Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Problem:
How should the Department treat the utilization of tax credits, to reduce foreign taxes, in the computation of FAT for the purposes of paragraph 95(1)(c)?
Position:
Tax credits are not considered to be taxes paid but are considered when utilized to first apply to taxes on the source of income to which they are attributable. For example employment tax credits and investment tax credits resulting from investments in assets to be used in an active business would first be considered to reduce taxes on active business income, while foreign tax credits would be considered to reduce taxes on foreign source income. Only when tax credits that could be considered applicable to active business income are utilized to reduce tax to an extent greater than that required to eliminate taxes on active business income would they be considered to reduce taxes on FAPI.
General tax credits not attributable to any source income would be considered to reduce tax on the various sources of income on a pro rata basis.
Comments:
- • The application of tax credits first to the tax on the source of income to which they apply fits within the scheme of the Act as it relates to FAPI. The Act taxes income differently based on its source and requires that taxes paid be allocated based on the source of income to which they are applicable.
- • Tax credits are not taxes paid, they just reduce taxes otherwise payable. In most cases Governments use tax credit systems to, in effect, not tax certain amounts of income (at least not at full rates) provided the taxpayer meets certain conditions such as investing in qualified assets or paying tax on the income to foreign countries. In order to qualify as FAT the Act requires that the tax be paid.
- • No hard and fast rules can be set for the computation of FAT. Each case stands on its own and the test is one of reasonableness versus unreasonableness.
- • A more detailed analysis is available in the position paper attached to this Decision Summary in the Policy Decision File.
- • Related Decision Summaries:
Foreign Accrual Tax (FAT) and Capital Gains
- Foreign Accrual Tax (FAT) and Consolidated Returns (prior to 1982)
Foreign Accrual Tax & Tax Credits
Problem: How should the Department treat the utilization of tax credits, to reduce foreign taxes, in the computation of foreign accrual tax (FAT) for the purposes of paragraph 95(1)(c)? Three alternatives are as follows:
Alternative 1
The effective rate of tax on a foreign affiliate's taxable income should be determined after the application of tax credits and that effective rate of tax applied to the FAPI to determine the FAT.
Alternative 2
Tax credits are considered taxes paid and their utilization would have no affect on the tax that was otherwise considered to be paid on the FAPI even if the foreign corporation paid no taxes to foreign government after the application of the tax credits.
Alternative 3
Tax credits are not considered to be taxes paid but are considered when utilized to first apply to taxes on the source of income to which they are attributable. For example employment tax credits and investment tax credits resulting from investments in assets to be used in an active business would first be considered to reduce taxes on active business income, while foreign tax credits would be considered to reduce taxes on foreign source income. Only when tax credits that could be considered applicable to active business income are utilized to reduce tax to an extent greater than that required to eliminate taxes on active business income would they be considered to reduce taxes on FAPI.
General tax credits not attributable to any source income would be considered to reduce tax on the various sources of income on a pro rata basis.
Consider the following examples.
Example I
Assume Canadian corporate tax rate is 50% on FAPI.
FA a foreign affiliate of Canco has the following tax position for 1980.
Taxable Income
Foreign Source Income (No FAP $16,000,000
Domestic Source Income
Active Business $9,000,000
Interest (FAPI) 1,000,000
Capital Gain 1,000,000
$11,000,000
$27,000,000
Taxes Payable by FA
Foreign Source Income (48%) $7,680,000
Foreign Credit 7,672,000
$8,000
Domestic Source Income
Active Business (48%) $4,320,000
Less: Investment
Tax Credit 2,900,000
1,520,000
Interest (48%) 480,000
Capital Gain 300,000
2,300,000
2,308,000
FA's effective rate of tax
- on Total Taxable Income 2,308,000 x 100 = 8.5%
---------
27,000,000
- on Domestic Source Incom 2,300,000 x 100 = 21%
---------
11,000,000
EXAMPLE 1
Alternative 1
In the extreme under Alternative 1, it could be argued that the effective rate of tax after the application of the foreign tax credit was 8.5% and therefore FA paid taxes at a rate of 8.5% on the interest and the capital gain. A more lenient approach under this alternative would be to recognize the effective rate of tax (21%) on domestic income as being the rate of tax on the interest income and the capital gain.
