CANADA Law and Practice Contributed by: Marc-André Godard, Pierre Allard, Isabelle Gagnon and Mehrez Houacine, BCF Business Law LLP
Taxable Surplus Treatment Taxable surplus generally captures “net earnings” from an active business carried on by the FA in a country with which Canada does not have a tax treaty and in respect of its foreign accrual property income (FAPI – see 6.5 Taxation of Income of Non-Local Subsidiaries Under Controlled Foreign Corporation-Type Rules). Dividends paid out of this surplus account are gener - ally included in the Canadian corporation’s income, though relief may be available in respect of underly - ing foreign taxes and amounts previously subject to Canadian tax. Pre-Acquisition Surplus Treatment Finally, a dividend may be paid from a pre-acquisition surplus. Such dividend is deductible in computing the Canadian corporation’s income but reduces the adjusted cost base of the shares in the FA. To the extent that the adjusted cost base of the shares is reduced below nil, a taxable gain will arise. 6.4 Taxation of Intangibles Developed by Local Corporations Non-Canadian subsidiaries can use intangibles devel - oped by Canadian corporations. However, the Cana - dian corporation that owns and markets the intellec - tual property must charge an arm’s length price to the related entity for the use of the intangible under the transfer pricing rules. The income earned from this agreement with the foreign subsidiary, such as royal - ties from a licensing agreement, is taxable in Canada for the Canadian parent. 6.5 Controlled Foreign Corporation-Type Rules Canadian corporations are taxed on the FAPI of an FA controlled by the Canadian taxpayer (controlled for - eign affiliate – CFA) in the proportion of ownership in the CFA. FAPI is essentially passive income earned by the CFA, notably property income and certain capital gains realised on assets not used in an “active busi - ness”, but the FAPI rules include numerous statutory inclusions and exceptions. In brief, if a Canadian cor - poration controls 80% of the CFA, 80% of the FAPI earned in the CFA at the end of each taxation year will have to be reported in the controlling Canadian corpo - ration’s tax return. It is taxed on an accrual basis (ie, even where this income is not repatriated to Canada).
If the CFA is taxed in the foreign jurisdiction, the Canadian parent is allowed a deduction, based on the foreign accrual tax multiplied by the relevant tax factor in order to avoid double taxation. The relevant tax factor varies depending on the corporate struc - ture of the Canadian parent. For general corporations, the relevant tax factor is 4, resulting in no net FAPI income where the foreign accrual tax is 25% or higher. Under proposed legislation, (Budget 2022 reprised in Budget 2025; applicable to taxation years that begin after 6 April 2022), the relevant tax factor for CCPCs would be 1.9, resulting in no net FAPI income only where the foreign accrual tax is 52.6% or higher (a tax rate similar to that applicable to Canadian indi - viduals). Mechanisms are also proposed to mitigate additional Canadian taxation on the repatriation and subsequent distribution of such highly taxed income to shareholders. By contrast, all income of foreign branches of a Canadian corporation is included in the corporation’s income for Canadian tax purposes, since the Cana - dian resident taxpayer is subject to tax on its world - wide income, which is subject to foreign tax credits to which it may be entitled. 6.6 The Substance of Non-Local Affiliates Canadian domestic legislation does not directly require substance in foreign subsidiaries. However, an FA may only earn “exempt surplus” to the extent it is resident in the treaty country, with residence for Canadian tax purposes, determined by where its central management and control is exercised. Cer - tain exceptions to FAPI are also available in limited circumstances, where the CFA employs more than five full-time employees and other conditions are met. 6.7 The Sale of Shares in Non-Local Affiliates A Canadian-resident corporation is taxable in Canada on its worldwide sources of income, including capital gains from the sale of FAs. Half of the gain is included in the taxpayer’s net income in Canada (as described in detail under 2.7 Capital Gains ). A deduction may be claimed with respect to available surplus pools. Where the capital gain is also subject to tax in the foreign jurisdiction in which the FA is resident, applicable tax treaties may limit or allocate taxing rights between Canada and that jurisdiction.
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