Prepared by Max Reed, Polaris Tax Counsel and Tim Barrett, Thorsteinssons LLP
In the April 2022 federal budget, the Canadian government proposed significant changes to the Canadian international tax rules (specifically the “foreign accrual property income” or “FAPI” rules). Details of those proposed changes were released on August 9, 2022. If enacted, these changes expose Canadian private corporations that own US corporations to twice the immediate tax burden that they are paying now. This post explains some of the changes, and future posts will explore planning strategies. Our view is that most of these structures need to be reviewed and potentially reworked in light of the proposed rule changes.
1. Current taxation of CanCo-US Co structure
The most common structure for investing into the United States (whether it is real estate or a business expansion) is a US C-Corporation (US Co) that is owned by a Canadian private company (CanCo). Currently, the basic tax premise of this structure is that there is generally no Canadian tax owed by the CanCo when US Co earns income or when funds are paid to it by US Co (although there is usually US withholding tax of 5%). That remains true even if US Co is earning rental or passive income.
Like many countries, Canada has a complex set of rules (the foreign accrual property income or “FAPI” rules) that try to prevent Canadian corporations from using foreign corporations to defer tax on property or investment income. But if the US corporate and withholding tax paid by US Co is at least 25%, then the amount of FAPI that is immediately taxable to CanCo is zero.
An example illustrates the current rules. Assume CanCo owns US Co, which owns a US rental real estate project that earns USD $10,000 of net rental income. Subject to some esoteric exceptions, rental real estate income earned by US Co is generally classified as FAPI, but since US Co generally pays US federal and state tax at a rate in excess of 25% there is no taxable FAPI to CanCo. That means that CanCo pays no Canadian tax in the year that US Co earns the income (or when the cash is paid out to CanCo). Canadian tax is only owed when CanCo makes a distribution to its shareholders. The immediate combined tax for both CanCo and US Co is thus the applicable US tax, which is generally 25% (the US federal corporate tax rate of 21% and an average US state corporate tax rate of 5%). Applied here to USD $10,000 of net rental income, the immediate Canadian and US tax to would be USD $2,500 (the corporate tax paid by US Co). However, starting with the 2022 tax year, the immediate Canadian and US tax burden will double.
2. Overview of the 2022 changes
In the April 2022 budget, the Canadian government decided that the scenario described above provided CanCo with the unfair ability to defer Canadian tax. The budget proposal essentially doubled the threshold (technically known as the “relevant tax factor”) at which CanCo will not have any taxable FAPI from 25% US corporate tax to approximately 52.63% US tax. Since US corporations don’t pay anywhere near 52.63% US federal and state income tax, this means that FAPI is now a problem for CanCo under the new rules.
Revisiting the prior example illustrates the changes. Recall that US Co (owned by CanCo) earns USD $10,000 of net rental income on which it pays USD $2,500 of US federal and state corporate income tax. There are no changes on the US side of the border. But because of the increase in the FAPI foreign tax threshold, CanCo only gets a FAPI offset of USD $4,750 ($2,500/52.63%) for the US corporate tax paid. That leaves CanCo with USD $5,250 of FAPI and a corresponding Canadian tax bill of approximately USD $2,634. In short, the immediate effective Canadian and US tax rate on the USD $10,000 of net rental income has more than doubled from USD $2,500 in 2021 to USD $5,134 in 2022.
3. FAPI is defined expansively
Above, we use as an example the simplest type of FAPI – rental income from real property. But it is important to note that FAPI drags in a lot more types of income than just rental income. For example, it can also include income from services done for the Canadian company. For example, a Canadian marketing company may have a US subsidiary with employees located in the US who perform work on behalf of the Canadian parent. Under the new rules, income earned by the US subsidiary would be treated in the same manner as the rental income in the first example. Therefore, even though the Canadian parent would be paying normal corporate tax rates on its income (approximately 26% in most provinces), it would pay approximately 52% tax on income earned by the US subsidiary (taking into account both the US corporate tax and the Canadian tax). As the definition of FAPI is complex and expansive, other examples abound.
4. Changes apply to active business income also
The Canadian rule changes will in some cases also affect the rate of tax that apply to dividends paid by a US subsidiary to its Canadian parent that originate from active business income (i.e., non-FAPI). Under the current rules, dividends from US corporation to its Canadian parent that originate from active business income are generally tax free in Canada. By contrast, under the proposed new rules, dividends paid out of active business income from a US subsidiary to its Canadian parent will be taxed at a combined US and Canadian tax rate of approximately 52% unless “management and control” of the US subsidiary is exercised from the United States.
Generally, “management and control” of a corporation is situated where the board of directors meets and makes decisions. For many Canadian private companies with US subsidiaries, this occurs in Canada where the Canadian shareholders live and work. As a result of the proposed changes, dividends paid by US subsidiaries that are effectively managed in Canada will no longer be tax-free to the Canadian private corporation shareholder – instead, they will be subject to a combined Canadian and US tax rate of 52%. That materially increases the immediate tax cost of operating a US subsidiary – even one earning active business income that is not FAPI.
5. Shareholder level adjustments
To compensate for this increase of tax at the corporate level, the Canadian government has also proposed certain changes to the tax paid by the shareholders of Canadian private corporations. Simply put, the shareholder level tax on dividends is reduced to reflect the higher rate of tax paid at the corporate level. Overall, the fully-distributed-to-shareholder tax rate on income earned in a US subsidiary will increase slightly, but there is a significant adjustment to who pays the tax and acceleration of when it is owed. The shareholder level adjustments will be cold comfort to many businesses that do not routinely make shareholder distributions or that have after-tax corporate obligations (such as loan repayments). For them, the doubled immediate rate of tax will be an onerous burden.
6. Conclusions
The CanCo -> US Co structure is ubiquitous for private businesses. Since the reduction of the US corporate tax rate in 2017, it has been a relatively tax efficient one. The 2022 Canadian international tax changes dramatically alter that. To summarize:
- Under current law, most income earned by a US corporation isn’t subject to further Canadian tax until it is distributed to shareholders.
- The proposed changes increase the requisite US tax threshold in order to have no Canadian corporate tax payable from 25% to 52%, meaning that some income earned by a US subsidiary will be subject to Canadian corporate tax when earned even if not distributed to the parent.
- On a simple example of net rental income earned in a US subsidiary, the effective immediate tax rate between the two countries will jump to 52% up from 25%.
- Many types of income earned by US companies are classified as FAPI.
- The doubled immediate tax rate will even apply to active business income if “management and control” of the corporation is not exercised in the United States.
- The reduction of shareholder level tax preserves the overall tax integration to a certain extent, but will be cold comfort to many private businesses with after-tax corporate obligations.
Because these changes will result in a sudden doubling of the immediate tax exposure for private Canadian businesses with US subsidiaries, all companies in that position should review their tax position accordingly.