Results Alternative 1 Effective Rate of Tax
8.5% 21%
Taxes Paid by FA
Interest $ 85,000 $ 210,000
Capital Gain 85,000 210,000
$ 170,000 $ 420,000
FAT 2ith respect to Canco
Interest $ 85,000 $ 210,000
Capital Gain 85,000 210,000
$ 170,000 $ 420,000
Alternative 1 Effective Rate of Tax
FAPI of Canco 8.5% 21%
(Subsection 91(1))
Interest $1,000,000 $1,000,000
Taxable Capital Gain 500,000 500,000
1,500,000 1,500,000
Deduction for FAT
(Subsection 91(4))(2xFAT) 340,000 840,000
Net Inclusion in Canco's
Income $1,160,000 $ 660,000
Alternatives 2 & 3
In Example 1 Alternatives 2 and 3 produce the same results. Alternative 2 requires that tax credits be recognized as taxes paid and therefore in Example1 FA would be considered to have paid taxes at full rates on the interest and the capital gain. As Alternative 3 requires that tax credits be first applied to reduce tax on the source of income to which they relate and in Example 1, since such tax credits do not eliminate the tax on FA's foreign income and domestic active business income, the source of income to which they relate, FA would be considered to have paid taxes at full rates on the interest and capital gain.
Results Alternative 2 & 3
Taxes paid by FA
Interest $ 480,000
Capital Gain 300,000
$ 780,000
FAT with respect to Canco
Interest $ 480,000
Taxable Capital Gain (equals
amount required to eliminate
Canadian tax on the capital gain) 250,000
$ 730,000
FAPI to Canco (Subsection 91(1))
Interest $l,000,000
Capital Gain 500,000
$1,500,000
Deduction for FAT
(Subsection 91(4)(2xFAT)) 1,460,000
Net Inclusion in Canco's Income $ 40,000
2. The same as example 1 except the investment tax credit is sufficient to eliminate all taxes payable and is so utilized.
EXAMPLE 2
Alternative 1 & 3
In Example 2 Alternatives 1 and 3 provide for the same result.
As no taxes are paid the effective rate of tax is 0% and no foreign tax is considered to have been paid on either the interest or the capital gain under Alternative 1. Under Alternative 3 tax credits are not considered as taxes paid therefore no foreign tax is considered to be paid on the interest or the capital gain. Under both Alternatives, Canco has to include FAPI of $1,500,000 in income pursuant to subsection 91(1) and there is no deduction from that income pursuant to the provisions of subsection 91(4).
Alternative 2
In Alternative 2 tax credits are considered as taxes paid when they are utilized. The result under Alternative 2 in Example 2 is the same as the result under Alternative 2 & 3 in Example 1, as illustrated above and the net inclusion in Canadian income would be $40,000.
Comments
A. The foreign affiliate rules require that income be broken down into its various sources and that taxes paid on those sources of income be applied against the applicable source. Therefore, it is reasonable that tax credits first apply to taxes on income of the source to which they are attributable. In Example 1, even if it is reasonable to say that the interest and capital gain had not been taxed at full rates and were only taxed at the effective rate, the position (as long as it is also reasonable) that is more favourable to the taxpayer will prevail.
B. Tax credits are not taxes paid, they just reduce taxes otherwise payable. In most cases Governments use tax credit systems to in effect not tax certain amounts of income (at least not at full rates) provided the taxpayer meets certain conditions such as investing in qualified assets or paying tax on the income to foreign countries. In order to qualify as FAT the Act requires that the tax be paid.
C. The recognition of tax credits as taxes paid for the purposes of the foreign affiliate rules could encourage some countries to levy taxes and simply have them offset by tax credits. This is not too remote possibility. We have subsection 126(4) in the Act to exclude from income and profits tax paid by a person resident in Canada to the government of another country, taxes or the portion of taxes paid to that country that would not be imposed if the person were not entitled to a deduction under section 126 or section 113 in respect thereof. (Editorial Comment CCH at 19730 page 13 022 "The apparent purpose of subsection 126(4) is to discourage so called "tax haven" countries from imposing a tax on Canadian residents in order to allow them to obtain a Canadian foreign tax credit and then perhaps re funding the tax.")
Conclusion
Alternative 3 is the recommended method of recognizing tax credits in the computation of foreign accrual tax for the following reasons:
- (a) The application of tax credits first to the tax on the source of income to which they apply fits in with the scheme of the Act as it relates to FAPI.
- (b) Tax credits are not recognized as taxes paid for the purposes of the foreign affiliate rules.
Foreign Accrual Tax (FAT) & Capital Gain
What amount of tax paid by a foreign affiliate (foreign taxes) on a capital gain can be considered to be reasonably applicable to FAPI when the full capital gain is taxed at special rates or included in full in income and taxed at regular rates?
