Foreign Affiliates and FAPI Rules in Canada - Part 1

As Canadian businesses and investors expand internationally, it is becoming increasingly common for Canadians to own companies outside of Canada.

A common assumption is that if income is earned and retained inside a foreign company, Canadian tax can generally be deferred until the money is eventually distributed back to Canada. However, this is not always the case.

Canada has a set of rules called the Foreign Accrual Property Income ("FAPI") rules that can require Canadian taxpayers to report certain income earned inside a non-resident corporation even if no dividend or other distribution has been made.

Over the next three articles, we will look at:

1. The fundamentals of foreign affiliates and FAPI, including the 91(4) Foreign Accrual Tax deduction;

2. Some unexpected situations where income that looks like active business income can nevertheless become FAPI; and

3. The new Foreign Accrual Business Income ("FABI") rules.

   
   

In this Part 1, we will focus on the fundamentals.

Before determining whether FAPI applies, the first question is whether the non-resident corporation is a Foreign Affiliate ("FA"), and if so, whether it is a Controlled Foreign Affiliate ("CFA") of the Canadian taxpayer. A FAPI inclusion under subsection 91(1) of the Canada's Income Tax Act ("ITA") generally arises only in respect of a CFA.

What is a Foreign Affiliate?

At a high level, a non-resident corporation is generally a FA where:

• The Canadian taxpayer has at least a 1% equity percentage (in any class of shares) in the non-resident corporation; and
  

• The Canadian taxpayer, together with related persons, has at least a 10% equity percentage (in any class of shares) in the non-resident corporation.

Few important points are as follows:

• Given that the equity percentage is in respect of any class of shares, even if the taxpayer economically only owns a very small percentage in a corporation (say, 0.001%), if that taxpayer owns all of the shares of say, Class Z Preferred Shares (regardless of how tiny the Class Z Preferred Shares are relative to other classes of shares economically) his equity percentage would be 100% in the non-resident corporation.
  

• If the taxpayer owns multiple classes of shares, you would take the class with the highest equity percentage for the FA testing.
  

• Equity percentage takes into consideration both direct and indirect ownership (through intermediary corporations). Generally, one does not look through ownership held through a partnership except for certain specific purposes.
  

• the foreign entity must be viewed as a "corporation" under Canadian tax principles. This is typically straightforward but there are instances where there are uncertainties as to whether an entity in a certain foreign jurisdiction may be viewed as a "corporation" for this purpose. The Canada Revenue Agency ("CRA") has published various letters in which they provide their views on whether certain foreign entities would be viewed as a "corporation". For example, the CRA has indicated that they would generally view US Delaware LLP to be a corporation.
  

• The corporation must also be a non-resident. Typically, for corporations resident in a country that has a tax treaty with Canada, this would also be straightforward as most tax treaties deem a corporation to be a resident in which it is incorporated. However, for corporations in jurisdictions with no tax treaty with Canada or say, a US LLC that may not qualify for benefits under the Canada - US tax treaty, one may need to review where the mind and management of a corporation is in order to determine its tax residency.

What is a Controlled Foreign Affiliate?

At a basic level, a FA will generally be a CFA where it is controlled by:

• The Canadian taxpayer; or

• The Canadian taxpayer together with:

  • persons who do not deal at arm's length with the taxpayer;

  • Top 4 other Canadian resident shareholders ("Relevant Canadian Shareholders") of the FA and those who do not deal at arm's length with Relevant Canadian Shareholders.

However, the CFA definition can take into account the shares owned by up to four other Canadian resident shareholders, as well as certain persons who do not deal at arm's length with those shareholders.

As a result, a non-resident corporation could be a CFA of a Canadian taxpayer even if that taxpayer only owns 10% in that corporation if, four other unrelated Canadian shareholders collectively own more than 40% in that corporation. The rationale of the Relevant Canadian Shareholders rule is that if a non-resident corporation is sufficiently owned by Canadians (related or not), they should fall under the Canadian tax net.

Last but not least, there are look through rules that are relevant for CFA testing found under 95(2.01) of the Canada's Income Tax Act.

Why Does CFA Status Matter?

This is where the FAPI rules become important. Generally, a Canadian taxpayer does not pay Canadian tax simply because a foreign corporation in which it owns shares earns income.

However, where the foreign corporation is a CFA and earns FAPI, the Canadian taxpayer may be required to include its share of that FAPI in its Canadian taxable income even if no money has been distributed from the foreign company.

For example:

• Canco owns 100% of ForeignCo.

• In 2026, ForeignCo earns $100,000 of FAPI and retains the entire $100,000 within the company.

• Canco may nevertheless be required to include the $100,000 of FAPI in its 2026 Canadian taxable income.

What is FAPI Rules in Canada?

At a high level, FAPI generally includes property income and certain taxable gains earned by a CFA. Common examples can include:

• Interest

• Dividends (other than dividends received from another foreign affiliate)

• Rental income

• Royalties

• Gains from disposal of portfolio investments

FAPI can also include income from an “investment business.” Broadly, an investment business is a business whose principal purpose is to earn income from property, such as interest, dividends, rents or royalties, or certain other investment type returns. Importantly, this can apply even where significant time and effort is spent operating the business.

