Residence-Based Taxation and FAPI:
A World of Fictions
Julie Bouthillier*
ABSTRACT
This paper covers two aspects of Canadian tax law—corporate residence and foreign
accrual property income (FAPI).
In the first part of the paper, the author reviews the development of the concept of
corporate residence in tax law. She shows that the law is so loose that a corporation
can establish residence in a country without actually having any operations there.
Parent corporations can set up subsidiaries that are resident in low-tax jurisdictions or
tax havens, and then transfer some of their taxable income from high-tax jurisdictions
to those subsidiaries in order to avoid tax. To deal with this problem, Canada has
enacted anti-avoidance legislation, notably, in the case of passive income, the FAPI rules.
In the second part of the paper, the author provides a broad description of the FAPI
system. The topics covered include FAPI as an anti-deferral measure; the controlled
foreign affiliate concept; attribution of “tainted” income of a controlled foreign affiliate;
the distinction between business income and property income, and between an active
and an inactive business; rules to deem income to be from a business other than an
active business; and the calculation of FAPI.
In the third part of the paper, the author briefly considers whether it would be
possible to amend the law of corporate residence to get rid of the legal fictions on
which it relies and reduce the need for supplementary measures such as the FAPI rules.
KEYWORDS: INTERNATIONAL TAXATION ■ MULTINATIONAL CORPORATIONS ■ RESIDENCY ■ FAPI ■
TAX AVOIDANCE ■ TAX POLICY
CONTENTS
Introduction
Corporations and Residence
Historical Context
Residence: The Determination
Origins of the Test of Residence in UK Case Law
Central Management and Control
Incorporation
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* Articling at Paquette Gadler, Montreal.
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Foreign Accrual Property Income Rules: Section 95
FAPI: An Anti-Deferral Measure
The Controlled Foreign Affiliates Concept
Definition
Attribution of “Tainted” Income of the Controlled Foreign Affiliate
Foreign Direct Investment and Portfolio Investment
Foreign Accrual Property Income
Exclusions from FAPI: Active Business Income and Other Income
Calculation of FAPI
Tax Reform: Is It Time To Get Rid of Fictions?
Conclusion
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INTRODUCTION
We live in a world where the law depicts reality through tales and legal fictions and
translates complicated issues into legal subsets. To provide definite answers to
concrete questions, reality is simplified and rationalized. In some areas of the law,
however, this process can create a distorted image of reality. As focus is adjusted in
an incremental manner to reflect the multiple layers of reality, we can pass from
oversimplification to “overcomplexification.” The problems that can result are
evident in the area of corporate taxation.
Indeed, the entire body of corporate tax law relies on a principle bearing no
relation to economic reality: the legal personality of corporations. This principle
disregards the fact that a corporation’s financial health affects its shareholders, and
fails to recognize that a group of corporations may constitute a sole economic
entity.1 Corporations, which are mere aliases, mere nominees and agents of their
shareholders, are considered to be separate legal entities,2 taxpayers in their own
right,3 subject to full tax liability on the basis of their residence.
The concept of residence, however, is elusive and may not be adapted to modern
economic realities. Easily manipulated, it offers a myriad of possibilities for tax
avoidance. It is also an inappropriate tool for implementing policy objectives.
Indeed, the Canadian government must not only try to prevent erosion of the tax
base by elaborating complex anti-avoidance rules, but must also take into consideration the perverse effects that these rules may have on Canada’s ability to remain
competitive, a balance that, owing to globalization and income mobility, is increasingly difficult to achieve.
These legal fictions were created for pragmatic reasons, but the notion that a
multinational corporation should simply be taxed where it resides—that is, where its
1 Vern Krishna, The Fundamentals of Canadian Income Tax, 7th ed. (Toronto: Carswell, 2002), 559.
2 Salomon v. Salomon & Co., [1897] AC 22 (HL).
3 See the definitions of “taxpayer” and “person” in subsection 248(1) of the Income Tax Act,
RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless otherwise
stated, statutory references in this paper are to the Act.
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central management and control is located—does not efficiently address Canadian
concerns. The Canadian government must prevent erosion of the tax base without
compromising fundamental principles of taxation such as neutrality, equity, simplicity, and equality, or infringing international conventions.
The foreign accrual property income (FAPI) system was designed to ensure that
these objectives will be met in situations where treaties do not apply because
corporations operate through subsidiaries rather than branches. By imputing FAPI
to Canadian multinational corporations, the legislature attempted to resolve the
problems created by the inadequacies of residence as the tax nexus.
Some writers have suggested replacing or adapting the legal fictions at the heart
of our corporate tax system.4 In my opinion, this would bring neither clarity nor
simplicity to the tax law. Although the taxation of corporations as separate entities
and on the basis of residence is a deeply flawed approach, reflecting the deficiencies
of these concepts, the FAPI system constitutes an adequate, if imperfect, remedy. By
changing the core tax rules, we would simply be trading a world of complexity for
another set of problems.
CORPORATIONS AND RE SIDENCE
In 1897, the House of Lords, in Salomon v. Salomon5 established the patrimonial
autonomy of corporations,6 paving the way for decisions that would further shape
developments in the area of worldwide taxation. The idea that corporations were
legal persons permanently changed the legal landscape.
Corporations became taxpayers in their own right and could owe economic
allegiance to any country in the world. The tax nexus was determined by analogy
to individuals. A corporation was, and still is, considered to reside where its central
management and control is located. However, without supplementary anti-avoidance
measures, this test could be rendered virtually useless by the ingenuity of tax planners.
Historical Context
Multinational corporations are often erroneously considered to be a by-product of
modern commerce, and their growth is generally associated with the recent development of new technologies for global communication. In fact, multinationals
already existed when the courts developed the fictions that are at the core of our
current corporate and international tax systems. Like multinationals today, these
early corporations controlled assets throughout the world, but the way they did
business and the way they were organized were extremely different. Although a
series of inventions—first, cars, trucks, and airplanes, then television, the telephone,
4 See infra notes 86 to 90 and the accompanying text.
5 Supra note 2.
6 See Dominic C. Belley, “The Corporate Veil in Tax Law: In Praise of Judicial Circumspection
(2000) vol. 48, no. 3 Canadian Tax Journal 929-78, at 932.
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and the Internet—did account in part for the rapid globalization of business and
the transformation of these entities, the roots of multinational corporations are
firmly embedded in the 19th century.
Up to the 1930s, markets were highly receptive to multinational corporations;
even the First World War could not halt their dynamic growth.7 Conversely,
during the Great Depression, the decline of the gold standard (which facilitated
the international mobility of capital), the drastic exchange measures adopted by a
number of countries, and the difficulty of repatriating capital created a severe
disincentive to foreign investment.8 The level of foreign investment attained prior
to the 1930s would not be reached again until the beginning of the 1980s. By then,
however, new forms of foreign investment had been introduced and multinational
operations had become highly integrated, reflecting major changes in the global
economic landscape.
It is now possible for a company to hold assets in a foreign jurisdiction and control
them from another location, or to advertise and render services in a foreign jurisdiction, without an employee or any representative ever setting foot in that jurisdiction.
The evolution of global communications technology has also changed the methods
used to control production processes and diminished the risks and costs of crossborder investment.
These gargantuan advances have further complicated the taxation of multinationals; however, the issues are not entirely new. They present the same challenges
and hurdles, only faster,9 thus highlighting the acuteness of problems that are caused
by the deficiencies of artificial concepts and that have existed from the outset.
Residence: The Determination
Regardless of the transformation the world has undergone, Canada’s tax law is still
governed by principles developed almost a century ago. Those principles were embodied in our first income tax statute, the Income War Tax Act, which was enacted in
1917 to fund the extraordinary expenditures resulting from the First World War.