The Law
Paragraph 95(1)(c) Foreign Accrual Tax
Subsection 91(1 Inclusion of FAPI in Income
Subsection 91(4) Deduction from Income of foreign taxes paid
that are reasonably considered applicable
to the amounts included in income under
subsection 91(1)
Subparagraph 5907(1)(b)(i) Exempt Earnings
of the Regulations
Subparagraph 5907(1)(f)(ii) Net Earnings
of the Regulations
Clause 5907(1)(i)(ii)(B) Taxable Earnings
of the Regulations
Paragraph 5907(1)(l) Underlying Foreign Tax
of the Regulations
Summary of the Purpose of the Law and How it Works
When a person controls a foreign corporation (foreign affiliate) and that foreign affiliate has passive income or certain capital gains subsection 91(1) operates to tax that income an the accrual basis as if the income was earned directly rather than through the corporation. Paragraph 95(1)(c) and subsection 91(4) provide a deduction with respect to foreign taxes paid that may reasonably be regarded as applicable to amounts included in income under subsection 91(1). The result is that there will be no Canadian tax if the foreign taxes on the FAPI are at least 46% (the basic Canadian corporate tax rate). Thus, as with the foreign tax credit deductions as set out in Section 126, there is no double taxation as the result of taxes levied in both Canada and the foreign country and the FAPI rules are in harmony with the Income Tax Conventions that Canada has with other countries for the avoidance of such double taxation.
There is also a provision that prevents the FAPI from being taxed in Canada again when it is received in the form of a dividend.
The Problem
FAPI is determined under Canadian Income Tax rules and includes taxable capital gains which only represent one half of the capital gain. One half of the capital gain less applicable foreign taxes goes into exempt earnings (subparagraph 5907(1)(b)(i) of the Regulations) and one half less applicable foreign taxes goes into taxable earnings (subparagraph 5907(1)(f)(ii) and clause 5907(1)(i)(ii)(B) of the Regulations). When the full gain is taxed in the foreign country it is not clear how much of the foreign tax should be allocated to the taxable capital gain which is FAPI and therefore, what portion of the foreign tax is deducted from exempt earnings and what portion is deducted from taxable earnings.
As exempt earnings become exempt surplus and taxable earnings become taxable surplus the balance of this report will refer to exempt surplus and taxable surplus.
There are three alternatives
- 1. One half of the foreign tax paid is allocated to the FAPI. One half is deducted from exempt surplus and one half is deducted from taxable surplus.
- 2. In all cases the full amount of the foreign tax paid is allocated to the FAPI and the full amount of this tax is deducted from taxable surplus.
- 3. Foreign tax paid is considered applicable to FAPI and deducted from taxable surplus up to the extent that such foreign tax is required to eliminate Canadian income tax on the gain and any excess foreign tax paid is deducted from exempt surplus.
Consider the following
- • Canco has wholly-owned subsidiary, FA1, in the U.S.
- • FA1 has a capital gain of $100 and the full capital gain is taxed at a special rate of 30%.
- • Before realizing the capital gain, FA1 had $100 in taxable surplus with respect to Canco and FA1 had no underlying foreign tax with respect to that taxable surplus and no exempt surplus with respect to Canco.
- • Assume the basic Canadian Corporate tax rate is 50%.
Allocation of Foreign Tax Paid
Results Alternative
1 2 3
One half All to To FAPI
To FAPI FAPI to extent
required
(1) Capital Gain $100 $100 $100
(2) Foreign Tax $ 30 $ 30 $ 30
(3) Net gain available for
distribution to Canada $ 70 $ 70 $ 70
(Item (1) - Item (2))
(4) FAPI 91(1) (one half Item $ 50 $ 30 XXX
(1))
(5) FAT 95(1)(c) $ 15 $ 30 XXX
(6) Deduction from Income 91(4)
(Lesser of 2 times Item (5)
and Item (4)) $ 30 $ 50 $ 50
(7) Net Income Inclusion in
Canada (Item (4) - Item (6))$ 20 - -
(8) Canadian Tax on FAPI
(50% Item (7)) $ 10 - -
(9) Total Tax on Gain
domestic plus Foreign
(Item (2)+Item (8)) $ 40 $ 30 $ 30
(10)Tax if gain had been
Domestic $ 25 $ 25 $ 25
Adjustment to Exempt Surplus
(11)1/2 of the gain $ 50 $ 50 $ 50
(12)Foreign taxes applicable 15 - 5
(13)Net adjustment $ 35 $ 50 $ 45
(14)Exempt Surplus After
Adjustment $ 35 $ 50 $ 45
Adjustment to Taxable Surplus
(15)1/2 of the gain $ 50 $ 50 $ 50
(16)Foreign taxes applicable 15 30 25
(17)Net adjustment $35 $ 20 $ 25
(18)Taxable Surplus After
Adjustment (Includes
opening balance of $100) $135 $120 $125
(19)Increase in Underlying
Foreign Tax (also new
balance) $ 15 $ 30 $ 25
Amount available as a Tax-free
dividend to Canada because
of the gain
(20)From exempt surplus (Item
(14)) $ 35 $ 50 $ 45
(21)From taxable surplus
(Deduction) equal to Item
(19)) 15 30 25
(22)Deduction under 91(5) (also
from taxable surplus) 20 - -
(23) $ 70 $ 80 $ 70
Balances after tax-free dividend
(24)Exempt Surplus (Item
(14)Item (20)) - - -
(25)Taxable Surplus $ 100 $ 90 $100
(Item(18) - Item(21)+Item
(22))
(26)Underlying Foreign Tax
(Item(19) - Item(21)) - - -
Comments
A. Alternative 1, except that the rate of overall taxation is not reasonable, is a logical approach and makes some sense in relation to the various provisions of the law. It could be argued in favor of Alternative 1 that as only 1/2 the gain is included in FAPI only 1/2 of the tax applies and the other 1/2 of the tax was on income exempt from tax in Canada. Therefore the FAPI should attract additional Canadian tax so that the total tax on the FAPI equals 50%, the basic Canadian Corporate tax rate. However, in the example, Alternative 1 results in Canadian income tax on a source of income, the capital gain that is already taxed in the foreign country at rate (30%) of tax higher than the Canadian effective rate (25%) of tax on that income. In fact, the combined rate of tax on that source of income is 40%. This appears to be in conflict with spirit of the law which is to tax FAPI in Canada only to the extent that foreign tax is lower than the tax in Canada would be on that income.
