Unlocking tax relief: Section 93.4 for Canadian businesses abroad

The newly proposed section 93.4, introduced in August 2024, provides Canadian-controlled private corporations (CCPCs) and substantive CCPCs (SCCPCs) with tax relief on income earned abroad. The foreign accrual business income (FABI) rules, offering two elective regimes that allow companies to benefit from a higher relevant tax factor. These elections aim to ensure that income earned by foreign affiliates is taxed similarly to Canadian income, fostering integration. The legislation applies to taxation years starting after 2024, with optional retroactive application to prior years. Canadian businesses with foreign affiliates in real estate or services should consider these elections to optimize their tax positions.

Draft legislation released in August 2024 introduces a new measure that addresses the taxation of foreign earnings by foreign affiliates of Canadian-controlled private corporations (CCPCs) and substantive CCPCs (SCCPCs). Newly proposed section 93.4 introduces the foreign accrual business income (FABI) rules, which aims to provide better tax integration for CCPC and SCCPCs that generate certain foreign income or receive dividends from foreign affiliates.

These new rules ensure fair and efficient taxation with tax rates in line with what would have been applicable had that income been earned domestically. These rules apply to taxation years starting after 2024 with possible retroactive effect if an election is filed.

Policy behind section 93.4

The driving force behind section 93.4 is Canada's tax principle of integration, which aims to make a taxpayer theoretically neutral between earning income individually versus earning income through a corporation. However, in cases where Canadian companies earns income through foreign affiliates, the interaction between the rules that apply to foreign companies and the rules that apply to domestic company can lead to inefficient tax outcomes.

For CCPC and SCCPCs, aggregate investment income (AII) is subject to an additional refundable tax which closely resembles to the highest marginal tax rate for individuals, which thereby minimizes tax deferral advantages on most types of investment income earned. Further, the foreign accrual property income (FAPI) rules also prevent tax deferral by requiring Canadian shareholders to include a proportion of their controlled foreign affiliate’s FAPI in their income on an accrual basis. Generally speaking, FAPI of a controlled foreign affiliate includes many types of investment income similar to AII, but under certain circumstances can include other sources of income that would not be included in AII had it been earned domestically. FAPI earned by a Canadian corporation through its controlled foreign affiliates is subject to an additional refundable tax since the amount is included in its AII.

Canadian shareholders are then entitled to claim a foreign accrual tax (FAT) deduction to offset a FAPI income inclusion based on foreign taxes paid by the controlled foreign affiliate on FAPI earned. This deduction is calculated by multiplying the foreign taxes paid by a “relevant tax factor” (RTF), which has recently been reduced from 4 to 1.9 for CCPCs and SCCPCs, diminishing the tax shelter on FAPI. The RTF also applies when computing the income inclusion for Canadian corporations that receive a dividend from a foreign affiliate. Section 93.4 aims to align the taxation of FABI with how similar income would be taxed in Canada.

What is FABI?

FABI refers to specific types of income earned by a foreign affiliate of a Canadian corporation. FABI is a subset of FAPI that, despite its underlying nature as business income, was characterized as FAPI due to the application of certain tax rules. It generally applies to:

1. Income from services where the consideration paid for the services was deductible in calculating the income from an active business in Canada or the FABI of another affiliate.
2. Income from real property development or leasing, provided that the business employs the equivalent of more than five full-time employees both inside and outside of Canada.

How section 93.4 provides relief

Section 93.4 introduces two main elective regimes that allow CCPCs and SCCPCs to benefit from a higher RTF of 4.

1. Election to apply a higher RTF to FABI

One of the key elections under section 93.4 is to allow Canadian corporations to use the higher RTF of 4 (instead of the default 1.9) when calculating FAT deduction on FABI earned by a controlled foreign affiliate. This election is beneficial because it aligns foreign business income with Canadian corporate tax rates, ensuring that businesses are not penalized with higher tax burdens simply because the income was earned abroad.

For example, if a controlled foreign affiliate earns income from real estate leasing or development and pays foreign taxes of 25% or more, the RTF of 4 ensures that the Canadian company can fully offset the Canadian tax on that foreign income via a FAT deduction.

2. Election for dividends derived from a foreign affiliate’s FABI surplus

The second election under section 93.4 allows companies to apply the RTF of 4 to dividends paid from a foreign affiliate’s FABI surplus. This election prevents foreign earnings, which have already been taxed in the foreign country, from facing a second round of high taxes when distributed as dividends to the Canadian parent company. By making this election, dividends derived from FABI surplus are taxed more favorably.

Election for pre-2025 taxation years

There are additional elections in section 93.4 to apply these elections retroactively. This is particularly useful for businesses that have foreign affiliates and have already earned FABI prior to the full implementation of the new rules.

Taxpayers are permitted to elect for taxation years that began before April 7, 2022. This is beneficial where FABI was included in the income of a Canadian corporation in a taxation year before April 7, 2022, but FAT is paid in a taxation year starting on or after that date. Additionally, it covers dividends received in a taxation year beginning on or after April 7, 2022 if the FABI was earned in taxation years starting before April 7, 2022.
Taxpayers may also elect to apply section 93.4 for taxation years beginning after April 6, 2022, and before 2025, to avoid any recalculation of the capital dividend account (CDA) and capital dividends.

Practical implications for businesses

1. Neutrality and fair tax treatment: The elections under section 93.4 allow businesses to achieve greater neutrality between foreign and domestic operations. This ensures that income is taxed based on the type of business, not its geographical location.
2. Increased competitiveness in global markets: By offering better tax treatment on foreign earnings, section 93.4 encourages Canadian companies to invest and operate globally without facing punitive taxes. This strengthens their position in international markets.
3. Improved cash flow: By applying the higher RTF to foreign earnings, companies can reduce the taxes payable on foreign income, improving cash flow and enabling more reinvestment or growth.
4. Flexible tax planning: The ability to elect retroactively for past taxation years, and which retroactive election to make, provides businesses with greater flexibility, ensuring that foreign income is treated consistently and fairly across different time periods.

Who should consider these elections?

Businesses that operate internationally or have foreign affiliates involved in real estate development or leasing as well as service providers should consider making these elections.

Evaluate your ability to take advantage of these new rules starting in 2025!

By allowing elections to apply a higher RTF of 4 on foreign business income and dividends, the new FABI rules ensure that Canadian companies can operate globally without facing disproportionate tax burdens. For businesses with foreign operations, these elections offer essential tax relief, reducing the risk of double taxation and improving competitiveness in international markets.