FAPI inclusion if US tax rate on FAPI is only 21% - but potential s. 113(1)(c) deduction against other income on distribution (p. 18:11)
[T]he pre-TCJA 35 percent US federal corporation tax rate enabled many Canadian taxpayers to overlook whether an FA earned FAPI. …
[A]ssume that a CFA (CFA 1) of a CCPC earned $100 in year 1 of the CCPC. … [T]he income inclusion would be completely offset by a deduction under subsection 91(4) because CFA 1 paid FAT of $35. For year 1, this is the same outcome, from a Canadian tax perspective, as if CFA 1 had instead earned income that was not FAPI. By contrast, if CFA 1 paid FAT of only $21 because of the reduced US corporate rate, then the CCPC would recognize a $16 income inclusion in year 1.46 This $16 would be added to the CCPC’s ACB of the CFA 1 shares, pursuant to paragraph 92(1)(a).
… [A]ssume that CFA 1 then repatriated the after-tax amount ($100 − $35 = $65) to the CCPC in year 2. Assuming that the amount was FAPI earned by CFA 1, the CCPC would be entitled to a full deduction under paragraph 113(1)(b) (that is, UFT ($35) × RTF − 1 (3) = $105). The CCPC would not receive any further deduction for withholding tax because of the limitation in subparagraph 113(1)(c)(ii). This is the same result as if the dividend had been prescribed to be paid from exempt surplus of CFA 1. …
By contrast, if the applicable US corporate tax rate is only 21 percent … [and] the amount of the dividend was derived from FAPI earned by CFA 1, then the CCPC would be entitled to only a $63 deduction under paragraph 113(1)(b), with the balance of the dividend being deducted under subsection 91(5). In addition, an amount would be deductible under paragraph 113(1)(c). Because the CCPC’s deductions under subsection 91(5) and paragraph 113(1)(b) are already sufficient to shelter the dividend paid from taxable surplus, the CCPC would be able to use the subsection 113(1)(c) deduction to shelter other income. If the amount of the dividend was instead derived from active business income earned by CFA 1, then the entire amount of the dividend would be offset by a deduction under paragraph 113(1)(a) (assuming that it was paid from exempt surplus) … .
Income inclusion if CMC of FA distributes its active-business earnings (p. 18:12)
In a similar vein, the reduction of the US federal corporate tax rate from 35 to 21 percent may also necessitate a determination of whether central management and control of an FA is exercised in Canada. … [I]f an FA incorporated in the United States is nonetheless 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. …
[P]aying a $79 dividend from exempt surplus versus taxable surplus produces different tax results if the applicable US tax rate is only 21 percent (that is, $100 − $21 = $79):
- In the case of a dividend prescribed to be paid from exempt surplus, the CCPC would be entitled to a full deduction under paragraph 113(1)(a). The CCPC would not be entitled to any further deduction under paragraph 113(1)(c). It would be able to use the withholding tax only to claim credit against other qualifying US-source income.
- If the dividend was paid out of taxable surplus, the CCPC would be required to use the deductions under both paragraphs 113(1)(b) and (c) to shelter the dividend inclusion. However, even then there would be $0.20 of unsheltered income that was recognized by the CCPC.
Timing mismatches if an LLC distributes only a portion of its profits (pp. 18:23–25)
Timing mismatches can arise if an LLC distributes only a portion of the profits allocated to an individual member in a year. For example, for US tax purposes, an individual member may be taxed on $100 of income allocated by an LLC. If the LLC only distributes sufficient cash to the member to pay the tax ($37), then the resident member will have only $37 of property income on the shares of the LLC for Canadian tax purposes.
