Foreign Accrual Property Income – Part 2

Allan Madan, CA
 Aug 29, 2014
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If you think that FAPI doesn’t apply because you're investing a country with a higher corporate tax rate, think again.

I have previously discussed how the Foreign Accrual Property Income (FAPI) applies to Canadians who establish corporations in a different country. For my previous article, please visit What is the Foreign Accrual Property Income (FAPI) in Canada? . After reading the article, more shrewd readers may ask, “What if I create a corporation in a country with higher taxes than Canada? Isn’t it clear that I am not incorporating to take advantage of lower tax rates?”  

Many Canadians find themselves in this position, especially as they set up American corporations to buy rental properties. As US corporate tax rates are usually higher than Canadian ones, it’s logical that this regulation surrounding passive investment income shouldn’t apply to rental income for Canadians. Recognizing such an issue, Canada allows a particular deduction against the Foreign Accrual Property Income. Done on a tax return, they base this deduction on underlying foreign taxes and a certain formula. You can find the formula in section 91(4) of the Income Tax Act. If you are a foreign affiliate, visit KPMG at Foreign Affiliate Rules Now Set — Take Action to Manage Their Impact.

Let’s look at an example. First, note the following facts:

  • A Canadian corporation owns 100% of a foreign corporation that earns rental income
  • All amounts are in $CAD
  • Rental income for the year: $1,000
  • Foreign taxes paid: $250
  • Relevant tax factor (ITA s.95(1): 1 / (.38 – .13) = 4
 

Amounts

US Rental Income $1,000
FAPI included in Canadian taxpayer’s tax return $1,000
Foreign taxes paid $250 (A)
Relevant tax factor 4 (B)
Section 91(4) deduction for foreign taxes paid on the Canadian taxpayer’s tax return $1,000 (A * B)
FAPI net of Section 91(4) deduction reported on the Canadian taxpayer’s tax return $0

As you can see, Canada will provide full tax relief on the Foreign Accrual Property Income if the company meets the following condition. If they pay international taxes of $250 on a $1,000 of investment income, they will get relief. $250 is close to what they would have paid had they earned $1,000 directly in Canada. Therefore, the CRA understands the business did not take advantage of lower foreign tax rates. Do you have foreign employment income? Want to reduce your taxes? See our resource: can I reduce my Canadian taxes for foreign taxes?

FAPI for Individuals

The application of Foreign Accrual Property Income is different if you're a Canadian individual. Read on to learn more.

In our next example, assume the same facts as the first example. However, now it is a Canadian individual owns 100% of an international corporation. For more information on how’s the CRA Assessing Position can reduce your FAPI, please visit McCarthy Tétrault: How the CRA’s New Assessing Position Can Reduce Your FAPI.

Relevant tax factor (ITA s.95 (1): 2.2

 

Amounts

US Rental Income  $1,000 
FAPI included in Canadian taxpayer’s tax return  $1,000 
Foreign taxes paid    $250 (A)
Relevant tax factor    2.2 (B)
Section 91(4) deduction for foreign taxes paid on the Canadian taxpayer’s tax return   $550 (A * B) 
 FAPI net of Section 91(4) deduction reported on the Canadian taxpayer’s tax return $450 

This example includes $450 of FAPI the individual’s personal tax return. Had the individual paid the approximate $454 (~45% tax), the taxpayer would have been eligible for a full deduction of $1,000. The CRA views 25% tax as too low, since Canadian personal tax rates are much higher. Are you receiving a foreign inheritance? Visit our resource: taxes on foreign estates.

I hope you can now see that Canada does give relief for any underlying foreign taxes paid on FAPI. However, this calculation can be complicated. I suggest you contact a tax professional if you feel that you or your business may be subject to the Foreign Accrual Property Income. In the next instalment, we’ll discuss the implication of declaring a dividend from a foreign corporation to Canadian corporation if the foreign corporation earns investment income. For more on the subject, please visit Foreign Accrual Property Income FAPI.

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.

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