Foreign Accrual Business Income (FABI) Rules in Canada - Part 3
- Francis Do
- 16 hours ago
- 9 min read
In Part 1 of this series, we discussed the fundamentals of Canada's Foreign Affiliate ("FA") and Foreign Accrual Property Income ("FAPI") rules. We also discussed the Foreign Accrual Tax ("FAT") deduction under subsection 91(4) and an important change affecting Canadian controlled private corporations ("CCPCs").
Very generally, where a Controlled Foreign Affiliate ("CFA") earns FAPI and pays foreign income tax on that income, the Canadian shareholder may claim a deduction based on:
Foreign Accrual Tax × Relevant Tax Factor ("RTF")
For CCPCs, the RTF was reduced from 4 to 1.9 for taxation years beginning on or after April 7, 2022. As illustrated in Part 1, the following example shows the impact of this change where a CFA earns $100,000 of FAPI and pays $25,000 of foreign tax:
Before 2022 RTF Change | After 2022 RTF Change | |
FAPI | $100,000 | $100,000 |
Foreign Accrual Tax | $25,000 | $25,000 |
RTF | 4 | 1.9 |
Subsection 91(4) deduction | ($100,000) | ($47,500) |
Remaining taxable amount | nil * | $52,500 |
* As a side note, prior to 2022, it was actually advantageous for a CFA of a CCPC to earn passive income if the CFA operated in a jurisdiction in which it was subject to 25% tax. As you can see, there is no remaining taxable amount that the CCPC needs to report on its Canadian corporate tax return. Contrast this to situation where the CCPC earns passive income directly. It would have been subject to tax rate of ~51% in Canada. This type of planning is what the Department of Finance aimed to curtail with the 2022 rule change.
Because the Canadian shareholder is a CCPC, that remaining amount would generally be included in its Aggregate Investment Income ("AII") and subject to the high corporate tax rate applicable to investment income.
However, there is an important problem with treating all FAPI this way.
As we discussed in Part 2, not everything that is technically FAPI is passive investment income. Canada's FAPI rules can sometimes recharacterize income from a genuine operating business as FAPI.
Canada's new Foreign Accrual Business Income ("FABI") rules are intended to address this mismatch.
1. Why Were the FABI Rules Introduced?
The logic behind the rules is relatively straightforward. Passive investment income earned by a CCPC is generally subject to a high corporate tax rate because the tax system does not want an individual to obtain a significant tax deferral simply by holding investments inside a private corporation.
The same policy is reflected in the FAPI regime. That is why the RTF applicable to a CCPC was reduced from 4 to 1.9. The lower RTF generally leaves more FAPI taxable in the CCPC and causes that amount to be taxed under the refundable investment income regime.
However, FAPI is broader than passive investment income. As we saw in Part 2, a foreign affiliate could have employees, an office and genuine business operations outside Canada, yet still have income deemed to be FAPI under specific provisions of the Income Tax Act.
If that same income had instead been earned directly as business income by the Canadian corporation, it would not ordinarily have been subject to the approximately 50% corporate tax rate applicable to investment income.
The FABI regime attempts to correct this result. Broadly, it identifies the portion of FAPI that is more business like in nature and allows a CCPC to obtain tax treatment that more closely resembles the treatment that would have applied if that income had been earned as business income in Canada.
2. What is Foreign Accrual Business Income in Canada?
It is important to understand that FABI is not some sort of exclusion from FAPI. FABI is FAPI. Therefore, where a CFA earns FABI, the Canadian taxpayer would still generally have a FAPI inclusion under subsection 91(1) on its Canadian tax return.
Instead, FABI identifies a particular portion of the foreign affiliate's FAPI that satisfies additional requirements. Very generally, the FABI definition asks us to perform a hypothetical test:
"If the foreign affiliate were itself a CCPC and the relevant FAPI amounts were earned from Canadian sources, would those amounts form part of its AII?"
If the answer is yes, the income generally should not qualify as FABI. If the income would not have formed part of AII, it may potentially qualify, subject to the detailed requirements and anti base erosion rules contained in section 93.4.
What Types of FAPI Can Qualify as FABI?
FABI is generally most relevant where income is treated as FAPI under the foreign affiliate rules, but comparable income earned by a CCPC in Canada would not be treated as AII.
One common example is business income recharacterized as FAPI under paragraph 95(2)(b) as discussed in Part 2 of this article series. For example, a foreign affiliate may earn service income from a related Canadian company that is deemed to be FAPI even though it arises from an active commercial business. That income can potentially qualify as FABI if the payment is deductible by CanCo in computing its active business income.
