By: Nick Pantaleo
Yes, Virginia, there is FAPI
“Nick, there is no such thing as FAPI.”
That was the surprising reaction I got from an unimpressed partner a number of years ago when, as a young practitioner, I rushed into his office with the news that I thought one of our clients had a “FAPI” issue.
But that was a long time ago. My girls were still just a twinkle in my eyes; hockey season started on time; Septembers were still exciting for Blue Jay fans; Canada Trustco referred to a FAPI, not a GAAR case; and I was younger than Nat Boidman.
Then came the 1995 changes which tightened and expanded the FAPI regime by adding to the base erosion rules and introducing the investment business definition. Suddenly, foreign affiliate planning and compliance became a lot more challenging and complicated.
In his last post Wally argued that Canada’s base erosion rules have really not stood the test of time and like certain other countries have done, they need to be carved back to ensure that they do not adversely affect today’s global operations of Canadian companies. But, what about the investment business definition – has it stood the test of time?
As a refresher, in 1991, the Tax Court of Canada in Canada Trustco Mortgage Company v. The Minister of National Revenue, concluded that a business carried on by a foreign affiliate for the purpose of earning interest income was an active business. Hence, the interest was income from an active business and not FAPI. In response, this is what was defined as an investment business: a business where the principle purpose of which is to derive income from property (such as interest, rents, royalties and dividends from non-foreign affiliates), as well as income from the insurance or reinsurance of risk, the factoring of accounts receivable, or the disposition of certain properties known as investment properties. Income from an investment business is FAPI.
There is an exception in the definition for a business of regulated financial institutions (including insurers, and traders and dealers in securities or commodities), real estate developers, leasing and licensing companies and money lenders provided the business is conducted principally with persons dealing at arm’s length with the foreign affiliate and employs more than 5 full-time employees.
The Advisory Panel on Canada’s System of International Taxation, of which I was a member, heard a lot about the complexity of the FAPI system generally and, in particular, the difficulties taxpayers have in meeting the exception to the investment business definition. For example, although it parallels the domestic investment business test, the more than 5 full-time employee requirement is somewhat arbitrary and perhaps not as suitable for foreign affiliates. The Panel also referred to difficulties meeting the test when activities such as real estate development, leasing, and the management of global businesses are carried out for non-tax reasons through more than one foreign affiliate.
The definition has gone through various amendments, mostly relieving, but the changes have not eliminated some of the inherent certainties such as, for example, whether royalties or licensing fees derived from intangible and other property are caught if the affiliate has created or developed the underlying property.
Is there a better alternative to the investment business definition?
Brian Arnold in his book, Reforming Canada’s International Tax System: Toward Coherence and Simplicity, recommends that the definition be dropped and that the FAPI definition be expanded to include specific sources of passive income. The Advisory Panel did not go that far, instead recommending that the scope of the definition be more properly targeted and clarified to eliminate the above problems and uncertainties to ensure it does not impede bona fide business transactions.
Part of the challenge is that the Canadian FAPI regime applies to all foreign affiliates, regardless of where they are located or the level of foreign tax they are subject to; the CFC regime for many other countries is restricted to income earned in low-tax jurisdictions. Arnold suggests that a “designated jurisdiction approach” should be considered to, among other things, simplify the regime and he offers a couple of approaches.
Conceptually, I like our system.
At its core, the Canadian tax treatment of income earned abroad by foreign affiliates as FAPI or as active business income is not dependent on the level of foreign tax the income is subject to. This is an important competitive feature of the Canadian system. To do otherwise would mean limiting, for example, the application of paragraph 95(2)(a), something that would ignore how Canadian companies conduct their global operations. It is why section 18.2, since repealed, made no sense.
However, this comes at a cost. We need to deal with more complexity in the FAPI rules because they need to be robust, especially so if Canada moves to a full exemption system. More on this topic in my next post.
Thoughts? Comment? Leave them below.