Understanding Canada’s FAPI rules is key for companies with foreign operations

An evaluation regarding whether a foreign corporation qualifies as a foreign affiliate must be conducted to determine whether any income earned in a foreign corporation constitutes as FAPI.

A foreign affiliate is generally a non-resident corporation in which a Canadian taxpayer has a significant ownership interest. However, foreign affiliate status is determined under the statutory rules and is not based solely on legal ownership.

While the statutory definition is technical and depends on specific ownership thresholds and attribution rules, businesses should generally consider whether they have a meaningful direct or indirect interest in a foreign corporation before assessing the application of the FAPI rules.

The legislation considers factors such as direct and indirect ownership, partnership interests, attribution rules and interests held by related persons.

Not all foreign affiliates are CFAs.

A controlled foreign affiliate is generally a foreign affiliate that is controlled, directly or indirectly, by a Canadian taxpayer—either alone or together with related or non-arm's-length persons.

However, CFA status is determined under the statutory ownership and control rules in subsection 95(1) of the Income Tax Act. The analysis considers factors such as direct and indirect ownership, related and non-arm's-length persons and the applicable deeming rules.

A FAPI inclusion usually arises only where the foreign affiliate also qualifies as a CFA.

Once a company is established as a foreign affiliate that is also a CFA, the next step is to determine whether the income earned is FAPI or FABI.

FAPI generally includes passive or investment income, such as interest, rent, portfolio dividends, certain royalties, income from property, investment business income and certain taxable capital gains.

Conversely, FABI often consists of active business income. This distinction is important because income that is characterized as FAPI is generally included annually in the Canadian shareholder's income, whereas FABI is generally taxed when repatriated back to Canada.

Investment business income generally falls within the FAPI rules. However, there are exceptions, such as where the foreign business has sufficient employees and carries on genuine business activities.

Because these exceptions depend on the specific facts and legislative requirements, businesses should carefully assess whether the FAPI rules apply to their foreign operations.

Where the FAPI rules apply, the income is calculated at the foreign affiliate level and may be adjusted for items such as prior-year losses and foreign taxes paid. The Canadian shareholder would most likely be required to include its share of that income in its Canadian taxable income—even if no funds were distributed from the foreign affiliate.

Losses from passive income earned by a foreign affiliate may be available to reduce future FAPI earned by that same affiliate.

Businesses should maintain accurate records of these losses as they may help reduce future Canadian tax liabilities.

Income earned outside Canada may also be taxed in a foreign jurisdiction. Depending on the circumstances, the Income Tax Act provides relief to help reduce the risk of double taxation.

Businesses should consider both the Canadian and international tax implications when operating abroad.

Canadian taxpayers with foreign affiliates may need to file Form T1134 with the Canada Revenue Agency (CRA). This form reports information about foreign affiliates and should be consistent with the taxpayer's Canadian income tax return and any FAPI calculations. . This form reports information about foreign affiliates and should be consistent with the taxpayer's Canadian income tax return and any FAPI calculations.

Maintaining accurate ownership and financial records can help ensure compliance and reduce the risk of CRA inquiries.