Although it was meant to be a temporary war measure, that statute laid the foundations
of our modern system of international taxation10 and determined the “connecting
factors” giving Canadian authorities the power to tax corporations.
Inspired by principles developed in the United Kingdom, residence was chosen
as the primary tax nexus, source taxation being used only as an adjunct to full tax
liability.11 Both criteria indicate the existence of a connection between the taxpayer
7 See Geoffrey Jones, The Evolution of International Business (London: Routledge, 1996), 56.
8 Ibid., at 44-45.
9 See Jinyan Li, International Taxation in the Age of Electronic Commerce: A Comparative Study
(Toronto: Canadian Tax Foundation, 2003), 1-2.
10 See Angelo Nikolakakis, Taxation of Foreign Affiliates (Toronto: Carswell, 2000), 1-4 to 1-5.
11 Krishna, supra note 1, at 70.
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and the taxing jurisdiction. Residence-based taxation follows from the idea that a
person “owe[s] economic allegiance to the country with which he or she is currently
most closely connected in economic and social terms,”12 whereas source-based
taxation is territorial in nature, looking to the country in which income is earned.
From a policy standpoint, the closer relationship that residents have with Canada,
as compared with those who only carry on business here, explains in part the accrued
tax liability incurred by residents. Indeed, residents are taxable on their worldwide
income, whereas non-residents are taxed, in Canada, only on their income earned
in Canada.
Origins of the Test of Residence in UK Case Law
When Canada introduced its first income tax legislation in 1917, the UK courts had
already dealt with the definition of the term “residence.” Indeed, the judicial test
for determining corporate residence dates back to 1906, when Lord Loreburn
affirmed, in De Beers Consolidated Mines Ltd. v. Howe,
that a Company resides, for purposes of Income Tax, where its real business is carried
on . . . and the real business is carried on where the central management and control
actually abides.13
The formulation of the test was greatly influenced by the legislative and historical context in which it was developed. As Robert Couzin points out in his book
Corporate Residence and International Taxation, there is no common law of taxation;
taxation is a statutory creature. Legislation therefore imposes the boundaries of
judicial interpretation.14 The UK courts had already rejected the place of incorporation as the test of residence because it was too easily manipulated15 when the “real
business” test was gradually developed within the limits imposed by the legislation
until it was enunciated by Lord Loreburn in its definitive form. In elaborating the
proper connecting factor, the courts could not ignore the principles enacted in the UK
tax statute. The statute treated corporations as separate legal entities with the same
rights and obligations as natural persons; thus, artificial persons were virtually
assimilated with natural persons. The statute also provided that, while residents
would be taxed on their worldwide income, non-residents carrying on business in
the United Kingdom would be taxed only on income derived in the United Kingdom.16 These provisions formed the background of any judicial attempt to define
12 Ibid.
13 (1906), 5 TC 198, at 213 (HL).
14 Robert Couzin, Corporate Residence and International Taxation (Amsterdam: International Bureau
of Fiscal Documentation, 2002), 26-29.
15 See Royal Mail Steam Packet Company v. Braham (1877), 2 App. Cas. 381, at 386 (PC).
16 Couzin, supra note 14, at 26-29.
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the term “residence.” Because the legislation did not distinguish between individuals and corporations, the courts felt compelled to define corporate residence in a
manner consistent with the case law on individual residence. According to Lord
Loreburn, we ought
[i]n applying the conception of residence to a Company, . . . to proceed as nearly as
we can upon the analogy of an individual. A Company cannot eat or sleep, but it can
keep house and do business.17
But, in determining a corporation’s way to eat or sleep, statute law closed off an
avenue that might otherwise have been perfectly acceptable. It was not open to the
courts to determine that a corporation was resident in the United Kingdom merely
on the fact that it carried on business there, since this criterion was already the
primary determinant of source-based taxation. The courts must establish, in Lord
Loreburn’s words, “where the central management and control actually abides.”
Central Management and Control
Although the words used by Lord Loreburn offered some guidance, the courts
struggled to determine the meaning of the expression “central management and
control” for some time after the famous judgment was rendered.
The place of central management and control must be determined on the facts
of each case. Articles of incorporation indicating the location of the head office or
the seat of the corporation are not proper indicia of where the real business is
carried on.
Similarly, the place of central management and control is unrelated to certain
formalities that must be observed under corporate law. The requirements that a
corporation have an address, a place where it keeps its records and transcripts, and
bank accounts appear to be inconsequential conditions of operating a company.
Some judges, struggling with the concept of multiple corporate residences—a complication that was not contemplated by the court in De Beers—suggested that a
corporation’s administrative acts were “vital organic operations incidental to its
existence as a company”18 and sufficient, subject to incorporation in the jurisdiction,
to establish residence. This proposed alternate test was considered for several years
until it was definitively rejected in 1928 in Egyptian Delta Land and Investment.19
Correctly interpreted, central management and control requires more than the
administrative acts that are necessary to establish limited liability or maintain dayto-day operations. Such actions require a level of control that cannot be described
as central or anything more than doing business in a jurisdiction.
17 De Beers, supra note 13, at 212.
18 The Swedish Central Railway Company, Limited v. Thomson (1923), 9 TC 342, at 353 (KB).
19 Todd v. The Egyptian Delta Land and Investment Co., Ltd. (1928), 14 TC 119 (HL).
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Ultimately, the courts appear to have adopted the “pinnacle” test: central management and control is found at the highest level of the corporate structure. Without
attempting to locate the intrinsic source of “final and supreme authority,”20 the
courts have determined that the real business of a corporation usually takes place
where business policy and financial decisions are made. “Beyond that, the key
elements of direction of the ‘real business’ probably vary depending upon the
nature of that business.”21
While the place of central management and control should always be determined on the facts of each case “through the scrutiny of the course of business and
trading,” the courts generally consider the real business to be carried on where the
directors hold board meetings and exercise their decision-making authority.22 In so
ruling, the courts are not departing from a presumably settled and fundamental
principle; on the contrary, their decisions have a strong factual basis. The control
structure of a corporation is largely governed by the rules and requirements of
corporate law. For example, under the Canada Business Corporations Act (CBCA),
directors have the duty and authority to “manage, or supervise the management of,
the business and affairs of a corporation”;23 shareholders, on the other hand, have
decision-making powers relating to the election of directors and the bylaws of the
company, rather than its day-to-day business operations.24 Consequently, the CBCA
creates a set of facts that, absent special circumstances, leads to the conclusion that
the real business of a corporation is carried on where directors’ meetings are held.
The place where shareholders’ meetings are held is generally of little significance.
However, where evidence adduced at trial proves that the directors and officers
of the company are mere puppets of the shareholders, the courts have held that the
place of residence of the corporation is the place where those who effectively
control the corporation reside.25 This is one of the few instances where the identity
of shareholders has been held to influence the tax treatment of the corporation.
Indeed, reflecting the separate legal identity of corporations, the nexus between
Canada and a corporation is not, in usual circumstances, determined by the nationality, residence, or domicile of the shareholders.26 Surprisingly, the non-resident
status of subsidiaries is rarely contested by Canadian tax authorities.
20 Union Corporation, Ltd. v. Commissioners of Inland Revenue (1952), 34 TC 207, at 271 (CA); aff ’d.
on other grounds at (1953), 34 TC 207, at 279 (HL).
21 Couzin, supra note 14, at 60.
22 See Jinyan Li, “Tax Jurisdiction,” Supplementary Course Material for International Tax
(Osgoode Hall Law School of York University, Winter 2004), 16; Victoria Insurance Co. Ltd. v.
