Canadian Taxation: International Tax Rules Related To Ownership Of Foreign Corporations
by George Gonzalez
Many Canadian investors create foreign corporations as part of their asset ownership structure. This may be done for various non-tax reasons. Among these are:
- Estate planning: facilitating the transferring of wealth to beneficiaries.
- Probate planning: titling assets in the name of a corporation to avoid local probate on those assets.
- Asset protection: titling ownership of assets in the name of a foreign corporation to protect against potential litigation.
The above are just some of the non-tax reasons for establishing a foreign corporation. In terms of tax planning, generally there are few, if any, tax reasons for a Canadian resident to create a foreign corporation as part of an asset ownership structure. Canadian international tax rules have several provisions related to foreign corporations that make it difficult or prevent altogether the minimization of Canadian income taxation on income earned by a foreign corporation owned by a Canadian resident.
For a Canadian non-resident, on the other hand, the use of a foreign corporation, as compared to a Canadian corporation, would generally be desirable for minimizing Canadian income tax. The income of a non-resident owned corporation resident in Canada is subject to worldwide Canadian taxation, while the income of a non-resident owned corporation that is not resident in Canada avoids Canadian taxation. Thus, from a tax perspective, it makes complete sense for a Canadian non-resident to use a foreign corporation, rather than a Canadian corporation, as part of their asset ownership structure for investing outside of Canada.
This article focuses on the international tax rules that apply to foreign corporations owned by Canadian residents. Being aware of these rules is important prior to setting up an asset structure that includes a foreign corporation, to avoid unpleasant surprises.
The discussion that follows is divided into the following sections:
- rules related to how the definition of corporate residency may result in a foreign corporation being deemed to be resident in Canada, and therefore subject to Canadian taxation on its worldwide income;
- reporting requirements for Canadian residents with ownership in a foreign corporation that falls under the definition of “foreign affiliate”;
- income taxation rules (the Foreign Accrual Property Income, or FAPI, rules) for Canadian residents with ownership in a foreign corporation that falls under the definition of “controlled foreign affiliate”.
A Foreign Corporation May Be Deemed To Be Resident By Canada
Under Canadian tax law, a corporation can be resident in Canada without being a Canadian corporation. This is the result when the “central management and control” of the corporation resides in Canada. The key details are explained in the following excerpt from the Government of Canada’s web site:
“… the true rule in determining the residence of a company for purposes of income tax is “where the company’s real business is carried on.” In the opinion of the courts, “the real business is carried on where the central management and control abides… This is a pure question of fact to be determined, not according to the construction of this or that regulation or by-law, but upon a scrutiny of the course of business and trading.”
“Usually central management and control abides where the members of the board of directors meet and hold their meetings. Relevant to the residence of a company is not where central management and control is exercised according to the articles of incorporation, but where it is actually exercised. It may well happen that actual control is exercised by directors resident in one country, while directors resident in another country who ought to have exercised control stood aside from their directorial duties.”
In practical terms, the above states that a foreign corporation that is controlled and managed by directors/shareholders who reside in Canada is deemed to be resident in Canada. This, in turn, means that the foreign corporation will be subject to Canadian taxation on its worldwide income, as if it were a Canadian corporation.
This is critically important for a Canadian investor to bear in mind. Not infrequently in my conversations with Canadian resident investors who invest in overseas markets they tell me about their plans to set up a foreign corporation with the intention of avoiding Canadian income taxes on the income earned by the corporation. They are not aware of the above definition of corporate residency under Canadian tax law, and are surprised to learn that their foreign corporation will be deemed resident for Canadian taxation purposes.
The establishment of a foreign corporation by a Canadian resident for investment purposes can be based on legitimate and worthwhile non-tax reasons, such as estate planning and asset protection. For tax planning purposes, however, the use of a foreign corporation as an income conduit offers few, if any, opportunities to minimize taxes.
Foreign Affiliate Reporting Rules
Under Canadian tax law a foreign affiliate is a foreign corporation that is not resident in Canada and has at least 10% of its shares owned by a Canadian resident. A Canadian resident who has ownership in such a foreign affiliate must file an annual report with the Canada Revenue Agency (CRA) on Form T1134 (Information Return Relating to Controlled and Non-Controlled Foreign Affiliates). The form is filed by including it with the individual’s annual income tax return.
Note that Form T1134 is independent of another information report with which most Canadian investors are familiar: Form T1135 (Foreign Income Verification Statement). Form T1135 is an annual reporting form that must be filed if the Canadian resident’s total cost of all “specified foreign property” exceeded C$100,000 at any time during the year. Shares in a foreign corporation are considered “specified foreign property” unless they are shares in a foreign affiliate. Foreign affiliate shares do not fall under the Form T1135 reporting rules, as these shares are reportable separately in Form T1134, as previously mentioned.
The penalties for failing to file Form T1134, or any other required international reports, can be quite severe. Hence, it is critical that you are aware of the CRA’s international reporting requirements and comply with them. The Table of Penalties web page on the CRA’s site sets forth the penalties for failing to comply with the Form T1134 and other international reporting requirements.
