Foreign affiliate rules tightened in Federal Budget 2018
The 2018 Federal Budget introduced new provisions affecting foreign affiliates controlled by a Canadian taxpayer, as explained in our video and article below:
Foreign affiliate – Investment business (tracking arrangements)
Where a non-resident corporation (“affiliate”) is controlled by a Canadian taxpayer and earns passive income, such income may be included in the income of the Canadian taxpayer in the year in which it is earned by the affiliate, regardless if the income is actually distributed by the affiliate to the Canadian taxpayer. Such income is referred to as foreign accrual property income (FAPI). In contrast, active business income earned by an affiliate is generally not included in the income of the Canadian taxpayer until a distribution has been received from the affiliate (in the case of a Canadian corporate taxpayer, dividends may be received on a tax-free basis). One of the objectives of the existing FAPI regime is to ensure that Canadian tax on passive income cannot be deferred where such income is being earned by an affiliate in a jurisdiction with a lower effective corporate tax rate than Canada’s.
Given the difference in treatment between passive and active business income earned by an affiliate, it is beneficial to the Canadian taxpayer to have income earned by an affiliate treated as active business income for Canadian tax purposes.
An investment business is generally defined as a business where the principal purpose is to derive income from property (such as rents, royalties, dividends, interest income). However, an investment business does not include a business carried on by an affiliate if certain conditions are met. One of these conditions, in general terms, is that the affiliate employs more than five full-time employees (or the equivalent) in the active conduct of its business. If the affiliate’s investment activities require more than five full-time employees (assuming other conditions are met), the affiliate’s property income is treated as an active business and is excluded from the computation of FAPI by the Canadian taxpayer.
Certain Canadian taxpayers whose foreign investment activities would not warrant more than five full-time employees, have entered into planning with other taxpayers to meet the employee exemption noted above by pooling their financial assets in a common foreign affiliate. While the taxpayers take the position that the affiliate is carrying on a single business, their investment returns are tracked and determined separately by reference to the property contributed to the common affiliate. It is the government’s view that under these contractual tracking arrangements, the assets contributed by the Canadian taxpayers are not truly pooled, and the affiliate is essentially used as a conduit entity to obtain a tax advantage by avoiding the FAPI regime.
Budget 2018 proposes to modify the investment business definition to address these arrangements. Where income attributable to specific activities carried out by an affiliate accrues to the benefit of a Canadian taxpayer under a tracking arrangement, those activities will be deemed to be a separate business carried on by the affiliate. Each separate business of the affiliate will therefore need to satisfy the relevant conditions in the investment business definition, including the more than five full-time employee test, in order for the affiliate income from that business to be considered active business income and excluded from FAPI.
Since draft legislation was not included with the budget information, it is yet to be seen how broadly a tracking arrangement will be defined with respect to an investment business. While the government appears to be aiming at tracking arrangements entered between unrelated parties, certain legitimate joint ventures and treasury structures of Canadian multinational companies may be caught inadvertently by the proposed measures. Despite the absence of the draft legislation, these measures will apply to taxation years of the taxpayer’s affiliates that begin on or after February 27, 2018.
Foreign affiliate – reporting requirements
Canadian taxpayers are required to file T1134 information disclosure returns for each year in respect of their foreign affiliates. These returns are due 15 months after the end of its taxation year. Budget 2018 proposes to shorten the filing deadline to six months of the end of the taxpayer’s taxation year. This measure will apply to taxation years that begin after 2019. Given the shortened timeframe, taxpayers may find it challenging to obtain information required to report activities of their affiliate on time. The penalty for late filing the T1134 information return is $25 per day for up to 100 days.
Middle market businesses with foreign affiliates should speak to their advisor to formulate strategies to manage the tax implications arising from the 2018 Federal Budget.