MNR, 77 DTC 320 (TRB); and Birmount Holdings Ltd. v. The Queen, 78 DTC 6254 (FCA).
23 Canada Business Corporations Act, RSC 1985, c. C-44, as amended, section 102(1).
24 CBCA section 106(3).
25 See Bullock (HM Inspector of Taxes) v. The Unit Construction Co. (1959), 38 TC 712 (HL), and Li,
supra note 22, at 16.
26 Bedford Overseas Freighters Ltd. v. MNR, 70 DTC 6072 (Ex. Ct.).
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The judicial test of residence is fundamentally flawed. For example, in Victoria
Insurance,27 even though it was admitted that the Canadian-resident majority shareholders effectively controlled the subsidiary, evidence that all the regular board
meetings were held in the Bahamas and the fact that reinsurance is for the most
part a passive business were sufficient for the court to conclude that the subsidiary
resided in the Bahamas, not in Canada. This case is only one of many demonstrating the inadequacy of the test established in De Beers.28
Incorporation
Since the judicial test of residence was clearly unsatisfactory, in 1970 the Income
Tax Act was amended to include a provision deeming corporations incorporated in
Canada after April 27, 1965 to be Canadian residents.29 Thus, the place of incorporation, which was rejected by the courts as being too easily manipulated, was
introduced as a determining factor by the Income Tax Act. Nevertheless, the judicial
test, as inept as it was, remained untouched. Principles laid down at the beginning
of the 20th century still govern where a company is incorporated, or continued,
outside Canada. Concerns linger about the elasticity of the concept of residence and
the consequent potential for double taxation and tax avoidance. As Vern Krishna
has observed,
[c]orporate taxpayers in particular may [still] derive all the economic, political, and
legal benefits of residence in a country and arrange their international transactions so
as to source their income in low-tax countries or tax havens.30
Evidently, Canada’s modest attempt to clarify the conditions resulting in the
taxation of worldwide corporate income did not alleviate problems related to the use
of residence as a tax-planning tool. It was equally unsuccessful in resolving the
problem of double taxation.
Even if a multinational corporation elected to reside in Canada,31 it would not
automatically be protected against another country’s exercise of tax jurisdiction.
Not only has it long been established that a corporation can reside in more than
one country,32 but the mere fact of earning income in a foreign jurisdiction is
sufficient to trigger liability to tax in that jurisdiction. Consequently, absent an
extensive network of treaties with trustworthy countries,33 multinational corporations
27 Victoria Insurance, supra note 22.
28 Supra note 13.
29 Subsection 250(4). Different rules apply to corporations incorporated before that date.
30 Krishna, supra note 1, at 70.
31 Ibid.
32 See Union Corporation, supra note 20.
33 Generally, Canada does not enter into tax treaties with tax havens, Barbados being a notable
exception.
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operating as single entities would be vulnerable to double taxation. Through attribution rules and concepts such as permanent establishment, Canada recognizes that
other countries might, depending on their domestic tax rules, be entitled to tax a
multinational corporation.
Multinational corporations can avoid the problem of double taxation through
the use of non-resident subsidiaries. However, in order to shelter their income,
multinationals residing in Canada must not only incorporate those subsidiaries outside Canada, but also ensure that decision making permanently takes place outside
Canada.
In summary, no matter how diligently judges and legislators searched for a determinant of tax nexus that would prevent multinational corporations from sheltering
profit through the use of subsidiaries located in low-tax jurisdictions, tax havens, or
countries that engage in harmful tax competition, their efforts proved to be in vain.
The inherent intangibility of the corporation frustrated attempts to impose the
simple rule that a corporation owes economic allegiance to the country where its
central management and control is located. Economic allegiance and physical
boundaries can apply to physical persons, but appear to be irrelevant in the case of
artificial persons. Indeed, it would be ridiculous to presume that multinational corporations and individuals can be made subject to the same rules. The gap between
them appears even wider because of technological developments.
FOREIGN ACCRUAL PROPERT Y
INCOME RULE S: SECTION 95
Judges and legislators strove to create a corporate residence test that would not be
easy to manipulate. Their intentions were noble, but their efforts proved futile.
The ingenuity of tax planners, the proliferation of tax havens, and the existence of
harmful tax competition transformed a carefully elaborated test into an opportunity for tax avoidance.
The fictions devised to reduce reality to a simple equation failed to capture the
versatile nature of corporations. The FAPI system provides an adequate, though
imperfect, remedy.
FAPI: An Anti-Deferral Measure
The rules known as the FAPI system were adopted by Canadian tax authorities in
the 1970s to address the difficulties caused by the taxation of corporations both as
separate legal entities and on the basis of residence. The predecessor of the FAPI
system combined an exemption for foreign-source income with a deduction for
foreign taxes. Income earned by a foreign subsidiary was not included in the
Canadian tax base until dividends were received by private shareholders, resulting
in a substantial deferral benefit.34 Moreover, the lower the tax rate imposed by the
34 Nikolakakis, supra note 10, at 1-14.
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foreign jurisdiction, the greater the incentive to leave the income within the subsidiary.35 The FAPI system was designed to rectify that situation by eliminating any
undue tax-deferral incentive.
Since non-resident corporations fall outside Canada’s tax jurisdiction, foreign
subsidiaries of Canadian residents are not taxed directly. Instead, subsection 91(1)
includes in the computation of the income of the Canadian-resident taxpayer for
the year, the pro rata share of “the foreign accrual property income of any controlled foreign affiliate of the taxpayer.” Thus, the FAPI system attempts to remedy the
failure of the concept of residence by attributing to a Canadian resident income
that, through the conjunction of the separate legal identity of corporations and the
flawed definition of residence, would otherwise escape Canadian tax.
Subsection 91(1) extends the reach of the Canadian tax authorities to foreignsource income that would otherwise lie beyond their grasp. The inclusion of income
under this provision depends upon the type of income earned by the foreign corporation and the connection between the corporation and the Canadian-resident
taxpayer.
The charging provision refers to a number of defined concepts that interact to
reflect the policy objectives of the tax authorities. Since their enactment, the FAPI
rules have been amended in an attempt to achieve neutrality and equity. The definition of “controlled foreign affiliate” has been tightened. The definition of “foreign
accrual property income” has been extended to include income deemed to have its
source from a “business other than an active business.” The definition of “active
business” has been refined.36 However, the core of the FAPI system and the computation rules has remained unchanged.
The Controlled Foreign Affiliates Concept
Definition
Since the introduction of the FAPI system, the existence of a “controlled foreign
affiliate” of a Canadian taxpayer has been central to the concept of FAPI. It is the
first requirement in determining whether or not the income earned by a nonresident corporation will be caught by the FAPI rules. Under section 95 of the Act,
the income earned by a non-resident corporation will be imputed to a Canadianresident taxpayer only if, at any time during the taxation year, the non-resident
corporation could properly be described as a controlled foreign affiliate of the
taxpayer. Although the ownership thresholds were adjusted in 1994, to reflect more
accurately the extent of the power exercised by shareholders over dividend income,
35 Jinyan Li, “Foreign Accrual Property Income (FAPI),” Supplementary Course Material for
International Tax (Osgoode Hall Law School of York University, Winter 2004), 1.
36 Recently, the regime was extended in order to apply to income earned through foreign trusts
and other such entities. See section 94.1.
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this basic principle and the scope of the controlled foreign affiliate concept have
remained unchanged.37
In essence, for a foreign corporation to be a controlled foreign affiliate, the Act
requires that connected Canadian-resident taxpayers own a certain proportion of
shares in the foreign corporation. The foreign corporation must also be controlled
by persons residing in Canada.38 More precisely, a “foreign affiliate” is generally
defined as a corporation in which a Canadian-resident taxpayer owns directly at
least 1 percent and together with other related persons at least 10 percent of a class
of shares.
