FAPI earned by foreign sub of a CCPC will be double-counted under the s. 125(5.1)(b) passive-income grind

The reduction of the US federal corporate tax rate from 35% to 21% (assuming no substantial state income tax) may now necessitate a determination of whether central management and control of an FA is exercised in Canada. If a US-incorporated foreign affiliate nonetheless is centrally managed and controlled in Canada, its net earnings from an active business will be added to its taxable surplus rather than its exempt surplus. On a full distribution of the FA's after-tax earnings of $79 out of taxable surplus, Canco would be required to use the deductions under both ss. 113(1)(b) and (c) to shelter the dividend inclusion and, even so, there would be $20 of unsheltered income that was recognized by Canco.

Where active business income earned by a controlled foreign affiliate that is an LLC in Year 1 is distributed to its member in a subsequent year, this results in an effective tax rate (in the case of a B.C. resident) of 66.87%. This high effective tax rate results from the member being entitled to a deduction only under s. 20(12) respecting the US tax. If there is no timing mismatch, then the ETR improves to 57.67%.

Where there is a Canadian-controlled private corporation, the optimal structure for the earning of aggregate investment income entails the AII being earned by a C corp. that is a CFA of the CCPC. The all-in ETR is 50.75%, which compares favourably to the ETR for AII earned by a CCPC directly of 54.99%.

S. 125(5.1)(b) provides an additional restriction on the business limit of a CCPC based on the passive income (a.k.a., AAII) of it and associated corporations. A CFA usually will be associated with the CCPC, in which case, the AAII of the CFA will be taken into account for these purposes. However, such income, by virtue of being foreign accrual property income, also will be AAII of the CCPC itself (without any “FAT” deduction under s. 91(4).)

Therefore, FAPI earned by a CFA that is associated with the Canadian corporate taxpayer may be counted twice toward the new passive income restriction.

Neal Armstrong. Summaries of Tim Barrett and Kevin Duxbury, “Corporate Integration: Outbound Structuring in the United States After Tax Reform,” 2018 Conference Report (Canadian Tax Foundation), 18:1-76 under s. 113(1)(c), s. 20(11), s. 20(12), Reg. 5907(1) – net earnings, s. 91(4), s. 91(5), s. 129(1), s. 120.4(1) – split income – (a)(i), s. 129(4) – NERDTOH, s. 125(5.1)(b).