FABI can also apply to certain foreign real estate businesses. For example, rental or real estate development income may remain FAPI because the foreign affiliate does not satisfy the investment business employee exception on its own, but may potentially qualify as FABI where the comparable Canadian test would be satisfied after taking relevant Canadian employees into account.
These examples reflect the purpose of the FABI rules: to provide more favourable treatment for certain business like income that is nevertheless caught by the FAPI rules.
3. There Are Actually Two FABI Elections
For simplicity, people may refer to a "FABI election," but section 93.4 contains two separate but related elections that deal with different stages of the investment.
Election #1: When the FAPI is Earned
Subsection 93.4(2) affects the subsection 91(4) FAT deduction when the CFA earns FABI.
Where the requirements are satisfied and the election is made, an RTF of 4 can effectively be used in determining the FAT deduction attributable to FABI, rather than the normal RTF of 1.9 applicable to a CCPC.
Election #2: When the Foreign Earnings are Repatriated
Subsection 93.4(3) deals with the later stage, when earnings are distributed by the foreign affiliate to the Canadian corporation.
The rules create the concept of FABI surplus and can allow the higher RTF of 4 to apply when calculating deductions under paragraphs 113(1)(b) and (c) in respect of the relevant taxable surplus dividend.
This is important because the FABI regime is designed to address both:
Canadian taxation when the income initially becomes FAPI; and
Canadian taxation and integration when the foreign earnings are eventually distributed to Canada.
For the numerical example below, I will assume the applicable elections are made at both stages.
4. Example
Assume the following:
CanCo is an Ontario CCPC.
CanCo owns 100% of ForeignCo, which is a CFA of Canco.
ForeignCo earns $100,000 of income from providing services to CanCo. This amount is deductible in computing CanCo's active business income.
The entire $100,000 is FAPI and qualifies as FABI in respect of ForeignCo.
ForeignCo pays foreign corporate income tax of 25%, or $25,000.
ForeignCo distributes its after-tax Year 1 earnings in Year 2 to CanCo.
There is no withholding tax on distribution by ForeignCo.
The ultimate individual shareholder is an Ontario resident taxed at the top marginal rate (39.34% on eligible dividend and 47.74% on ineligible dividend).
Tax savings for CanCo on the service fee expense of $100,000 is ignored.
Let's compare the result with and without the FABI elections.
Year 1 — ForeignCo
No FABI Election | FABI Election | |
Services Income | $100,000 | $100,000 |
Foreign Tax (25%) | $(25,000) | $(25,000) |
After-Tax Earnings in ForeignCo | $75,000 * | $75,000 |
** $75,000 would be added to taxable surplus of ForeignCo and $25,000 would be added to the underlying foreign tax pool. These would be relevant in Year 2 when CanCo claims 113(1)(b) deduction.
Year 1 — CanCo
No FABI Election | FABI Election | |
FAPI inclusion — s.91(1) | $100,000 | $100,000 |
91(4) FAT deduction (Foreign tax × RTF) | $(47,500) (RTF 1.9) | $(100,000) (RTF 4) |
Net taxable FAPI | $52,500 | $0 *** |
CCPC tax on investment income (permanent, 19.5%) | $(10,238) | $0 |
CCPC tax on investment income (refundable, 30.67%) * | $(16,102) | $0 |
Net after-tax funds remaining within corporate group ** | $48,660 | $75,000 |
* The refundable portion is recoverable later, but only once a taxable dividend is actually paid. See Year 2 below.
** Services Income less Foreign and CCPC tax on investment income.
*** If the foreign tax rate was only 20% so that the CFA only paid $20,000 in foreign taxes, the enhanced FAT deduction would generally be: $20,000 × 4 = $80,000. This leaves $20,000 taxable in Canco. However, because the amount is attributable to FABI, it is generally excluded from AII. It would therefore be subject to ordinary corporate taxation rather than the additional refundable tax regime applicable to investment income.
Year 2 — CanCo
No FABI Election | FABI Election | |
Dividend received (= Year 1 after-tax earnings of ForeignCo) | $75,000 | $75,000 |
113(1)(b) deduction — (RTF − 1) × underlying foreign tax | $(22,500) (RTF 1.9) | $(75,000) (RTF 4) |
91(5) deduction (previously-taxed FAPI) * | $(52,500) | $0 |
Net taxable dividend | $0 | $0 |
Refund of Year 1 refundable tax (RDTOH-type refund) | $16,102 | $0 |
Amount available for dividends | $64,762 | $75,000 |
* The subsection 91(5) deduction is intended to prevent double taxation in situations where CanCo has already included and paid Canadian tax on the underlying income as FAPI in Year 1. When that same income is subsequently repatriated, it should generally not be subject to Canadian tax again.