Simply holding shares in a foreign affiliate does not trigger the application of
the FAPI rules. Control is a prerequisite. In the original FAPI legislation, control was
not a prerequisite; a 25 percent voting participation in a foreign corporation, through
either direct or indirect ownership, was sufficient to trigger the application of the
rules if other conditions were met. This aspect of the FAPI system was strongly
criticized, and the rules were amended in 1994.
Under the current rules, the taxpayer must exercise de jure control. De jure
control exists where one or more persons hold a sufficient number of shares
carrying voting rights to constitute a majority in the election of the board of
directors.39 Such control need not be exercised by the taxpayer alone. The definition of “controlled foreign affiliate” provides that control with no more than four
other Canadian residents with whom the taxpayer deals at arm’s length, or with any
number of persons with whom the taxpayer does not deal at arm’s length, is capable
of triggering the taxation of the foreign corporation’s income on an accrual basis.40
Under the earlier version of the rules, Canadian multinational corporations could
circumvent the control requirement and escape the attribution of FAPI by holding
property in an offshore investment fund; however, section 94.1 was enacted in
1985 to close this loophole.
To summarize, income from outbound foreign investment constituting FAPI is
taxed on an accrual basis only when a Canadian resident controls, directly or indirectly, the management of the foreign entity. In other words, “tainted” outbound
foreign investment income is taxed whenever a Canadian resident has de jure control
of the corporation as opposed to de facto control. Consequently, where a foreign
corporation has a significant connection with Canada through its shareholders, but
would otherwise escape Canadian tax jurisdiction because of the deficiencies of the
corporate residence concept, the FAPI system applies.
Conversely, portfolio investment, which, by definition, does not result in control of the foreign corporation by a Canadian resident, does not constitute a
37 Nikolakakis, supra note 10, at 1-35.
38 See the definitions of “foreign affiliate” and “controlled foreign affiliate” in subsection 95(1).
39 Buckerfield’s Ltd. et al. v. MNR, 64 DTC 5301 (Ex. Ct.).
40 See the definition of “controlled foreign affiliate” in subsection 95(1).
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sufficiently strong connection between the Canadian-resident shareholder and the
corporation to justify taxation of the corporation’s income on an accrual basis.
Small shareholders of a widely held foreign corporation could not comply with the
requirement to include their share of the corporation’s income as they would not
be in a position to access the necessary information.41 In addition, when shareholders
do not have control over the election of the board of directors, they have extremely
limited influence over the management of the company. They have no control over
the distribution of retained earnings and thus no way to recover their investment,
other than by selling their shares. If they were taxed on an accrual basis, these
investors could be faced with serious liquidity problems and might have to borrow
or sell their shares to pay Canadian tax.
While this liquidity problem is not intrinsically tied to the lack of control, those
who hold control have remedies that are unavailable to small shareholders. Directors are expected to take decisions in the best interests of the corporation and are
not bound by the suggestions of the shareholders. For a variety of reasons, the
directors of a foreign affiliate may choose not to distribute income as it accrues. If
they retain it, the controlling shareholders will encounter the same cash flow problems. However, those problems are not necessarily solved only by borrowing or by
selling the shares. For example, controlling shareholders can remove and replace
unsatisfactory directors.42 Unlike shareholders who lack control, they do have
alternative ways to recover their investment.
Thus, there are compelling policy reasons not to tax income on an accrual basis
in all cases where a taxpayer holds shares in a non-resident corporation.
It follows from the definitions of “foreign affiliate” and “controlled foreign
affiliate” that the FAPI system applies only to outbound foreign investment. Foreign investors can make investments in Canadian subsidiaries without risk of being
taxed on FAPI earned through branches or other subsidiaries located anywhere in
the world. Inbound foreign investment income is taxed on a strictly territorial
basis. Not only is there no rationale for accrual taxation of non-residents making
inbound investments, but such a practice would go against established international taxation principles and would divert foreign direct investment from Canada.
In such a situation, if the parent corporation operated through a branch, it would
not be considered a resident of Canada under the De Beers test, nor should it be.
Given the true nature of the corporate tax—a mere proxy permitting the government to tax residents on their worldwide income and non-residents on their income
earned in Canada—income from investment from a foreign source, made by persons who owe no economic allegiance to Canada, should be subject to tax only on a
territorial basis. If the FAPI system reached up to tax a foreign parent corporation
41 Brian J. Arnold, “A Tax Policy Perspective on Corporate Residence” (2003) vol. 51, no. 4
Canadian Tax Journal 1559-66, at 1560.
42 CBCA section 106(3).
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simply because it had a Canadian subsidiary, it would be perceived as an inequitable and “colourable attempt to tax non-residents on foreign income.”43
Thus, the rules that rely on the definition of “controlled foreign affiliate”
require a substantial connection between the Canadian parent and the foreign
subsidiary for the FAPI system to apply.
Attribution of “Tainted” Income of the
Controlled Foreign Affiliate
Foreign Direct Investment and Portfolio Investment
Although the principle underlying the taxation of income earned by a controlled
foreign affiliate has a strong policy basis—namely, that Canada clearly cannot,
through inaction, provide an incentive for Canadian-resident corporations to invest in low-tax jurisdictions or tax havens—the FAPI system raises serious questions
that are not unfamiliar in the area of residence-based taxation. In particular, it
raises questions about the desirability of foreign investment.
Whether a corporation earns income in a foreign jurisdiction directly or through
a subsidiary, to the extent that its income is taxable on an accrual basis, double
taxation becomes a predominant concern. It can dissuade corporations from engaging in any type of foreign direct investment. Such a disincentive is not considered
to be a desired result of worldwide taxation. Opportunities for foreign investment are
virtually unlimited, and foreign direct investment—that is, foreign investment
involving management control44—is perceived as both an engine of economic
growth45 and a vehicle for the transfer of technology. The transfer of technology
resulting from foreign direct investment is not necessarily restricted to technologies specific to the activities of multinational corporations. Indeed, in developing
countries lacking adequate infrastructure, “social technologies” such as telephone,
police, and postal services and an education system might be introduced.46 Increases
in employment and living standards, cost reduction, and economic and industrial
strength are also often attributed to foreign direct investment.47 The value of foreign
direct investment is potentially gigantic. In contrast, portfolio investment is generally not perceived in such a favourable light. Because of its passive nature, the
advantages that are believed to follow from foreign direct investment are not associated with portfolio investment.
Furthermore, because other countries do not adopt an aggressive approach,
levying taxes on foreign income regardless of its source and regardless of the
connection between the affiliate, the taxpayer, and the taxing jurisdiction could
43 Couzin, supra note 14, at 7.
44 Jones, supra note 7, at 5.
45 Ibid., at 234.
46 Ibid., at 235.
47 Organisation for Economic Co-operation and Development, Corporate Tax Incentives for Foreign
Direct Investment, Tax Policy Study no. 4 (Paris: OECD, 2001), 19.
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greatly impair the ability of Canadian corporations to remain competitive. They
would be faced with a burden that foreign multinationals would not have to bear,
and foreign investors would flee the Canadian market.
Consequently, taxation should not create a disincentive to foreign direct investment. Portfolio investment, on the other hand, does not require such deference. At
the international level, through an extended treaty network allocating the tax base
and providing for recognition of foreign taxes, countries attempt to remove the
barrier to foreign investment raised by worldwide taxation. At the domestic level,
the FAPI rules attempt to achieve a similar result. When the FAPI system was first
elaborated, neutrality between the taxation of foreign subsidiaries and the taxation
of foreign branches was not one of the guidelines. However, Canadian tax authorities could not avoid grappling with policy questions raised on the international
scene about foreign branches, nor could they ignore the results that inevitably
follow from the need to prevent double taxation.
