporation is not a controlled foreign affiliate.

2.47   The above explanation of the FIE rules provides only a very brief description of the reach and complexity of these rules. A complete description of their operation is beyond the scope of this paper. The proposed FIE rules were released in 1999 and have since been revised many times.5 Some argue that these rules are too complex; others argue that they are needed to ensure that the FAPI rules cannot be circumvented by indirectly earning passive income using other structures.

FAPI Issues for Consideration

2.48   As noted above, FAPI earned by a non-controlled foreign affiliate falls under the Credit Method. Under a broader exemption system, the issue that arises is whether such FAPI income should continue to be taxable upon repatriation under this method. If so, there would be a need to maintain the accounts to track these earnings and the related underlying foreign tax. Alternatively, FAPI income earned by a non-controlled foreign affiliate could be exempt on the basis that the FIE regime would capture any passive income that should be taxed on an accrual basis.

Base Erosion Rules

2.49   The Base Erosion Rules target certain arrangements whereby a foreign affiliate of a Canadian resident taxpayer derives income that is considered to be connected to a business carried on in Canada or to Canadian resident persons. The targeted arrangements have the effect of reducing the Canadian tax base. One example of how these rules operate is illustrated in the accompanying box.

Base Erosion Rules

The following example illustrates how the Base Erosion Rules generally operate. Assume a Canadian company (“Canco”) chooses to source a product from an arm’s-length company located in Country A (“ManufactureCo”). The cost of the product to Canco is $60 and the Canadian company expects to sell the product for $100 to Canadian customers. Assume the transportation costs are $5 and other costs (such as administrative and financial costs) are $15, so the additional costs are $20 and the total profit is also $20 [i.e., $100 – ($60 + $15 + $5)].

Canco could reorganize its structure to create a wholly owned subsidiary in a low-tax foreign jurisdiction (“Subco”) and have Subco purchase the product from ManufactureCo. Subco could assume the risks of transporting the product from Country A to Canada and perform other functions such as acting as the central purchasing agent for the entire corporate group. The income flows would now be different: Subco would purchase the product from ManufactureCo for $60 and sell it to Canco for, say $70, so that it could earn a profit. Canco would incur additional costs of $15 (as the transportation costs are borne by Subco) such that its profit would be $15 [i.e., $100 – ($70 product cost + $15 administrative cost)].

The net result is that Subco now earns $5 and the Canadian company’s profit on the transaction is decreased by $5 to $15 — the overall profit for the entire group remains $20. While the full $20 was subject to Canadian tax before the introduction of Subco, absent the Base Erosion Rules, now only $15 is taxed in Canada and the other $5 is taxed in the low-tax jurisdiction.

The Base Erosion Rules seek to tax this $5 profit earned by Subco as FAPI. Similar rules seek to tax the profit related to income from services and certain financial transactions that have the same effect. The rules provide for numerous exceptions. For example, if Subco earns more than 90 percent of its gross revenue from this business from arm’s-length parties, then its profit ($5 in our example) is not considered FAPI. This exception reflects the view that, if the subsidiary is doing business with third parties, then it may not have been set up principally to shift profit from Canada.

2.50   The Base Erosion Rules include arrangements or activities whereby the affiliate derives income from the sale of property (where the property’s cost is relevant in computing the income of a Canadian resident taxpayer) and from certain services and financial transactions.

2.51   One exception to these rules applies where the subsidiary manufactures or sources its product in the same location in which the subsidiary is incorporated. Under this exception, a U.S. subsidiary of a Canadian parent can sell product it produces or sources in the U.S. to its Canadian parent without having the income on that sale considered FAPI. However, it is common for foreign businesses to manufacture and source product in more than one jurisdiction. It seems timely to review the Base Erosion Rules to investigate whether they deal appropriately with such transactions.

2.52   In some cases, it can be argued that the transfer pricing rules should adequately protect the Canadian tax base against this form of erosion. In other cases, however, the effectiveness of such rules is uncertain.

Questions on Foreign Accrual Property Income

  1. If Canada adopts a broader exemption system, should the scope of the FAPI rules be changed? For example, should Canada consider changes to the Base Erosion Rules?
  2. How should the excluded property test be extended to operate appropriately in a broader exemption system?
  3. How should passive income earned by non-controlled foreign entities be treated?
  4. Should the Base Erosion Rules be reconsidered to accommodate companies that manufacture and source their product from several different jurisdictions?
  5. Are there other types of transactions to which the Base Erosion Rules should apply?
  6. Is there a way to simplify the FAPI rules while maintaining their tax policy objectives?
  7. Are there other issues or options related to the taxation of passive income of foreign corporations that should be reviewed and considered?

 

3 See New Zealand Inland Revenue Department, Policy Advice Division, and New Zealand Treasury, New Zealand’s International Tax Review: Developing An Active Income Exemption for Controlled Foreign Companies, October 2007, at paragraph 1.7 and discussion from pages 7 to 15.

4 See United Kingdom, HM Treasury and HM Revenue and Customs, Taxation of Companies’ Foreign Profits: Discussion Document, June 2007, at page 10.

5 Proposed new rules on non-resident trusts (NRT) have also been released. Like the proposed FIE rules, the proposed NRT rules are complex and have been revised many times. They are generally understood to impact individual tax matters, but given their reach, they could have broader application.

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