When Active Business Income Becomes FAPI in Canada - Part 2

In Part 1 of this series, we discussed the fundamentals of Canada's Foreign Affiliate ("FA") and Foreign Accrual Property Income ("FAPI") rules.

At a high level, income from property and investment businesses can generally be FAPI, while income earned from an active business carried on by a Foreign Affiliate ("FA") is generally not. Typically, provision of services and sale of goods are considered active business and not FAPI. However, Canada's Income Tax Act ("ITA") contains a number of specific rules that can deem income that would otherwise appear to arise from an active business to be FAPI.

The general purpose of these provisions is to prevent shifting of income from Canada to another jurisdiction (i.e. base erosion).

In this Part 2, we will look at three common scenarios to watch out for:

1. When a FA provides services to a related Canadian person;

2. When a FA provides services to third party clients and subcontracts the work to a related Canadian person; and

3. When a FA sells goods to a related Canadian person.

1. Foreign Affiliate Provides Services to a Related Canadian Person

Consider a Canadian corporation that establishes a foreign subsidiary to provide services to its Canadian operations.

The foreign subsidiary may have its own employees, office and management outside Canada. From a commercial perspective, it may clearly appear to be carrying on an active service business.

However, paragraph 95(2)(b)(i) of the ITA can produce a different result for FAPI purposes.

Broadly, where a FA provides services and the amount paid for those services is deductible in computing income from a business carried on in Canada by the Canadian taxpayer, or certain persons who do not deal at arm's length with the taxpayer or FA, the resulting income would be deemed to be FAPI despite the fact that the revenue is service in nature.

Example

Refer to Exhibit 1 below. Assume CanCo owns 100% of IndiaCo (a corporation resident in India). IndiaCo has an office in India and employs 20 people who provide R&D, IT, and administrative services to CanCo.

During the year, IndiaCo charged $100 to CanCo for these services and CanCo deducted this fee in computing its Canadian taxable income.

At first glance, IndiaCo appears to earn active business income. It has employees, an office and conducts its operations in India.

However, because the service fee is deductible in computing Canco's income from a business carried on in Canada, 95(2)(b)(i) would deem IndiaCo's income to be FAPI. In computing the FAPI however, IndiaCo may deduct expenses that reasonably relate to the services income (e.g. salary for its employees, rent, etc.).

Furthermore, FAT deduction may be available to the extent that IndiaCo paid income tax in India with respect to the income that is FAPI.

It is critical to understand that this income is not very forgiving. Many businesses say:

• The fees charged by IndiaCo are arm's length price and we've performed transfer pricing analysis; or

• This structure is the norm in our line of business. Everyone has offshore R&D department or offshore administrative team and this is how we stay competitive in our market.

An arm's-length transfer price or valid commercial rationale does not, by itself, prevent 95(2)(b) from applying. The analysis ultimately depends on the statutory requirements and exclusions discussed below.

It is also worthwhile to note that 95(2)(b)(i) is broader than the Canadian business scenario discussed here and can also apply in certain circumstances where the corresponding amount is deductible in computing another foreign affiliate's FAPI

2. Foreign Affiliate Provides Services to Third Parties but Related Canadian Persons Perform the Work

The services FAPI rules can also apply in a much less obvious situation.

Suppose a FA provides services entirely to unrelated customers outside Canada. One might assume that 95(2)(b) cannot apply because the customers are unrelated and no Canadian person is paying the FA.

However, the rules also look at who actually performs the services.

95(2)(b)(ii) can deem service activities to be FAPI activities to the extent that the services are performed by the Canadian taxpayer or certain non-arm's length persons.

Example

Refer to Exhibit 2 below. Assume CanCo owns 100% in USCo (corporation resident in the US).

USCo enters into consulting engagements directly with a third party US Client.

During the year:

• USCo invoices its third-party customers $105;

• USCo is legally responsible for delivering the consulting services; and

• USCo subcontracts the work to CanCo and CanCo's employees in Canada performs the services and charges USCo $100.

  
  

Canco may charge USCo an arm's length subcontracting or service fee for the work performed in Canada.

Nevertheless, to the extent that the services USCo agreed to provide are actually performed by Canco or other relevant non-arm's-length Canadian persons, 95(2)(b)(ii) can deem the relevant activities to be FAPI activities.

As a result, $5 of profit retained by USCo in this situation would be considered as FAPI.

The rationale of this rule is that CanCo could have directly provided services to the third party client and earned $105. However, in the current arrangement, $5 is shifted to a jurisdiction outside of Canada.

Not Every Activity is a "Service" for These Rules

It is important to note that, 95(2)(b) recharacterizes certain services income to FAPI. As such, for 95(2)(b) to apply, the FA must be performing a "service".

What constitutes a "service" is broad but 95(3) contains specific exclusions on what constitutes "services" for purposes of 95(2)(b).

For example, the definition generally excludes:

• Transportation of persons or goods;

• Services performed in connection with the purchase or sale of goods;

• Certain transmission activities outside Canada; and

• Certain manufacturing or processing activities performed outside Canada under contract involving property owned by the Canadian taxpayer.