Not unlike what is accomplished by treaty, the definition of FAPI is designed to, in
effect, allocate the tax base. Each inclusion in and exclusion from FAPI aims to
achieve a proper balance between competing policy objectives that sometimes appear
irreconcilable. By including in the computation of income a percentage of the
“tainted” income of any controlled foreign affiliate of a Canadian taxpayer, Canada
attempted to respond to the erosion of the tax base that resulted from the blurring
of commercial boundaries.
In order to avoid double taxation, the FAPI system also takes into account
foreign accrual taxes paid by the controlled foreign affiliate with respect to amounts
included in FAPI and the effect of taxation on an accrual basis when a controlled
foreign affiliate distributes its earnings.
Foreign Accrual Property Income
The FAPI system, through the definitions contained in section 95, establishes a
distinction between active and passive income. Recognizing the importance and
the value of foreign direct investment, the FAPI system considers income from such
investment to be income from an active business and excludes such income earned
by a controlled foreign affiliate from attribution to the Canadian parent. Conversely,
passive income, which generally arises from portfolio investment, constitutes FAPI
and is thus attributed to the Canadian-resident taxpayer.
More specifically, the term “foreign accrual property income” encompasses two
types of income: property income and income from a business other than an active
business.48 Conceptually, property income and inactive business income are the
opposite of active business income. The distinction between these sources of
income is fundamental to the effective operation of the FAPI system. It is through
the determination of the source of earnings that policy concerns are addressed and
attribution is determined.
48 Li, supra note 35, at 11.
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Property Income and Business Income: The Distinction
Dividends, interest, rent, and royalties are typical examples of property income
that, when earned by a controlled foreign affiliate, will be subject to taxation on an
accrual basis. However, there is no single definition of property income. It is only
by way of contrast with business income that characterization can be achieved.
One of the defining features of property income is that it is earned in a passive
manner. Unlike business income, it can be earned without investing in labour and
capital, and without the need for extensive organization of the affairs of the corporation. The required level of intervention is extremely low.49 It does not involve the
transfer of technology, even of a social type, or of organizational structures between
jurisdictions. While earning this type of income, investors are “passive,” contributing
only funds to the foreign economy. Consequently, investment that generates property income does not appear to carry any of the benefits of foreign direct investment.
Business income, on the other hand, requires a higher level of intervention. In
Wertman v. MNR,50 for example, Justice Thurlow considered that the nature and the
extent of services provided were relevant in determining whether rental income
earned from leasing premises was income from property or business income. According to this decision, providing linen and maid service could transform what
would otherwise be property income into business income.
Courts have consistently held that the characterization of income as property
income or business income should always be “made from an examination of the
taxpayer’s whole course of conduct viewed in the light of surrounding circumstances.”51 By considering the level of services, the number and value of transactions,
the time devoted to investment activities, etc., judges distinguish income from property from income from a business.52 However, corporations incorporated for the
purpose of earning profits for their shareholders are presumed to carry on business
activities whenever they put their assets to any “gainful use.”53
Canadian Marconi v. The Queen 54 and Canada Trustco Mortgage Company v. MNR55
are classic cases. While Marconi did not involve FAPI, it is nonetheless relevant. In
that case, the judge had to determine whether the management of short-term
securities bought in order to earn interest income while maintaining a certain level
of liquidity could constitute business income. Relying on the aforementioned
presumption, the Supreme Court held that surrounding factors were not sufficient
49 Krishna, supra note 1, at 241-42.
50 64 DTC 5158 (Ex. Ct.).
51 Canadian Marconi v. The Queen, 86 DTC 6526, at 6529 (SCC), citing Cragg v. MNR, 52 DTC
1004, at 1007 (Ex. Ct.).
52 Krishna, supra note 1, at 245-46.
53 American Leaf Blending Co. v. Director-General of Inland Revenue, [1979] AC 676, at 684 (PC).
There is some doubt with regard to the application of the presumption when no object is stated
in constating documents: Marconi, supra note 51.
54 Marconi, supra note 51.
55 91 DTC 1312 (TCC).
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to overturn the presumption even though the Federal Court of Appeal found that
few employees were involved in investment activities.
In Canada Trustco, the judge held that an extremely low level of activity was
sufficient to characterize the income as income from an active business; in fact, the
foreign affiliate appeared to carry on an even lower level of activity than the Canadian Marconi Company. Whereas Marconi was described by the Supreme Court as
conducting a “large scale investment activity,”56 the foreign affiliate in Canada
Trustco simply explored opportunities for investment and eventually bought a limited
number of mortgages in Canada. After referring to the presumption set out above,
the court came to the conclusion that unsuccessful exploration of new business
opportunities could constitute an active business. Although the court did not refer
expressly to the presumption, it must have greatly influenced the court’s decision.
Thus, even in the context of FAPI, the threshold for income to be characterized
as business income rather than property income is relatively low. It appears from
the case law that as long as some activity is carried on, as long as income is not
earned in a completely passive manner, income earned by corporations will be
characterized as business income. Consequently, business income does not necessarily have the attributes that render foreign direct investment valuable. Nothing
ensures that technology will cross borders and that wealth will be produced as a
result. Reflecting the fact that the concept of business investment does not necessarily imply a bona fide purpose for engaging in offshore investment, business
income is not automatically excluded from the FAPI calculation under section 95. It
will be excluded only if it can properly be described as active business income.
Active Business and Inactive Business:
Misinterpreted Concepts
After struggling with the distinction between property income and business income,
the courts eventually arrived at a definition that was accepted by the Canadian tax
authorities in most areas of the tax law. However, when it came to the distinction
between an active business and an inactive business, their interpretation was far
removed from what was intended by the tax authorities. Indeed, the courts’ definition of active business effectively eviscerated the concept of inactive business. The
decision in Canada Trustco is a blatant example of this error of interpretation.
In Canada Trustco, the judge not only had to determine whether income earned
by the wholly owned foreign subsidiary constituted business income, but also had
to determine whether the income was active business income. When we look at the
facts of the case, it is obvious that, but for tax considerations, the foreign affiliate,
Canada Trust Company BV (“BV”), would likely not have chosen the Netherlands as
its country of residence and would not have acquired a portfolio of mortgages from
its parent. It is also clear that the few investments that were made could never
qualify as a type of investment that would create employment and enrich society.
56 Marconi, supra note 51, at 6531.
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BV was a wholly owned subsidiary of Canada Trustco Mortgage Company
(“Canada Trustco”) and incorporated under the laws of the Kingdom of the Netherlands. BV had three managing directors, one of whom was a Canadian citizen
residing in Amsterdam. He had been posted to the Netherlands by Genstar Corporation to work for the company’s offshore affiliates and, throughout the entire
commercial venture, was remunerated by Genstar Corporation.
In 1984, when the mortgage loans were remitted to the Netherlands, interest
on such loans was not subject to Canadian withholding tax, nor was it subject to tax
in the Netherlands, by virtue of the Canada-Netherlands treaty. Dividends received by the parent corporation from its foreign affiliate were also exempt from
Canadian tax. It is particularly significant that, when the Canada-Netherlands
treaty was renegotiated and the terms were changed, allowing the Netherlands to
tax interest on such loans, the agreements between BV and Canada Trustco “were
then no longer financially attractive on an after tax basis.”57 It appears from the
judgment that, aside from the mortgage loans, BV was not doing any business
within the jurisdiction in which it was incorporated. Hence, it seems that the only
possible explanation for BV’s choice of the Netherlands as its country of residence
is tax planning. By their interpretation, the judges reinstated a flaw inherent in the
conjunction of separate legal entity and residence that the FAPI system had tried to
correct.
