Inclusion of FAPI in aggregate investment income ("AII") (p.1052)
[F]API, as income earned from a share, should be included in a CCPC's AII in the year earned… . [T]he general corporate income tax rate in British Columbia for 2015 is 26 percent while the corporate income tax rate applicable to AII is 45.7 percent. ...
Potential advantage of earning ordinary income as FAPI (p. 1054)
Consider a CCPC subject to tax in British Columbia ("BCco") that acquires a royalty interest. The royalty interest generates $100,000 of income in 2015. If the royalty interest is owned directly by BCco, the resulting income should be subject to the combined corporate tax rate for investment income of 45.7 percent.
...[I]f Forsub is established in a jurisdiction that levies an overall effective tax rate of 25 percent on the royalty income…[t]he FAPI inclusion to BCco should still be $100,000. But because Forsub pays $25,000 in foreign tax in respect of the royalty income, BCco should be entitled to an offsetting FAT deduction of $100,000 ($25,000 multiplied by the RTF of 4). As a result, BCco will have nil net FAPI and will not be subject to Canadian corporate tax on the royalty income despite paying only $25,000 in foreign taxes….
Likely disadvantage of generating services income as FAPI (pp. 1055-6)
[C]onsider a Canadian company ("Canco") that sells its product directly to consumers all around the world. Canco establishes a foreign wholly owned subsidiary ("Forco") in a local jurisdiction to provide brand support and technical services in respect of Canco's product sales to that country. Forco earns an arm's-length service fee from Canco for providing these services…. .
Had the income front services rendered been earned by a Canadian corporation, the entity's business income would have been subject to the general corporate tax rate (for example, 26 percent in British Columbia for 2015, ignoring the small business deduction). Instead, the FAPI earned by Forco potentially results in an income inclusion to Canco that is characterized as All [aggregate investment income]and taxed at higher rates…
Inefficiency of realization of capital gains by CFA of CCPC (p. 1062, 1064)
[T]he realization of capital gains at the CFA level...is rarely good news… .
[T]he foreign affiliate regime does not contemplate increases to the CCPC's capital dividend account (CDA). The taxable portion of a capital gain on the disposition of non-excluded property gives rise to FAPI. That amount is included in income of the Canadian-resident corporation, and to the extent that the CFA is subject to FAT in respect of the taxable capital gain, an offsetting FAT deduction is available. Where the Canadian-resident corporation is a CCPC that has a net inclusion to taxable income in respect of FAPI (that is, the FAT is less than one-quarter of the FAPI), that amount is AII, which is taxed accordingly at high rates and generates RDTOH. From the perspective of the CFA, that FAPI and the underlying foreign tax paid are respectively included in the CFA's taxable surplus and underlying foreign tax (UFT) balances. ...[T]he non-taxable portion of the capital gain......is included in the exempt surplus pool.
...Exempt surplus dividends...are inherently exempt from further Canadian tax. Because a deduction is available under section 113, the amount is added to a CCPC's GRIP. The CCPC does not receive an addition to its CDA where a CFA has disposed of capital property. In contrast to capital dividends paid from the CDA, eligible dividends paid from the CCPC's GRIP will be subject to further tax in the hands of the ultimate shareholder. The significant difference in the overall effective tax rate stems from this additional tax payable on the non-taxable portion of the capital gain at the individual shareholder level….
Disposition of CFA shares by CCPC (as contrasted to sale by CFA) (pp. 1065, 1067)
[A] Canadian-resident shareholder may have a Canadian holding company ("CCPC 1")…Often interests in foreign subsidiaries will be structured through a dedicated Canadian holding company ("CCPC 2")… .
[T]he overall flow-through tax result can be improved if a purchaser is willing to acquire the shares of the CFA | rather than the asset directly. The disposition of the shares in the CFA would be a taxable transaction. The capital gain to the vendor (CCPC 2) would be determined as the difference between the proceeds of disposition of the CFA shares and the adjusted cost base of the shares. One-half of the capital gain would be included in taxable income while the other half would be included in CCPC 2's CDA.
