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12.3.1. Main Rules

Under Canada’s Foreign Accrual Property Income (FAPI) rules, Canadian residents are taxed on  certain ‘investment’ incomes of a controlled foreign affiliate. Such income includes passive income such as dividends, interest, rents and royalties, certain income from property, and in some cases capital gains. FAPI is included in a Canadian taxpayer’s income in the year it is earned.

A foreign company is considered a controlled foreign affiliate when the Canadian resident along with other related persons owns at least 10% of the foreign company, and the Canadian resident owns at least 1% itself.

The FAPI rules are not applicable to regulated foreign financial institutions, which carry out bona fide active financial services (as against an ‘investment’ business). With an aim to curb certain financial institutions that primarily carry out proprietary activities (ie, investing or trading in securities on their own account rather than facilitating financial transactions for customers) from availing this exemption from FAPI rules, the Canadian government, in 2014, introduced stringent conditions for qualifying as a regulated foreign financial institution, The government has indicated that, In addition to satisfying these conditions, a taxpayer has to demonstrate the bona fides of its regulated financial business, in order to avail the exemption.

FAPI and Captive Insurance Arrangements

Specific anti-avoidance measures have been introduced to curb the practice of shifting income from insuring Canadian risks to offshore jurisdictions. Under the Income Tax Act, income of a foreign affiliate from the insurance of risks in respect of persons resident in Canada, property situated in Canada or businesses carried on in Canada (“Canadian Risks”) is considered as FAPI and taxable in the hands of the Canadian taxpayer under accrual basis, if more than 10% of the controlled foreign affiliate’s gross premium revenue (net of reinsurance ceded) is in respect of Canadian Risks.

Effective 1 January 2014, the scope of FAPI to such captive insurance arrangements was expanded to cover insurance swap arrangements (i.e. arrangements where foreign affiliate insures foreign risks but maintains economic exposure to Canadian Risks).Prior to 2014, subject to other rules in the Act, income from such arrangements would qualify as ‘active business income’ of the foreign affiliate and hence excluded from the scope of FAPI, if such arrangements were structured in a manner where the foreign affiliate did not own the Canadian Risk but only retained economic exposure.  However, the Federal Budget 2014, deems such foreign risks to be related to Canadian Risks and applies when:

  • The affiliate’s risk of loss or opportunity for gain or profit in respect of foreign risks would reasonably be considered to be determined by reference to certain criteria in respect of other risks (the “tracked policy pool”) that are insured by other parties’; and
  • and at least 10% of the tracked policy pool comprises Canadian Risks

The Budget 2016, introduced further amendments to the captive insurance rules, to ensure that ceding of Canadian Risks by a controlled foreign affiliate would be taxable in Canada.

Foreign Account Tax Compliance Act (FATCA)

In 2010, the government of United States of America, enacted the Foreign Account Tax Compliance Act (FATCA) provisions, which require non-US financial institutions to identify accounts held by US persons (including those living outside USA), and report them to the US Internal Revenue Service (IRS) . On 5 February 2014, the Canadian government entered into an agreement with the United States, to provide for significant exemptions and relief under the FATCA rules. Canadian financial institutions are required to report the necessary information under FATCA to the Canada Revenue Agency (CRA) which isthen transmits to the IRS under the Canada-US tax treaty, subject to confidentiality safeguards. A variety of registered accounts (including Registered Retirement Savings Plans, Registered Retirement Income Funds, Registered Education Savings Plans, Registered Disability Savings Plans, and Tax-Free Savings Accounts) and smaller deposit-taking institutions, such as credit unions, with assets of less than CAD 175 million are exempt from reporting. The reporting requirements under the FATCA are effective July 2014.

As part of the Canada-US agreement, the CRA will receive information from the US in respect of Canadian resident taxpayers that hold accounts at US financial institutions. While the Canada-US tax treaty contains a provision that allows a country to collect the taxes imposed by the other country, the CRA will not collect the US tax liability of a Canadian citizen if the individual was a Canadian citizen at the time the liability arose (whether or not the individual was also a US citizen at that time). This enhanced tax information exchange has been implemented in 2015.

Debt Parking Rules

Under the Canadian tax laws, in computing the taxable income, all amounts must be denoted in CAD. Any foreign currency amount has to be converted to CAD and thereafter included in the income computation. Due to such currency fluctuations, the taxpayer may realize foreign exchange gain or loss on repayment of foreign currency debt. To avoid realizing foreign exchange gain on repayment of a foreign currency debt, some taxpayers enter into a ‘debt-parking’ transaction. To counter such transactions, the Federal Budget 2016, introduced rules that require any accrued foreign exchange gain on foreign currency debt to be realized when the debt becomes a parked obligation.

Cross-Border Surplus Stripping

The Canadian tax laws contain ‘anti-surplus-stripping’ rules, to prevent non-resident persons from extracting/ stripping the retained earnings or surplus from a Canadian resident corporation in excess of the paid-up capital of its shares on a tax-free basis. In particular, the rule applies where non-resident persons dispose of their shares of a Canadian resident corporation to another Canadian resident corporation, with which the non-resident person does not deal at arm’s length.

An exception to the above rule was applicable to ‘sandwich’ structures, where the non-resident corporation is "sandwiched" between two Canadian corporations and the non-resident corporation disposes of shares of the lower-tier Canadian corporation to the Canadian corporation to eliminate the sandwich.

With a view to restrict any unintended use of the exception rule, the Federal Budget 2016, amended the exception criteria, to provide that the exception does not apply to dispositions occurring after 21 March 2016, where at the time of the disposition the non-resident person:

  • Owns, directly or indirectly, shares of the Canadian corporation; and
  • Does not deal at arm’s length with the Canadian corporation.

Automatic Exchange of Tax Information

Canada intends to implement OECD’s Common Reporting Standard starting 1 July 2017, allowing a first exchange of information in 2018. Canadian financial institutions will be expected to identify accounts held by non-residents and to report the required information to the Canada Revenue Agency (CRA). The CRA intends to formalize exchange arrangements with foreign jurisdictions, having verified that each jurisdiction has appropriate capacity and safeguards in place, and thereafter exchange information on a reciprocal, bilateral basis.