Year 2 — Personal Tax (shareholder level)
No FABI Election | FABI Election | |
Capital dividend (tax-free, added to CDA) | $22,500 * | — |
Eligible dividend ** | — | $75,000 |
Non-eligible dividend | $42,262 | — |
Personal tax — eligible dividend (39.34%) | — | $(29,505) |
Personal tax — non-eligible dividend (47.74%) | $(20,176) | — |
After-tax cash to shareholder | $44,586 | $45,495 |
Overall Effective tax rate | 55.41% | 54.51% |
* Where no subsection 93.4(3) FABI election is made, the relevant amounts deductible under paragraphs 113(1)(b) and (c) in respect of the foreign affiliate dividend are generally added to the corporation’s capital dividend account (“CDA”), subject to an adjustment for foreign withholding tax (if applicable). The corporation may generally distribute its CDA balance as a tax-free capital dividend to a Canadian-resident individual shareholder.
** Where a CCPC makes the subsection 93.4(3) election and receives a dividend out of a foreign affiliate’s FABI surplus, the relevant amounts deductible under paragraphs 113(1)(b) and (c) are generally added to the CCPC’s general rate income pool (“GRIP”), subject to an adjustment for foreign withholding tax (if applicable).
In this example, making the FABI elections improves the shareholder's ultimate after tax outcome by approximately $909. However, the potentially more significant benefit is the tax deferral. Without the FABI election, Canco pays approximately $26,340 of Canadian corporate tax in Year 1, including $16,102 of refundable tax that generally remains unavailable until Canco pays sufficient taxable dividends.
With the FABI election, the full $75,000 of ForeignCo's after tax earnings can remain within the corporate group. If those funds remain invested in the business for several years before being distributed personally, the value of that tax deferral can be significant.
5. FABI Is Not Automatic
It is important not to assume that any active looking FAPI automatically qualifies for FABI. The definition contains detailed requirements and anti base erosion provisions.
For example, if the foreign affiliate earns management fees that would normally be business income, such income may nevertheless not qualify as FABI if the corresponding payments reduce investment income subject to high investment tax rate in a related CCPC or reduce non FABI FAPI of another foreign affiliate.
This makes sense given that FABI is intended to provide relief for business like income that happens to be caught by the FAPI rules. It is not intended to allow passive or other highly taxed income within a corporate group to be converted into income eligible for more favourable FABI treatment simply by moving deductions or payments around the corporate group.
6. When Do the New Rules Apply?
The FABI rules generally apply to taxation years beginning after 2025. Accordingly, for a corporation with a calendar year end, the rules would first apply to its taxation year beginning January 1, 2026.
The FABI elections under subsections 93.4(2) and (3) generally must be filed by the corporation's filing due date for the applicable taxation year. For a calendar year corporation, the election in respect of its 2026 taxation year would therefore generally be due by June 30, 2027.
Importantly, transitional elections are also available for taxation years beginning before 2026. Subsections 93.4(4) and (5) can effectively extend the FABI regime to those earlier taxation years. These transitional elections must generally be made by the filing due date for the taxpayer's first taxation year beginning after 2025.
For example, a calendar year corporation that wants to make the applicable transitional elections for its historical FAPI and FABI surplus would generally have until June 30, 2027 to do so.
The actual deadline will depend on the corporation's taxation year end. Therefore, CCPCs with foreign affiliates should review their historical FAPI, foreign tax and taxable surplus balances before the filing deadline for their first taxation year beginning after 2025.
Final Thoughts
The FABI rules add another layer of complexity to Canada's already complicated foreign affiliate regime, but they also provide meaningful relief. For a CCPC with foreign operations, it is no longer enough to determine simply whether income is FAPI. Rather, where FAPI exists, the analysis should now continue to determine whether some or all of FAPI is FABI.
This is particularly important where the FAPI arose from income that commercially resembles operating income, such as services or other business activities that have been recharacterized as FAPI under the foreign affiliate rules.
If the income qualifies, the FABI elections can restore the RTF of 4, remove the relevant amount from the CCPC's investment income regime and provide corresponding relief when the foreign earnings are ultimately repatriated.
For Canadian private companies expanding internationally, this can significantly change the timing of Canadian tax and the economics of holding earnings inside a foreign subsidiary.
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.
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