Foreign Accrual Property Income (FAPI) Rules
A foreign corporation that is not resident in Canada and whose shares are owned more than 50% by a Canadian resident, whether directly or indirectly, is designated a “controlled foreign affiliate” of the shareholder. The main significance of this is that the Canadian shareholder of such foreign corporation is subject to the Foreign Accrual Property Income (FAPI) rules. These rules state that a shareholder of a controlled foreign affiliate must include a proportionate share of the foreign corporation’s passive income in their own individual income tax return.
The FAPI rules apply to passive income only; they do not apply to active business income. Passive income is income that is earned passively, i.e., without much effort after the initial investment. Passive income includes income such as interest, dividends, capital gains, and passive rental income. This contrasts with active business income, which is earned through ongoing effort contributed to the corporation’s operations.
To demonstrate how the FAPI rules work, let us take an example. Assume that a corporation is created in the British Virgin Islands (BVI) with three shareholders, whom we’ll refer to as shareholders A, B and C. The main facts are:
- Shareholder A is a Canadian resident who owns 60% of the shares;
- Shareholder B is an unrelated Canadian resident who owns 30% of the shares;
- Shareholder C is a resident of BVI who owns 10% of the shares;
- Shareholder C, in addition to owning shares in the BVI corporation, is also one of the directors of the corporation, along with other directors who are all also BVI residents. These directors control and manage the BVI corporation;
- The corporation engages in passive income investments only. It earned passive income of C$100,000 for the taxation year.
The following stem from the above set of facts:
- The BVI corporation is controlled and managed in the BVI; hence it is considered to be resident in the BVI, not in Canada.
- Shareholder A owns 60% of the shares of the BVI corporation:
- Since shareholder A owns at least 10% of the BVI corporation, this shareholder is subject to the Form T1134 reporting requirements.
- Since shareholder A owns more than 50% of the BVI corporation, the corporation is considered a controlled foreign affiliate of A for Canadian tax purposes, and therefore shareholder A is subject to the FAPI rules.
- Shareholder B owns 30% of the shares of the BVI corporation:
- Since shareholder B owns at least 10% of the BVI corporation, the corporation is considered a foreign affiliate of B for Canadian tax purposes, and therefore shareholder B is subject to the Form T1134 reporting requirements.
- Since shareholder B does not own more than 50% of the BVI corporation, the corporation is not a controlled foreign affiliate with respect to shareholder B.
- Shareholder C is a non-resident of Canada and would therefore not be subject to any Canadian reporting or income taxation rules like those that apply to shareholders A and B.
Application of Foreign Affiliate Reporting Rules: Both shareholder A and shareholder B own at least 10% of the BVI corporation, and therefore the corporation is a foreign affiliate to both A and B. Both shareholders would be required to complete Form T1134 and include it with their annual individual income tax return filed with the CRA.
Application of the FAPI Rules: The corporation is a controlled foreign affiliate with respect to shareholder A, but not shareholder B. Therefore, the FAPI rules apply to shareholder A only. Under the FAPI rules, shareholder A would be required to include their proportion of the corporation’s passive income in their own individual income tax return. That proportion would be C$100,000 x 60% = C$60,000.
If the BVI corporation paid foreign income tax on its C$100,000 of passive income, shareholder A would be entitled to claim a foreign tax credit in their Canadian income tax return. The calculation of this foreign tax credit has nuances that are beyond the scope of this article and will not be discussed here.
Canadian investors commonly create foreign corporations for their asset ownership structure. There are many legitimate non-tax reasons for doing this. In terms of taxation, however, a foreign corporation offers few, if any, tax benefits.
For a Canadian investor who establishes a foreign corporation for their asset ownership structure, it is important to be aware of the international tax rules that impact them. This article has discussed three of these:
- A foreign corporation that is centrally managed and controlled out of Canada by directors/shareholders is deemed to be resident in Canada, and accordingly subject to Canadian taxation on its worldwide income;
- Canadian international reporting rules require the annual filing of Form T1134 by Canadian residents who have ownership in a foreign affiliate (A foreign affiliate is a foreign corporation in which the Canadian resident shareholder owns at least 10% of the corporation);
- Canadian international taxation rules include the Foreign Accrual Property Income (FAPI) rules, which require Canadian residents with ownership in a controlled foreign affiliate to include their proportionate share of the corporation’s passive income in their own individual income tax return. (A controlled foreign affiliate is a foreign corporation in which the Canadian resident shareholder owns more than 50% of the corporation.)
For those Canadian residents who create a foreign corporation as part of their asset ownership structure, ideally it would be best to become aware of the international tax rules before creating the foreign corporation. Nonetheless, even if such awareness and related planning is not done before creating the foreign corporation, it is important to ensure compliance with these international tax rules, and avoid the potential severe penalties that could result from noncompliance.
2 From T1134 (Information Return Relating to Controlled and Non-Controlled Foreign Affiliates) https://www.canada.ca/en/revenue-agency/services/forms-publications/forms/t1134.html.
3 Form T1135 (Foreign Income Verification Statement) https://www.canada.ca/en/revenue-agency/services/forms-publications/forms/t1135.html.
5 The foreign corporation itself, since it is not resident in Canada, will not be subject to Canadian taxation.
6 The same applies for the creation of foreign trusts, which have their own set of reporting and taxation rules under Canadian law.