Income from an active business carried on by a Foreign Affiliate is generally not FAPI (but we will cover situations in which they may be FAPI in Part 2).

Exceptions to the Investment Business Rules

There is an exception to the investment business rules, but the requirements are relatively strict. Among other conditions, the business generally needs to fall within certain specified types of businesses, including:

• Development of real estate for sale;

• Lending money;

• Leasing or licensing property; or

• Insurance or reinsurance

  
  

The business must also employ more than five full time employees, or the equivalent, in the active conduct of the business throughout the period and the business must be conducted principally with arm's length parties.

For example, assume ForeignCo owns several rental properties in the foreign jurisdiction and has personnel that actively manages those properties. If the ForeignCo does not employ more than five full time employees, or the equivalent, the income would be considered to be income derived from an investment business and thus, FAPI.

Important Considerations When Computing FAPI

Computing FAPI can become complex fast. Here are some important tips:

• FAPI is computed under Canadian tax rules and for most parts, you have to pretend that the CFA is a Canadian person. This means that FAPI must be computed in CAD$ and calculations such as depreciations must be done according to Canada's Capital cost allowance ("CCA") rules.
  

• One must be wary of invisible foreign exchange gain/losses. For example, assume that the CFA is a resident of the US and has a US dollar denominated debt that was used for generating FAPI. Since FAPI is computed under Canadian rules and in CAD$, on repayment, there is likely going to be a foreign exchange gain or loss relative to CAD$ which itself would be FAPI (or loss). However, this won't be visible on the CFA's financial statements since for US accounting purposes, it's simply repaying US dollar denominated debt with no foreign exchange issue.
  

• If there are multiple CFAs and one CFA generates FAPI loss (or FAPL), such loss cannot be used to offset the FAPI of another CFA.
  

• The amount of FAPI that a Canadian shareholder is required to include in income is based on its “participating percentage” in the CFA. In a simple structure with only one class of shares, the participating percentage will generally correspond with the shareholder’s equity percentage. There is also a useful de minimis rule. Where the CFA’s FAPI for the year is $5,000 or less, the participating percentage is deemed to be nil. As a result, no subsection 91(1) FAPI inclusion generally arises in respect of that CFA for the year. Importantly, the $5,000 threshold applies to the CFA’s total FAPI, rather than the Canadian shareholder’s proportionate share of that FAPI.

Foreign Accrual Tax Deduction

If a CFA earns FAPI, there is another important question: What if the foreign country has already taxed the income?

In such cases, Canada provides relief from double taxation through subsection 91(4) or the Foreign Accrual Tax ("FAT") deduction. Generally, FAT represents foreign income or profits tax paid in respect of the income that is included as FAPI in Canada.

At a high level: FAT Deduction = Foreign Accrual Tax × Relevant Tax Factor ("RTF")

RTF is a fixed number based on who the Canadian shareholder is as follows:

Canadian Shareholder	RTF
Individual	1.9
Canadian-controlled private corporation ("CCPC")	1.9
Non-CCPC Corporation	4.0

For example, assume that a ForeignCo generates FAPI of $100,000 and pays 25% tax on the income. FAPI is the only source of income for the ForeignCo. Also, assume that the ForeignCo is wholly owned by the Canadian shareholder.

	Individual	CCPC	Non-CCPC Corporation
FAPI	$100,000	$100,000	$100,000
FAT [A]	$25,000	$25,000	$25,000
RTF [B]	1.9	1.9	4
FAT Deduction [A x B]	$(47,500)	$(47,500)	$(100,000)
FAPI less FAT Deduction	$52,500	$52,500	nil

Historically, CCPC was also entitled to a RTF of 4. However, in 2022, the Government of Canada introduced changes to bring the RTF for CCPC down to 1.9 to be aligned with the individual's RTF. The rationale was that passive income such as FAPI should be subject to the highest personal marginal tax rate, similar to the additional refundable tax regime for CCPC. However, in Part 3, we will discuss certain FAPI that may qualify for FAT deductions using the RTF of 4 for CCPCs.

Final Thoughts

The FAPI rules can result in Canadian tax even where no income has actually been distributed from a foreign corporation to its Canadian shareholder.

As we have seen, determining whether FAPI applies involves more than simply identifying passive income earned by a foreign corporation. One must first determine whether the corporation is a FA and CFA, properly compute the income under Canadian tax principles, and consider whether relief is available for foreign taxes already paid.

The rules can become even less intuitive where a foreign corporation carries on an active business. In certain circumstances, income that would ordinarily appear to be active business income can nevertheless be deemed to be FAPI.

In Part 2, we will look at some of these less obvious sources of FAPI and the recharacterization rules that Canadian businesses with foreign operations should be aware of.

In Part 3, we will discuss the new Foreign Accrual Business Income ("FABI") rules and how they can change the taxation of certain FAPI earned by foreign affiliates of CCPCs.

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.