2 June 1985 Income Tax Severed Letter RRRR104 - Foreign Accrual Tax (FAT)

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.

The purpose of this memorandum is to advise you that we have recommended our position with respect to the computation of FAT in the case of XXX which you referred to us and to clarify our present position.

The three issues which you raised are as follows:

A. Prior to 1981 in a consolidated group in the U.S. can a payment by one company to another company for the utilization of a loss be considered FAT in any circumstances?

B. When capital gains are included in full in income and taxed at full rates or special rates what portion of the taxes paid qualifies as FAT?

C. What bearing do tax credits have on the computation of FAT?

The following sections of this memorandum will deal with our position on these issues.

A. Utilization of Losses in a Consolidated Group in the U.S. Prior to 1981

XXX

B. FAT and Capital Gains

The principle behind the foreign affiliate rules and the taxation of FAPI in Canada is that FAPI will be taxed in Canada to the extent that the income taxes on the FAPI in the foreign country are less than the Canadian taxes would be if the FAPI was earned in Canada. While only one half of the capital gain of foreign affiliates is included in FAPI, we have taken the position that where the foreign country has taxed the full gain, the foreign taxes paid on such capital gain should be recognized as FAT up to the extent required to eliminate the FAPI and Canadian tax applicable to that capital gain. The balance of any foreign taxes would be considered to apply to the non-taxable half of the gain and be deducted from exempt surplus. This means that where foreign taxes paid on capital gain are equal to or greater than 23% (the effective rate of corporate tax on a capital gain in Canada) of the full gain there would be no FAPI or tax in Canada with respect to that gain. This is not only reasonable, it is within the spirit of the law and the Income Tax Conventions which Canada has with various countries.

(Note: If the foreign taxes were considered to be applicable on a pro rata basis to the taxable and the non-taxable portion of the gain, in any case where the taxes in the foreign jurisdiction were less than 46% there would be FAPI income taxed in Canada and the aggregate rate of tax, domestic and foreign, would be in excess of what the Canadian tax would have been if the gain was realized in Canada. (e.g. a 30% tax rate in the foreign jurisdiction would result in the gain being taxed in Canada at approximately 10% for an overall rate of tax on the gain of approximately 40%).)

Schedule B attached illustrates the results of this position.

C. FAT and the Application of Tax Credits

The foreign affiliate rules require that a foreign affiliate's income be broken down by source to determine how it should be taxed and requires that the foreign taxes paid be allocated to the sources of income to which they apply. While tax credits are not considered as taxes paid, they should first be considered to apply to the taxes on income to which they relate. For example employment tax credits and investment tax credits for investing in assets to be used in an active business should first be considered to apply to reduce taxes on active business income and only considered to reduce taxes on FAPI to the extent they are used to do so after taxes on active business income are eliminated. It follows that in a situation where tax credits eliminate all taxes in a taxation year (unless the taxation year is after 1981 and there is an intercompany payment that qualifies pursuant to the provisions of paragraph 5907(1.3)(a) of the proposed Regulations) there can be FAT for that taxation year. (Note: A general tax credit not related to any source of income would be considered to reduce taxes paid on the various sources of income on a pro rata basis).

Schedule C attached illustrates the results of this position.

We trust that the above comments clarify our position. In addition we would like to point out that where the word "reasonable" is used in a particular provision of the Act and a taxpayer takes a position with respect to that particular provision, we have to accept that position unless we can establish that it is an unreasonable position. In the case of FAT in particular we cannot make any hard and fast rules or follow any rigid formula to determine the amount which should be considered to be FAT. Each case will have to be decided on its own merits.

Schedule A
FAT and the Utilization of Losses in a Consolidated Group
                              Year 1              Year 2
FA1 Active Business Income    $500                ($300)
FA2 FAPI                      $100                 $100
Consolidated Income           $600                ($200)
Taxable Income after loss
   is carried back            $400                   -
Taxes paid by group after
   the loss is carried back
   (assuming a foreign tax
   rate of 50% on all income) $200                   -
FAT (FA2 pays FA $50 in year 1
   & year 2)                  $ 50                 $ 50

Schedule B

FAT and Capital Gains

• • FA1 has a capital gain of $100 which is taxed at a rate of 30%. This gain results in FAPI to Canco of $50. The Canadian rate of tax is 46%.
• • FAT in this case would be $23, the amount required to eliminate the FAPI and there would be no tax paid in Canada with respect to the gain. As all the amount of FAT has been utilized, there is no FAT to be carried forward as a result of the gain.
• • The effect on the surplus pots is as follows:
  

  Exempt Surplus      Taxable Surplus
  1/2 of gain                        $50                 $50
  Less:  Applicable portion of
     foreign taxes paid                7                  23
  Net increase                       $43                 $27

• • The underlying foreign tax would be $23 and a tax free dividend of $70 could be paid to Canada with $43 coming from exempt surplus and $27 (offset by $23 underlying foreign tax) coming from taxable surplus.
• • Note:
• The relevant tax factor is 2.174. For the purposes of the deduction under subsection 94(1), 2.174 times $23 is $50 and for the purposes of the deduction under paragraph 113(1)(b), 1.174 times $23 is $27.

Schedule C

FAT and Tax Credits

Year 1         Year 2
FA1
     Active business income             $100           $100
     Investment income (FAPI)           $100           $100
     Total income                       $200           $200
     Tax at 50% on all income           $100           $100
Less:
     Investment tax credit related
     to active business income          $ 50           $100
     Taxes paid assuming tax credits
     are fully utilized                 $ 50            NIL
     FAT                                $ 50            NIL