Property Income: A Revisited Definition
Following the Marconi and Canada Trustco decisions, the definition of “income
from property” in section 95 was amended to clearly indicate that income earned
by foreign affiliates should not be presumed to be income from an active business.58
Overturning the rebuttable presumption and the favourable treatment of income
earned by corporations, income from property, in the foreign affiliate context,
includes income derived from an “investment business” and from an adventure or
concern in the nature of trade as long as it is not deemed to be income from an
active business or income from a business other than an active business.
The use of the term “investment business” was inspired by the “specified
investment business” rules applicable in the context of the small business credit.59
An “investment business” is a business the principal purpose of which is to derive
income from property or “from the factoring of trade accounts receivable.” It also
includes businesses that derive profits from the disposition of “investment property”—that is, shares, an interest in a partnership or a trust, currency, real estate,
etc.60 However, in some circumstances, activities that would otherwise fall within
57 Canada Trustco, supra note 55, at 1317.
58 Li, supra note 35.
59 Nikolakakis, supra note 10, at 3-11.
60 See the definitions of “income from property,” “investment business,” and “investment property”
in subsection 95(1).
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the scope of the definition are excluded.61 Qualifying businesses that were conducted principally with persons with whom the affiliate deals at arm’s length and
employing at least five full-time employees in the active conduct of business are
excluded from the definition.
According to Angelo Nikolakakis, two broad categories of qualifying businesses
can be identified: regulated and unregulated businesses.62 Indeed, the definition of
an investment business specifically excludes income derived from a business carried
on by a foreign bank, a trust company, a credit union, an insurance corporation, or
a trader or dealer in securities or commodities that is regulated in the country in
which it operates. The definition also excludes, regardless of the existence of regulation, income from a business where the business carried on is the development of
real estate for sale, the lending of money, the leasing or licensing of property, or the
insurance or reinsurance of risks.63
Regulated businesses falling within the scope of the exclusion, either because of
their level of activity or because of the existence of rules restraining their operations, are presumed by the Act to have features indicating that tax avoidance is not
the sole purpose of their activities. Qualifying unregulated businesses with at least
five full-time employees benefit from the same presumption. However, as Nikolakakis
points out, the rationale for the restriction of the “five full-time employees” requirement to certain types of businesses is unclear.64
Business Other Than an Active Business
In the context of inactive business income, the difficulties encountered by the courts
led to further refinement. In 1994, the rules were amended to resolve certain issues
arising from decisions that were not always in harmony with the policies underlying the FAPI system. Five deeming rules were added to the Act. Income from the
sale of property, income from insurance, income from Canadian debt and lease
obligations, income from partnership debt and lease obligations, and income from
certain services rendered by a controlled foreign affiliate is deemed to be income
from a business other than an active business and, as such, cannot be recharacterized
as active business income under paragraph 95(2)(a) of the Act.65
Income from the Sale of Property
Under paragraph 95(2)(a.1), income earned through a foreign affiliate from the
sale of property or from services related to a purchase or sale of property is deemed
to be income from a business other than an active business when it is reasonable to
61 Nikolakakis, supra note 10, at 3-31.
62 Ibid., at 3-31.
63 See the definition of “investment business” in subsection 95(1).
64 Nikolakakis, supra note 10, at 3-31.
65 Li, supra note 35, at 19-20.
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conclude that the cost of the property is relevant in computing the income of the
corporation residing in Canada or of any person with whom the corporation does
not deal at arm’s length.
The provision was enacted in reaction to the Federal Court of Appeal decision
in The Queen v. Irving Oil Limited.66 At a time when transfer-pricing rules had not
yet been enacted, Irving Refinery Ltd., concerned with the tax consequences of an
arrangement with Standard Oil of California, incorporated an offshore subsidiary
in Bermuda for the purpose of acquiring crude oil. The subsidiary purchased the
crude oil at a price 60-65 percent below its market value and immediately resold it
to the parent corporation at fair market value. The subsidiary did not even have to
bear the cost of delivery, which was assumed by Standard Oil. An extra step in the
chain of operation, an extra transaction, and an extra subsidiary were created for
the sole purpose of avoiding tax. Even though the court came to the conclusion
that the offshore subsidiary did not have a bona fide business purpose and the only
reason for its existence was tax avoidance, it refused to apply section 245, the general
anti-avoidance rule.
There was no transfer of wealth or knowledge, or any of the benefits that make
foreign direct investment so valuable. In fact, no benefit to society could ever be
generated by such transactions. Given the court’s failure to apply the general antiavoidance rule, paragraph 95(2)(a.1) was enacted to act as a backstop to the new
transfer-pricing rules.
Paragraph 95(2)(a.1), however, permits exceptions. Income earned from the sale
of property that is “manufactured, produced, grown, extracted or processed” in the
country under whose laws the foreign affiliate was constituted,67 or in Canada,68 is
not included in the computation of FAPI.
While the exclusion of income earned by a foreign affiliate from the sale of
property it manufactured seems in accordance with the general principles governing the FAPI system, since manufacturing and processing seem to imply a bona fide
purpose, this is not the case for foreign affiliates that can buy property from
another manufacturer located in the same jurisdiction and then sell the property at
a higher price, or for foreign affiliates that manufacture property in other jurisdictions.69 The wording of subparagraph 95(2)(a.1)(ii) does not appear to effectively
target tainted income in all cases, as the tax treatment of income from the sale of
property “manufactured, produced, grown, extracted or processed” by foreign affiliates depends upon the place of origin of the product and not upon the possibility of
markup.
On the other hand, the exclusion of income from the sale of property “manufactured, produced, grown, extracted or processed in Canada” by the Canadian
66 91 DTC 5106 (FCA).
67 Subparagraph 95(2)(a.1)(ii).
68 Subparagraph 95(2)(a.1)(i).
69 Nikolakakis, supra note 10, at 3-48.
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taxpayer or by a person with whom the taxpayer does not deal at arm’s length,
provided that the property is sold to non-residents other than the foreign affiliate
(whether or not the latter acted as intermediary), was probably meant as a concession to Canadian exporters.
Currency transactions of certain regulated businesses, such as Canadian-resident
banks or insurance corporations, benefit from special status. Under subsection 95(2.3),
income derived from the sale or exchange of currency is excluded from FAPI whenever certain conditions are met.70
Paragraph 95(2)(a.1) also includes a de minimis provision intended to achieve
administrative efficiency. Where such property sales are considered to be insignificant—that is, where more than 90 percent of the gross revenue of the foreign
affiliate from the sale of property is derived from the sale of property manufactured
by Canadian businesses or in the affiliate’s home jurisdiction—those transactions
are disregarded in the computation of FAPI.71
Income from Insurance
Income from insurance is also deemed to constitute income from a business other
than an active business. Under paragraph 95(2)(a.2), unless more than 90 percent
of the gross premiums are in respect of the insurance of non-Canadian risks of
persons with whom the affiliate deals at arm’s length, when a foreign affiliate insures
a Canadian-resident person, property located in Canada, or a business carried on
in Canada, income that pertains or is incident to the insurance business must be
included in the computation of FAPI.
