Name of the book: How Canada taxes Foreign Income
(Guide to Practitioners and new Canadian Immigrants)
Bird’s Eye View of the Canadian Tax System
Canada has a self-assessing tax system. Canada tax rates are among the highest in
the world while internationally Canada has been consistently ranked among the top as
the best country to live in.
The tax system is based on the Income Tax Act which was first introduced as the War
Act during the Second World War. It usually taxes income only. It was overhauled
in 1970 and since then it taxes capital gain at 50% or 75% at different periods of time
depending on fiscal policy. Department of Finance proposes and makes changes to
the Canadian Income Tax Act (ITA) while Department of National Revenue through
Canada Revenue Agency (CRA) administers and enforces the ITA.
The Canadian tax system is based on residency, individual or corporation. Canadian
residents are taxed on worldwide income and thus would include capital gains on
foreign assets realized (or deemed realized) by a resident of Canada. Since 1971
Canada did not impose tax on gift and estate tax. Individuals and trusts, resident or
non-resident, are required to file income tax returns on annual basis while most
corporations and testamentary trusts are allowed to have year-end other than the
calendar year-end.
Visitors sojourning in Canada over 183 days in aggregate in a year will be deemed
residents of Canada for that year and taxed on worldwide income earned in that whole
year. If the visitors are residents of a country which has a tax treaty with Canada,
then the treaty tie-breaker rule will have the final say in determining their residency.
Non-residents of Canada are subject to tax on certain Canadian source income, such
as capital gains on assets described as taxable Canadian property. The main assets
included in the category of taxable Canadian property are real property situated in
Canada, shares of private Canadian corporations, shares of public corporations (if a
related group has held more than 25% during the five-year period preceding
disposition) as well as some natural resources property, and indirect interests in real
property such as partnership or trust interests or in some cases shares of foreign
corporations. Gifts or bequests of taxable Canadian property by non-residents will be
subjected to the same rules as if gifted or bequested by Canadian residents, subject to
treaty over-rides. Non-residents of Canada carrying on a business in Canada are
taxed if the business is carried on through a permanent establishment, such as an
office, warehouse, manufacturing plant, a heavy equipment, etc.
Carrying on business through an agent in Canada is also subject to tax. Non-resident
investors in real estates and earn rental income they are subject to withholding tax. If
they do not have an agent in Canada who has entered into an agreement with Canada
Revenue Agency (CRA), a withholding tax of 25% will be levied on the gross amount
of the rental income subject to treaty relief. If an agent has entered into an
agreement, on annual basis, with CRA on behalf of the non-resident owner of the real
estate to guarantee that the non-resident will file an income tax return in respect of the
rental income, withholding tax is on the net rental income and not on the gross
amount.
In Canada, business is usually classified as active or inactive business. The latter
includes investment business which means a business the principal purpose is to
derive income from property such as interest, dividends, royalties, rents, etc.
Canada does not interfere with normal active business, Canadian or overseas.
No matter how much income an active business made in the years, shareholders are
only taxed on dividends being distributed by a Canadian or overseas corporation.
Dividends received from a Canadian subsidiary company are treated differently from
foreign subsidiary company known as foreign affiliate. In order to keep Canada
competitive in the international stage, foreign affiliates are taxed differently from
Canadian resident corporations under a different set of rules known as Foreign
Affiliate Rules.
Canadian inactive business is treated the same way as active business but inactive
business overseas is treated differently. Shareholders of an inactive business are
taxed when the inactive business earns inactive business income known as FAPI
(foreign accrual property income) irrespective of whether it pays out dividend or not.
The mechanics of taxing FAPI and the mechanics of avoiding double taxation on
receiving dividends eventually paid out by the foreign affiliate from which FAPI had
previously been taxed can be found in Chapter 2 for concepts and Chapter 3 for
technical explanations with references to the Canadian Income Tax Act.
The Foreign Affiliate Rules serve two main purposes. The first is to keep Canadian
companies competitive in the international market with respect to active businesses
and transactions. The second is to discourage Canadians from investing overseas in
inactive businesses so as to preserve the Canadian tax base.
Inactive business is usually conducted in tax haven countries where income, active or
inactive, is taxed at very low rate or not subject to tax at all. Canadians try to
conduct inactive business overseas to avoid high taxes in Canada using
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foreign corporations known as foreign affiliates (FA) - one of the major
advantages of using a FA is to convert inactive business income into active
business income using certain part of the Foreign Affiliate Rules. Hence
funds repatriated back to Canada may not be subject to Canadian tax.
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non-resident trusts - one of the major advantages is to convert income into
capital and then distribute as tax free distributions to Canadian beneficiaries.
Under the Canadian ITA, there are two ways to tax foreign inactive business such as
Foreign Accrual Property Income (FAPI) Rules and Foreign Investment Entities (FIE)
Rules.
Under the FAPI rules, any taxpayer having controlling interest in a foreign affiliate
(known as CFA) has to report inactive business income on current basis. Unlike
other parts of ITA, control under FAPI rules means de jury control, i.e. 50% plus. In
some extreme cases the taxpayer having 1% equity percentage of ownership in a FA
can be deemed to have a controlling interest in the FA. In this case the FA is deemed
to be the CFA of the taxpayer and any inactive business earned by the FA is deemed
to be FAPI of the taxpayer in proportion to his participating interest in the FA.
Under the proposed FIE rules, any taxpayer having some ownership interest (known
as participating interest) in the form of shares in any foreign corporation, if certain
conditions are met, is required to report on current basis the inactive business income
earned by the FIE as FAPI. Hence under the combined rules of FA and FIE, any
taxpayer having investment in a controlled foreign corporation or having shares in
foreign corporations will be required to report FAPI if these foreign corporations meet
certain criteria and earn inactive business income.
Normally a non-resident trust is not subject to Canadian tax under the existing rules of
S. 94 unless it satisfies certain conditions. If section 94 applies under the existing
rules, a non-resident trust will be deemed resident in Canada only for the calculation
of FAPI and the non-resident trust will be treated as non-resident under other
provisions of the ITA. If section 94 applies under the proposed new non-resident
rules, the non-resident trust will be deemed to be resident in Canada subject to world
income. For detailed discussion of non-resident trust rules, please refer to Chapters 5
to 7 of the book. For the proposed FIE rules, please refer to Chapters 9 to 11.
How Canadian residents, individuals or corporations, are treated under ITA when they
earn income within Canada is beyond the scope of this book. Readers may refer to
ITA and other tax related publications and rulings issued by CRA for their answers or
visit the following website for assistance and support:
www.canadataxplan.com
or email to
peterling@canadataxplan.com for immediate attention.
Legal Notes and Disclaimer
Materials contained in this document are not legal advice and should not be used as
such. Readers including online readers should not act upon this information without
seeking their professional legal counsels. The information provided in this
presentation may or may not reflect the most current legal developments.
Reproduction and distribution in any form are strictly prohibited unless prior
permission of Peter Ling Tax Consulting Inc. has been obtained.