In calculating the 20(11) deduction, the CRA takes the view that the amount deductible under subsection 20(11) is calculated using the full amount of US non-business-income tax paid, not just the portion attributable to income that is actually allocated from the LLC in the year. To illustrate …
[A]ssume that the taxpayer’s share of the LLC income is $15,000 in respect of which the taxpayer paid U.S. tax of $4,500. Also assume that the LLC made a distribution of $10,000 to the taxpayer in the year. The amount that may be deducted under subsection 20(11) of the Act is:
$4,500 − (15% × $10,000) = $4,500 − $1,500 = $3,000. [fn: 121 … 1999-0010305]
… [I]f the LLC distributed only $3,000 to the individual member in the year, then only a subsection 20(11) deduction would be available in respect of the $4,500 US non-business-income tax paid by the individual member. …
High effective tax rate if LLC does not distribute its earnings currently (pp. 18:24-25)
[T]o the extent that the US tax [of an LLC] is not used for an FTC, a subsection 20(12) deduction will be available regardless of whether the individual member has other US-source income. [fn 123 2014-0548111E5…stated that it would consider US income tax paid by a resident individual on his or her portion of an LLC’s income to be a tax “in respect of that income” from the interest in the LLC for the purposes of the subsection 20(12) deduction. This would be the case even if the income of the LLC was not FAPI to the individual, and even if the LLC did not make any distributions to the individual in the year.] Corporate members of fiscally transparent LLCs cannot claim an FTC or a subsection 20(12) deduction for US tax paid on distributions. Recognition for US taxes paid is provided through subsection 113(1). …
The Canadian treatment of US taxes paid by Canadian-resident members can lead to adverse tax results when there is a mismatch between the year when US tax is paid, and the year when income is distributed to the member. This problem is most pronounced for individual members. The ETR is 66.87 percent if active business income earned by a CFA LLC of an individual member in year 1 is distributed in a subsequent taxation year of the member. The high ETR results from the member being entitled to a deduction only under subsection 20(12) in respect of the US tax paid. If there is no timing mismatch, then the ETR improves to 57.67 percent.
No reduction of net earnings of LLC for US taxes paid by corporate member (p. 18:24)
[B]ecause an LLC is not liable to tax in the United States, the net earnings of an LLC will not be reduced by the income or profits tax paid to the United States by a corporate member. This result makes sense from an integration perspective, because the income or profits allocated by an LLC to a corporate member will not have been reduced by US tax exigible in respect of that income. …
LLC-related FAT issues (pp. 18:24–25)
US tax paid by a Canadian member on an LLC’s income is not FAT for the purposes of subsection 91(4)….Accordingly, Canadian members of an LLC cannot claim a subsection 91(4) deduction for an income inclusion in respect of an interest in an LLC. …
[A] Canadian taxpayer that indirectly holds an interest in an LLC through a shareholder affiliate would be entitled to a deduction under 91(4) for tax paid by the shareholder affiliate in respect of FAPI earned by the LLC.
Although resident members cannot claim FAT deductions for FAPI earned by an LLC, individual members may claim a subsection 20(11) deduction and FTC for US tax paid in respect of FAPI included in income under subsection 91(1). [fn 139: 2013-0480321C6] Any excess US taxes paid by the individual member in respect of the FAPI income (that is, not deducted under subsection 20(11) or used as an FTC) may be deducted from income pursuant to subsection 20(12).
Current s. 91(5) deduction for FAPI included in individual LLC member’s income as the dividend payment (p. 18:27)
When an LLC pays a dividend to an individual member, the member will be entitled to a deduction under subsection 91(5) for FAPI included in computing the member’s income on a “share” of the LLC. Although there is arguably a timing issue with respect to taking a subsection 91(5) deduction for FAPI included in the member’s income in the same taxation year as the dividend, the CRA’s longstanding administrative practice is to permit the deduction. [fn 142: 59693] Because an individual member can take deductions and credits for US tax paid in respect of FAPI allocated from an LLC, the individual member is entitled to partial credit for US tax in the year of the FAPI inclusion, and to a full deduction when the FAPI is repatriated. …
Double taxation for corporate LLC members until dividend (p. 18:27)
[U]nlike individual members, corporate members are effectively subject to double taxation on FAPI inclusions until the income is repatriated. In some situations, this could result in permanent double taxation if the corporate member cannot use both the subsection 91(5) and paragraph 113(1)(c) deductions in the same year, or otherwise use the resulting NOL.
Double-taxation of FAPI where TOSI rules apply (p. 18:31)
[T]he TOSI rules do not interact well with FAPI. On the one hand, FAPI included in a taxpayer’s income under subsection 91(1) will not be split income. Therefore, FAPI earned by a CFA will not be subject to the TOSI rules until amounts are repatriated. However, on repatriation, the full amount of the dividend paid from the CFA will be split income. The TOSI rules do not provide any relief for subsection 91(5) deductions in respect of FAPI previously included in the taxpayer’s income on a share of the CFA. This may result in double taxation to the extent that the deduction available under subsection 91(5) cannot be used to offset other income of the taxpayer.
