As the last part of the three installments on ‘Foreign Accrual Property Income’, this article will focus on the Canadian taxation of dividends from foreign affiliates and controlled foreign affiliates that earns passive income. If you own a Canadian company that receives dividends from a US or foreign subsidiary then this article is for you.
First of all, Canada categorizes the retained earnings of the foreign corporation under the following:
- Exempt surplus
- Taxable surplus
- Hybrid surplus
For our purpose, we will only discuss the first two. Any portion of the foreign corporation’s retained earnings that was earned through active business (i.e. not passive investment) constitutes exempt surplus. Any portion of the retained earnings that was considered Foreign Accrual Property Income (net of foreign tax) constitutes taxable surplus.
Exempt Surplus (dividends paid by US subsidiary to Canadian parent)
Dividends paid out of the foreign affiliate’s exempt surplus are treated as a tax free dividend to the Canadian parent company. When this dividend is ultimately paid out to Canadian shareholders, the shareholders will qualify for the dividend tax credit system.
Dividends paid out of the foreign affiliate’s taxable surplus are fully taxable to the Canadian parent company. However, deductions are available under section 113(1) (b) & (c) of the Income Tax Act based on the amount of foreign taxes paid on income that adds to taxable surplus (i.e. investment income)
To illustrate the rule, let’s revisit our first example from Foreign Accrual Property Income – Part 2.
- 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 for corporation (ITA s.95(1)): 1 / (.38 – .13) = 4
- Withholding tax on dividend: 5%
- Section 113(1)(b) deduction = underlying foreign taxes paid * (relevant tax factor less one)
- Section 113(1)(c) deduction = withholding tax * relevant tax factor; up to the amount in which the dividend income exceed section 113(1)(b) deduction
|US Rental Income||$1,000 (A)|
|FAPI included in Canadian taxpayer’s tax return||$1,000|
|Foreign taxes paid||$250 (B)|
|Relevant tax factor||4 (C)|
|Section 91(4) deduction for foreign taxes paid on the Canadian taxpayer’s tax return||$1,000 (B * C)|
|FAPI net of Section 91(4) deduction reported on the Canadian taxpayer’s tax return||$0|
|Amount available for distribution after tax||$750 (A – B)|
|Dividend paid from foreign affiliate||$750|
|Section 113(1)(b) deduction for underlying foreign taxes paid: $250 * (4 – 1)||$750|
|Section 113(1)(c) deduction for withholding taxes paid: ($750 * 5%) * 4||$150*|
|Canadian income inclusion||$0|
* As section 113(1) (b) deduction was able to fully reduce the dividend income, section 113(1) (c) deduction was not utilized. If, for example, section 113(1) (b) deduction was only $700, then $50 of the $150 in section 113(1) (c) would have been utilized to fully reduce the dividend income.
In a more complex situation in which not all of the retained earnings are distributed in the form of a dividend in one year as illustrated in the example above, the following formula can be used to determine the applicable underlying foreign tax for the purpose of Section 113(1) (b) deduction:
(Amount of dividend attributable to taxable surplus)/(Total taxable surplus) x Underlying foreign tax balance
The CRA pools all of the foreign taxes paid on FAPI for all years and uses an ‘averaging’ method to determine the amount of foreign tax that is applicable to the dividend paid out of the foreign affiliate’s taxable surplus.
Rules surrounding foreign affiliates and FAPI are extremely complicated and as such, we highly recommend that anyone with foreign affiliates consult a tax professional to ensure that their tax affairs are in right order.
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.