It should be noted that CCPC 2 could consider making an election under subsection 93(l) to treat the capital gain realized on the disposition as a dividend received from the CFA….While the upfront tax cost associated with the gain in the hands of CCPC 2 could be reduced by such an election, ...the ultimate flow-through rate of tax, once the proceeds on the sale are distributed to the ultimate shareholder, may actually be higher.
...[T]he higher rate is driven by the fact that when the proceeds are distributed to the shareholder, the entire amount of the dividend is subject to tax…
Disposition of CCPC 2 (holding CFA) by CCPC 1 (pp. 1067-8)
The disposition of shares of CCPC 2 should generally yield results similar to those... [immediately] above….
Similar to the subsection 93(1) election above, the safe-income dividend provides the opportunity to convert a taxable capital gain to a dividend that should not give rise to immediate tax….While the dividend would reduce the immediate tax cost of the capital gain, the intimate flow-through tax cost of distributing the proceeds from the sale to the shareholder would likely be higher….
Safe income of foreign affiliate (pp. 1069-1071)
Conceptually, the modified "tax-free surplus balance" definition in paragraph 55(5)(d) is the amount of tax-free surplus balance that could hypothetically be paid as a dividend by the foreign affiliate to the Canadian corporation free from Canadian tax, as if the shares of the foreign affiliate were directly owned by the Canadian corporation. [fn 50: Not including preacquisition surplus. The carve-out of regulation 5905(5.6) results in an effective "flattening" of a foreign affiliate structure for the purposes of the safe-income calculation, such that all foreign affiliates are treated as if they were direct subsidiaries of the relevant Canadian corporation.]...
The CRA has commented that it believes that
in general, in computing the safe income on hand attributable to the shares of the capital stock of a corporation, the losses of a subsidiary of the corporation must be taken into account when the loss results in a decrease in the FMV [fair market value] of the corporation's shares. [fn 54: ...2001-0093385.]
Nothing specific in the 2011 amendments to paragraph 55(5)(d) appears to directly address the exempt deficit issue in the computation of a foreign affiliate's safe income on hand.
...[S]ince safe income would generally be calculated in Canadian dollars, it is usually necessary to translate the tax-free surplus balance into Canadian dollars for the purposes of determining the amount of safe income in respect of a foreign affiliate. The CRA has stated that "[w]hen computing exempt or taxable surplus of a foreign affiliate at any particular time the exchange rate at that time should be used. [fn 57: ...9414365... .] In the context of foreign affiliate safe income, the CRA noted that the particular time would be the safe-income determination time.
[A] foreign affiliate's surplus balances are increased by the earnings of the foreign affiliate only at the end of the taxation year in which the earnings arise. [fn 60: The definition of "earnings" in regulation 5907(1) refers to the "earnings" of a foreign affiliate…for a taxation year."…] The CRA has provided administrative relief by indicating that this stub period income may be included in the calculation of safe income in respect of a foreign affiliate. [fn 61: ...9611945... .]
An election made under section 338(h)(10) of the US Internal Revenue Code by the purchaser and vendor in a share purchase permits the purchaser to treat the transaction as an asset purchase for US tax purposes, thereby achieving a step-up in US tax basis of the assets of the acquired corporation. The CRA has commented that tax depreciation in excess of amounts paid for assets would be added back in computing the safe income of a foreign affiliate in respect of which a Code section 338(h)(10) election has been made. [fn 63: ...2013-049914117... .]
Advantage of book depreciation election (p.1071)
[A]n election is available under regulation 5907(2.1) to use book depreciation rather than tax depreciation deducted under foreign tax law in computing income from an active business in respect of the foreign affiliate. Particularly in the case of jurisdictions where accelerated depreciation deductions are permitted, a foreign affiliate's ability to pay dividends from exempt surplus may be decreased as a result of this reduction in taxable income and thus earnings….
This is relevant for the determination of a foreign affiliate's tax-free surplus balance as well since the computation does not make adjustments for temporal differences, including depreciation….
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