  (Unfortunately, there are no exclusions for receiving a bad service at your local restaurant despite one's strong conviction that they received no service).
  

Accordingly, the specific activities being performed should be reviewed before concluding that subsection 95(2)(b) applies.

With respect to the exclusion for services performed in connection with the purchase or sale of goods, CRA's interpretation is quite narrow and only relates to activities that are more immediately linked or related to the process of selling goods and transferring property in the goods from the seller to the purchaser (i.e. identifying and obtaining agreement as to the parties to the contract, the goods to be sold, the price to be paid and manner of payment and arranging for delivery of risk in, title to and possession of the goods sold).

Interesting piece is that in 2024, a court decision was released by the Tax Court of Canada (BlackBerry Limited v. The King) where the Court found that paragraph 95(2)(b)(i) did not apply to the particular set of facts because the service arrangements did not result in net erosion of the Canadian tax base. Alternatively, the Court found that the R&D services fell within the exclusions in subsection 95(3), including services performed in connection with the sale of goods and certain manufacturing or processing activities.

The decision potentially represents a broader interpretation of these provisions than the CRA has historically applied. However, the decision is under appeal to the Federal Court of Appeal and should therefore be followed with caution.

3. Foreign Affiliate Sells Goods to a Non-Arm's Length Canadian Person

The third scenario in which income which seemingly is derived from active business may nevertheless be FAPI involves the sale of goods rather than services.

Suppose a FA operates a genuine distribution business outside Canada and sells goods to its Canadian parent or another related Canadian company.

Again, one might assume that the FA simply earns active business income from buying and selling goods.

However, paragraph 95(2)(a.1) can cause certain sales income to be treated as income from a business other than an active business.

Broadly, the rule can apply where:

• The FA earns income from selling property;

• The cost of the property to the purchaser is relevant in computing income from a business carried on by the Canadian taxpayer or certain related Canadian persons; and

• The property was not manufactured, produced, grown, extracted or processed in the country in which the FA is organized and principally carries on its business.

  
  

Where the rule applies, the sale of the property is deemed to constitute a separate business other than an active business, and the resulting income can therefore become FAPI.

Example

Assume Canco owns 100% of USCo (a corporation resident in the US). USCo carries on a distribution business in the US.

During the year:

• USCo purchases products manufactured by an unrelated supplier in Brazil for $100;

• USCo sells the products to Canco for $105; and

• Canco subsequently sells those products to Canadian customers.

  
  

Commercially, USCo appears to be carrying on an active distribution business.

However:

• The cost of the products purchased by Canco is relevant in computing Canco's Canadian business income (i.e. it forms CanCo's cost of goods sold when it sells goods to ultimate Canadian customers); and
  

• The products were manufactured in Brazil, rather than US, where USCo is organized and principally carries on its business.
  

As a result, subsection 95(2)(a.1) would need to be considered. If the provision applies, no exceptions are met and USCo is a CFA, the resulting income from those sales could be FAPI even though USCo is carrying on a genuine distribution business.

Importance of Country of Manufacturing

An important part of subsection 95(2)(a.1) is the location where the property is manufactured or produced. In other words, 95(2)(a.1) applies when the goods are not manufactured, produced, grown, extracted or processed in the country in which the FA is organized and principally carries on its business.

Using the example above, if the goods were manufactured in the US, the 95(2)(a.1) would not be operative. There is no requirement that USCo itself manufactures the goods.

90% Arm's Length Sale Safe Harbour

Another exception to the rule is a 90% safe harbour. Highly simplified, this exception could apply where more than 90% of the FA's gross revenue from sale of goods are made to arm's length third parties.

For example, assume USCo sells 95% of its products to unrelated customers around the world and only 5% to its Canadian parent.

In this situation, the 90% exception may prevent subsection 95(2)(a.1) from applying.

However, it is worth noting that 95(2)(a.1) and its exceptions are highly complex. There are also additional exceptions and deeming rules, including rules for certain designated property and contract manufacturing arrangements, which are beyond the scope of this article.

Final Thoughts

A common misconception is that a genuine operating business carried on by a FA will necessarily generate active business income for Canadian tax purposes.

As the examples above demonstrate, that is not always the case.

Where a Foreign Affiliate provides services to a related Canadian business, relies on related Canadian persons to perform services for third-party customers, or sells certain goods into a related Canadian business, specific rules can recharacterize what otherwise appears to be active business income as FAPI.

For Canadian businesses expanding internationally, the FAPI analysis therefore involves more than asking whether the foreign company has employees, premises and real business operations.

It is also important to understand who the Foreign Affiliate does business with, who actually performs its work, and how goods move through the international supply chain.

In Part 3, we will discuss Canada's new Foreign Accrual Business Income ("FABI") rules and how they can change the treatment of certain amounts that are otherwise included in FAPI.

Warm regards, 

Francis Do, CPA, CA

Have any questions? Please contact Francis Do at Francis@francisdo.com or 416-572-9633.

Disclaimer: This article is not intended to be a tax advice. Always consult and verify with a tax professional.