B. There does not appear to be any basis to accept Alternative 2. The amount deductible under subsection 91(4) is limited to amount of the FAPI. There is no need to ensure that exempt surplus increases by an amount that is at least equal to of the capital gain, to ensure such an amount can be passed to Canada tax-free. In the example given it is logical that $70 (the net after tax) can come back to Canada tax-free. This is possible because, where there is underlying foreign tax, even the portion credited to taxable surplus can be repatriated tax-free. As shown above if Alternative 2 was accepted and there was taxable surplus, before the gain was realized, for which there was no underlying foreign tax, some of that surplus would be made available for a tax-free dividend as well as additional exempt surplus. The result in the example should be a $70 tax-free dividend not an $80 tax-free dividend. Assume the rate of tax on the gain in the above example was 50% of the gain in the above example. Followinng Alternative 2 a tax-free dividend of $100 could be paid ($50 out of exempt surplus and $50 out of taxable surplus) because there would be $50 in underlying foreign tax available to be used to free up $50 of the opening taxable surplus. The increase in surplus because of the capital gain was only $50. Based on the results Alternative 2 does not appear reasonable.
C. Alternative 3 results in no Canadian tax if the foreign tax on a source of income is equal to the Canadian tax. This appears to be within the spirit of the law, including the various Income Tax Conventions with foreign countries. Saving accepted that, the adjustments to exempt surplus and taxable surplus fall into place as set out in the above example and the appropriate amount of the gain (the net after foreign tax) $70 can be distributed to Canada tax-free with $45 coming from exempt surplus and $25 from taxable surplus. In addition, if the capital gain in the example was assessed at a rate of 50% in U.S., following Alternative 3 as a result of the gain a $50 (the net gain after foreign tax) tax-free dividend could be received by Canco with $25 coming exempt surplus and $25 coming from taxable surplus for which there would be $25 in underlying foreign taxes.
D. If in the example Canco had realized the capital gain directly rather than through a foreign affiliate the foreign tax credit as provided by section 126 would eliminate the Canadian tax of $25 on the gain and the $5 excess foreign tax is just lost with no carry forward. Canco would have $70 left from the gain after paying the foreign tax, the same amount Canco can receive tax-free under Alternative 3. Alternative I would result in $60 net after $10 in Canadian tax. Alternative 2 could result in a $80 tax-free dividend with $10, which should be taxed in Canada, effectively coming out of the opening taxable surplus. (Note: The taxpayer could deduct the $5 excess foreign tax mentioned above under the provisions of subsection 20(12) but this in effect creates a loss with respect to foreign non-business income because of foreign taxes paid. This was not the intent of subsection 20(12) and Current Amendments Division and the Department of Finance are considering an amendment to correct this situation.)
Conclusion
Where the foreign tax paid on the capital gain is greater than the Canadian tax would be on that gain Alternative 2 appears to be unreasonable and the real choice is between Alternative 1 and 3. However, Alternative 1 may be considered unreasonable if you consider that a source of income (capital gain) is taxed in the aggregate at a higher rate (40%) than it would be if the capital gain was realized in Canada (25%).
Alternative 3 is the recommended choice and it is felt that the resulting allocation of the foreign tax paid to exempt and taxable surplus and underlying foreign tax is reasonable. (Where foreign tax paid is less than the Canadian tax would be, Alternative 2 and 3 give the same result.).
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