Where most premiums relate to Canada, there is no purpose for operating the
business from a foreign jurisdiction other than tax avoidance. Furthermore, as
mentioned in Victoria Insurance,72 once contracts are drafted and concluded, the
insurance business becomes dormant. Nothing happens aside from premium payment unless there is realization of an insured risk. Consequently, when a Canadian
corporation operates the insurance business through a foreign affiliate, there is no
policy rationale for excluding the income from the business from FAPI.
Income from Canadian Debt and Lease Obligations
The rule encompassing the tax treatment of income from Canadian debt and lease
obligations was enacted as a further reaction to the decision in Canada Trustco.
Pursuant to paragraph 95(2)(a.3), income derived from indebtedness and lease
obligations of persons resident in Canada or in respect of businesses carried on in
Canada must be included in the computation of income from a business other than
an active business unless it is specifically excluded by this provision. Again, the
income of Canadian taxpayers is protected by a de minimis exclusion.
70 For an explanation of those conditions, see Nikolakakis, supra note 10, at 3-48.
71 Ibid., at 3-49 to 3-50.
72 Victoria Insurance, supra note 22.
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Under the current definition, controlled foreign affiliates managing short-term
securities73 or a portfolio of mortgages74 will be subject to this provision. Even
income earned by a capital-intensive firm whose employees devote a large percentage of their time to the day-to-day management of investments could be caught by
the FAPI rules.
Services Deemed Not To Be Active Business
Not unlike the rules pertaining to the tax treatment of income derived from the sale
of property, paragraph 95(2)(b) was designed to act as a backstop to the transferpricing rules. It provides that where payments for services rendered by a foreign
affiliate are deductible in computing the income of a business carried on in Canada
by any person in relation to whom the affiliate is a controlled foreign affiliate or by
a person related to that person, income pertaining or incident to those services is
deemed to constitute income from a business other than an active business.
The rationale underlying the enactment of this provision differs slightly from
the rationale for the other provisions discussed above. In contrast to the sale of
property, insurance, or Canadian debt or lease obligations, there may be a valid
reason for rendering services through a controlled foreign affiliate. The provision
of services may require technology and managerial expertise to cross jurisdictional
boundaries. Outsourcing services could definitely be an engine of growth. Yet
Canadian-resident corporations could be taxed on an accrual basis on this type of
income. This rule reflects the importance of services in the Canadian economy.
Indeed, in this case, the FAPI rules depart from neutrality to ensure that a foreign
affiliate will not take advantage of the development of communications technology
to offer services from a distance.
It is of particular significance in this regard to note that paragraph 95(2)(b) is
one of the few elements of the FAPI system to stray from the tax base allocation under
the model tax convention of the Organisation for Economic Co-operation and
Development (OECD),75 which does not distinguish between income from an active
business and income from services. Article 7 of the model convention concedes the
right to tax business income to the contracting state in which the business is carried
on if it is carried on through a permanent establishment.
In the case of the provision of services, there is little doubt that a permanent
establishment exists in the jurisdiction in which the business is carried on. Pursuant
to article 5 of the model convention, a permanent establishment is defined as a
“fixed place of business through which the business of an enterprise is wholly or
partly carried on.” Generally, when services are provided, there will be such a fixed
73 See Marconi, supra note 51.
74 See Canada Trustco, supra note 55.
75 Organisation for Economic Co-operation and Development, Model Tax Convention on Income
and on Capital: Condensed Version (Paris: OECD, January 2003) (herein referred to as “the model
convention”).
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place of business. Indeed, employees will give the business a physical presence.
Furthermore, where there are employees, the place of business cannot easily be
moved and will thus be fixed.76
In contrast, in the case of the other sources of income discussed above, a permanent establishment will probably not exist, either because of the truly passive nature
of the investment or because the definition of permanent establishment under the
model convention excludes certain types of facilities and activities.77 In the case of
insurance or debt and lease obligations, there is no need for physical presence.
Furthermore, this type of activity will almost always lead to activities that are
auxiliary in nature. The sale of property, on the other hand, could not give rise to a
permanent establishment because the use of facilities for the sole purpose of storage
or delivery of goods, the maintenance of merchandise for the purpose of processing by another enterprise, and the maintenance of a fixed place of business for the
sole purpose of selling and reselling goods are excluded.
Capital Gains
The taxable portion of capital gains, to the extent that they accrued after the
affiliate’s 1975 taxation year, is also included in FAPI unless the gains accrued from
the disposition of “excluded property.” The definition of “excluded property” in
subsection 95(1) is particularly concerned with the active nature of a business. The
destination of the property sold determines whether or not the capital gain will be
taxable in Canada. Excluded property includes property used or held by a foreign
affiliate principally for the purpose of gaining or producing income from an active
business.78 It also includes shares of the capital stock of another foreign affiliate of
the taxpayer where all or substantially all of the property of the other foreign
affiliate is excluded property,79 and an amount receivable the interest on which is,
or would be if interest were payable thereon, income from an active business.80
These exceptions reflect the particular importance of active business. Relief from
tax encourages the purchase of machinery and equipment that can contribute to
the creation of global wealth.
Summary
The foregoing review of the deeming rules indicates that whenever the sole raison
d’être of a controlled foreign affiliate is to shelter income from Canadian tax, whenever the affiliate has no bona fide business purpose, the Act deems the income from the
business to be income from a business other than an active business.
76 Li, supra note 9, at 467-73.
77 Article 4(4) of the OECD model convention.
78 See paragraph (a) of the definition of “excluded property” in subsection 95(1).
79 See paragraph (b) of the definition of “excluded property” in subsection 95(1).
80 See paragraph (c) of the definition of “excluded property” in subsection 95(1).
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Exclusions from FAPI: Active Business
Income and Other Income
Unlike passive or “tainted” income, active business income is excluded from FAPI.
As defined in subsection 95(1), active business income is income other than income
from an investment business or from a business deemed to be a business other than
an active business. It also includes certain types of income that would otherwise
qualify as income from property. When the taxpayer has a qualifying interest,
income derived from activities that can reasonably be considered to be directly
related to an active business carried on in a foreign jurisdiction and income derived
from interaffiliate payments, from the factoring of accounts receivable, or from
loans and lending of assets is deemed to be active business income.81 Interaffiliate
dividends are also excluded from FAPI.82
Calculation of FAPI
With regard to the tax treatment of foreign direct investment made through
foreign subsidiaries, Canada adopted an exemption and credit system. Active business income is exempt, thus reflecting capital import neutrality, whereas FAPI, after
deduction of foreign accrual tax, is included in the income of the multinational
corporation residing in Canada.
The amount of FAPI, calculated separately for each controlled foreign affiliate
and on a share-by-share basis, depends upon the participating percentage of the
controlled foreign affiliate at the end of the affiliate’s taxation year. “Participating
percentage” is defined in subsection 95(1). Although “participating percentage” is
not synonymous with “equity percentage,” the “participating percentage” will be
equal to the “equity percentage” where there is only one class of shares and the
FAPI of the affiliate for that year exceeds $5,000. Below this threshold, the participating percentage is nil.83
The system also provides relief for foreign taxes paid by a particular affiliate or
any other foreign affiliate of a taxpayer in respect of a dividend received from the
particular affiliate. Calculated separately in respect of each controlled foreign
affiliate, the deduction is limited to the lesser of two amounts: the amount of FAPI
imputed to the parent corporation in respect of the particular affiliate for the year
and for the five preceding years, and the amount of Canadian tax the affiliate would
have paid had it earned its income in Canada. Consequently, where an affiliate pays
more tax in the foreign country than it would have paid in Canada, the excess
amount cannot be used by the parent corporation to reduce the amount of Canadian tax payable in respect of income earned directly or through other affiliates.
81 See the definition of “active business income” in subsection 95(1) and paragraph 95(2)(a); and Li,
supra note 35, at 13-14.
