Enhancing the Competitiveness of Canada’s International Tax System (Part 3)

By: Wally Conway

Taxation of Foreign Business Income Earned by Foreign Affiliates   

In my last post (see http://pwc.typepad.com/tax_exchange/2011/12/enhancing-the-competitiveness-of-canadas-international-tax-system-part-2.html ), I argued that Canada should adopt a territorial system for taxing foreign source business income earned directly by a taxpayer.

This week, I apply the same arguments to support a territorial system for taxing such income earned indirectly by a taxpayer through a foreign affiliate. Generally, a foreign affiliate is a non-resident corporation in which a Canadian taxpayer has a 10% or higher interest.

As a general rule, a non-resident corporation is taxable in Canada on income derived from certain sources in Canada, including capital gains derived from selling certain types of Canadian properties.

However, if the non-resident corporation is a foreign affiliate of a taxpayer resident in Canada, that taxpayer may, under certain circumstances, be subject to tax in Canada in respect of its share of foreign source income and certain capital gains earned by the non-resident corporation. In other words, a sort of fiscal unity is established between a taxpayer and a foreign affiliate to prevent the taxpayer from establishing a non-resident corporation to inappropriately earn income and capital gains outside Canada that would not otherwise be subject to Canadian tax.

Under Canada’s foreign affiliate rules, the timing of Canadian taxation is dependent on the source of the income or capital gains earned by an affiliate. If the income or capital gain is derived from an active business or the sale of an active business asset, it is included in the taxpayer’s income when such income or capital gain is paid to the taxpayer as a dividend by the affiliate.

On the other hand, income or a capital gain that is foreign accrual property income (“FAPI”) of the affiliate is included in the taxpayer’s on a current basis if the non-resident corporation is a controlled foreign affiliate of the taxpayer. Relief in respect of foreign income taxes paid by the affiliate is available to reduce Canadian taxes and prevent double taxation.

A territorial system for taxing foreign source business income earned through a foreign affiliate would eliminate current complex and burdensome rules that deal with the determination, distribution and taxation of such income.

Instead, the foreign affiliate rules would consist largely of rules designed to protect the Canadian tax base (i.e., the FAPI rules) and efforts could be directed at ensuring that the FAPI rules do so while still accommodating current global business practices. This would further enhance and make the Canada’s tax system more competitive and help attract additional investment.  And, a Canadian territorial taxation system would eliminate inappropriate tax burdens, reduce compliance and administrative burdens and complexity, enhance business tax certainty and accommodate the global nature of business enterprises.

Stay tuned for more in future posts.