Addition of FAPI to Non-Eligible Refundable Dividend Tax on Hand in limited circumstances, and generating refund of such NERDTOH (p. 18:32)
FAPI allocated to a CCPC under subsection 91(1) will be added to NERDTOH only if the CCPC does not have sufficient deductions or credits for foreign tax. As the integration tables show, this should not arise with most outbound structures … because the CFA earning the FAPI will have sufficient FAT to eliminate the income inclusion. Even if the CFA does not have sufficient FAT, the deduction claimed under paragraph 113(1)(c) in respect of non-business-income tax (for example, withholding taxes paid on repatriation) will in many cases offset the FAPI inclusion. Finally, the amount of AII of a CCPC that is added to its NERDTOH is subject to the same restrictions for FTCs claimed as the old “refundable dividend tax on hand” (RDTOH) definition. In general, these restrictions are intended to ensure that the amount included in a CCPC’s NERDTOH is limited to the amount by which Canadian federal tax payable on foreign investment income exceeds the FTC to which the CCPC is entitled.
That said … a CCPC could be stuck having to pay noneligible dividends in order to claim a refund of NERDTOH generated as a result of a FAPI inclusion. This could occur where, for example, FAPI is included in a CCPC’s income in a given year but is repatriated in a later year. The FAPI would be considered AII, and 302⁄ 3 percent of this amount would be added to NERDTOH (assuming that none of the restrictions apply). When the FAPI is repatriated in the later year, the subsection 113(1) deductions could give rise to sufficient GRIP to make the entire amount of the dividend paid by the CCPC to its shareholders an eligible dividend. This will be the case where, for example, the entire amount of the dividend is paid from taxable surplus, and the aggregate amount of the paragraph 113(1)(b) deduction (representing UFT) plus the paragraph 113(1)(c) deduction (representing non-business-income tax) equals the amount of the net dividend. Whereas the payment of an eligible dividend would have given rise to a dividend refund from RDTOH, the CCPC is now required to distribute a portion of the dividend to its shareholders as a non-eligible dividend to secure a NERDTOH refund.
Double-counting of adjusted aggregate investment income (AAII) of CFA twice towards passive income restriction in s. 125(5.1)(b) (p. 18:32)
[A]n associated corporation could include a CFA if, for example, it was controlled, directly or indirectly, by another corporation. The definition of “associated” does not contain a residence requirement. …
AAII is calculated as if no FAT were deducted; therefore, FAPI earned by a Canadian-resident corporation would be considered AAII, irrespective of FAT paid by the relevant CFA on the FAPI.
However, the FAPI earned by the CFA could also be considered AAII earned by the CFA, depending on the character of the income. There does not appear to be any limitation in the definition of AAII that would preclude it from applying to property income earned by an FA of a taxpayer. Therefore, FAPI earned by a CFA that is associated with the Canadian corporate taxpayer may be counted twice toward the new passive income restriction. …
Deferral where use of CFA of CCPC to earn aggregate investment income (AII) (pp. 18:29–30)
[T]he reduction of the US federal corporate rate to 21 percent presents a considerable deferral possibility for AII earned through a US CFA. …
[T]he optimal structure … involves AII being earned by a C corporation that is a CFA of a CCPC. If the CCPC earned the AII directly, it would be subject to tax at an initial rate of 50.17 percent, assuming that the BC provincial tax applied. However, if the same income is earned by the CFA (in which case it will be FAPI in most circumstances), the income inclusion under subsection 91(1) will be entirely offset, pursuant to subsection 91(4), to the extent that the CFA pays foreign tax of 25 percent on the FAPI. Not only does this result in a deferral of over 100 percent, but most of the deferral persists when the FAPI is repatriated to the CCPC as a result of the reduced treaty withholding rate (5 percent) and the subsection 113(1)(b) deduction.
The ETR for FAPI earned by a CFA under this structure is 53.74 percent. This ETR compares favourably with the ETR for AII earned by a CCPC (54.99 percent). The superior ETR for AII earned through a US CFA results from the CCPC being able to pay non-eligible dividends from the repatriated AII, despite there being more corporate tax paid overall. In contrast, the CCPC would need to pay out non-eligible dividends to receive a refund of non-eligible refundable dividend tax on hand (NERDTOH) generated from the AII. If the total foreign taxes paid by the CFA on the FAPI is only 21 percent (that is, there is no state tax), the ETR for the holding structure improves to 50.75 percent, although there will be Canadian tax paid as a result of a FAPI pickup at the CCPC level if the FAPI is not repatriated in the year in which it is earned by the CFA.
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