82 Li, supra note 35, at 18.
83 See paragraph (a) of the definition of “participating percentage” in subsection 95(1).
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Since the very basis of the FAPI system is taxation on an accrual basis, relieving
provisions were inserted in the Act to ensure that, in the event that shares were
redeemed or sold, no double taxation would be incurred. Thus, the cost base of the
shares held by the taxpayer is adjusted to reflect the fact that income derived from
those shares has already been taxed. On the other hand, when retained earnings of
the controlled foreign affiliate are ultimately distributed, the cost base has to be
adjusted again to reflect the tax treatment of dividends paid out of previously taxed
FAPI.84
Consequently, the FAPI system, through complex rules, ensures that taxpayers will
not suffer the sting of double taxation. Through a system of inclusion and exclusion
based on the source of income, Canada strove to provide tax treatment that would
prevent tax avoidance, preserve export and import neutrality for income that Canada
believes to be beneficial, and preserve Canada’s competitiveness.
TA X REFORM: IS IT TIME TO GET
RID OF FICTIONS?
But for the obvious inefficiency of the corporate residence test, the FAPI system
would never have been created. Its adoption exemplifies the incremental approach
preferred by Canada’s tax authorities. Instead of revising the flawed concept that is
at the heart of the corporate tax system, they fashioned a set of rules that would
minimize the significance of its failures. Nonetheless, any attempt to defeat the
cleverness of tax planners or to better accomplish policy objectives should not be built
upon existing principles simply because they are recognized and well established.
The analogy on which Lord Loreburn relied in setting out the residence test
might have had some value and some grounding in reality when he proposed it
almost a hundred years ago; it might have been the result of a legitimate intent to
respect the boundaries imposed by the tax legislation that then prevailed. However,
without the adoption and constant modification of compensating measures, the
residence test appears to be ill suited to the complexities of global commerce and
the high level of integration of multinational corporations in the 21st century.
Indeed, there appears to be an inherent contradiction in the idea that a multinational corporation that extends its reach throughout the world could have a single
residence. This notion does not reflect economic reality. The disconnection is only
increased by the separate legal identity of corporations, which means that multinational corporations can consist of many separate entities. The number of subsidiaries
in relation to the number of multinational corporations is evidence of this fact;
according to UNCTAD, a United Nations agency, in 2003 there were 64,000 international corporations with 175,000 subsidiaries.85
84 See subsection 91(1), and Li, supra note 35, at 39. For further information concerning the cost
base adjustment of shares and the distribution of retained earnings in the context of FAPI, see
Nikolakakis, supra note 10.
85 Reported in “Corporate Tax: A Taxing Battle,” The Economist, January 31, 2004, 71.
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Some commentators, despairing of a solution to the problems raised by corporate residence, go so far as to call for the abandonment of worldwide taxation and
the adoption of territorial systems. Brian Arnold is skeptical about the feasibility of
such proposals.86 In his view, residence-based taxation should not be discarded so
readily. Even if it causes tax lawyers, tax planners, and tax authorities headaches,
Arnold believes the corporate residence test can be “tweaked or supplemented” to
ensure that it can no longer be used as a tax-avoidance tool.87
Couzin suggests that new tests could be added to the existing tests of place of
incorporation and central management and control.88 Day-to-day management,
among other things, is suggested as a proper nexus. Michael McIntyre, on the other
hand, considers that the central management and control test should be redefined
in terms rendering the test less open to manipulation.89 To him, “ceremonial events,”
such as the annual shareholders’ meeting, should not be considered central to the
determination of place of management.90 However, as Couzin himself underscores,
treaty tie-breaker rules could defeat such attempts at redefinition since they could
still work in favour of the other country.91
Controlled foreign affiliates could also be deemed to reside in Canada. However, as Arnold points out, enforcement difficulties could arise for tax authorities if
those foreign entities did not have assets in Canada. Thus, the Canadian shareholders would have to be taxed, but instead of paying tax “on their pro rata share of
[the] FAPI [of the subsidiary], they would be liable for their pro rata share of the
foreign corporation’s Canadian tax on its worldwide income.”92 Under such a
regime, problems relating to the characterization of income and tax base allocation
would not be eliminated. Rules adopted under the FAPI system would simply have
to be modified to reflect this reality.
Another possibility would be to adopt worldwide combined reporting with
formulary apportionment.93 McIntyre suggests that the system in place in California
could be adapted to the national context. Political and economic decision makers,
however, may not be ready to take such a radical step.
Although redefining the corporate residence test appears to be necessary, considering how flawed it is and how easily tax can be avoided, certain factors support
the status quo. There is an unavoidable risk in tax law that any change designed to
solve existing problems may create new ones. Furthermore, as Arnold suggests, the
86 Arnold, supra note 41, at 1564-65.
87 Ibid., at 1561.
88 Couzin, supra note 14, at 262.
89 Michael J. McIntyre, “Determining the Residence of Members of a Corporate Group” (2003)
vol. 51, no. 4 Canadian Tax Journal 1567-73, at 1570-71.
90 Ibid., at 1571.
91 Couzin, supra note 14, at 265-66.
92 Arnold, supra note 41, at 1563.
93 See McIntyre, supra note 89, at 1570-71, and Li, supra note 9, at 599.
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defects of the residence concept may not significantly affect the ability of tax authorities to maintain tax neutrality and meet other policy objectives.94 The FAPI system
was developed in this context, and its scope in preventing tax avoidance is extensive.
However, if the tax authorities opt to retain the present approach, the rules will have
to be strengthened to ensure that further developments in global commerce and the
inexhaustible creativity of tax planners do not defeat the purpose of the regime.95
CONCLUSION
Foreign direct investment can serve as a potential engine of growth for economies
around the world. It allows technology to cross jurisdictional boundaries and reduces
production costs. It distributes knowledge and stimulates creativity, pushing our
world a little bit further every day. It has the potential to improve the standard of
living in distant, and even remote, regions of the globe. Canada should therefore not
impose unnecessary constraints by placing an undue tax burden on Canadian investments in foreign jurisdictions; at the same time, it cannot allow Canadian residents
to escape tax through the use of non-resident subsidiaries.
In a world governed by ingenuity and competitiveness, either course of action
could have fatal and unwanted consequences. It would create a strong and destructive incentive to export capital, to earn income in a foreign jurisdiction rather than
invest in the Canadian market.96 It could potentially undermine the Canadian
market. It could destroy the base of any income tax levied by tax authorities. It
would jeopardize programs that are the pride of Canadian society and that could
never exist without wealth and complementary tax measures designed for efficient
revenue collection.
The concept of corporate residence, based on the tests of place of incorporation
and central management and control, is unable to ensure the viability of our system
without recourse to anti-avoidance measures. The FAPI system is an example of
such measures. In effect, it both lifts the corporate veil and allocates the tax base
through a complex set of rules. It permits the identification of the real beneficiaries
of corporate earnings and ensures that they are taxed in a way that respects policy
concerns relating to competitiveness, economic growth, and prevention of erosion
of the tax base. The foreign investment entity (FIE) regime, in section 94.1 of the Act,
is intended to complete the FAPI system by preventing deferral where a Canadian
resident invests in a foreign entity that is not a controlled foreign affiliate.
Some argue that the concept of residence-based taxation should be revisited and
propose a variety of alternatives. Others vouch for the status quo as long as the FAPI
system, completed by the FIE regime, and treaty networks are reinforced. Which
avenue tax authorities will choose, only time will tell.
94 Arnold, supra note 41, at 1565-66.
95 See Li, supra note 9, at 533.
96 See Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department of
Finance, April 1998).