Planning Considerations for Controlled Foreign Affiliates

It’s not uncommon for high net worth US citizen living in Canada to earn a substantial part of their income through a US business. Conventional wisdom may dictate to leave the corporate surplus within a corporation to benefit from tax deferral. Consequently, these business are often structured as a US C-Corp.

Unfortunately, the Canadian Income Tax Act includes complex rules to discourage Canadian residents from investing in foreign corporations with the objective of earning passive investment income. These rules apply to taxpayers resident in Canada that control a foreign affiliate company. Control can be achieved by owning more than 50% of voting shares of the US corporation.

Foreign accrual property income (FAPI) refers very generally to passive investment income earned by a foreign affiliate controlled by a taxpayer resident in Canada. The taxpayer resident in Canada will have the FAPI earned by a controlled foreign affiliate included in their income.

This means that all of the investment income earned in the US corporation that was intended to be retained in the corporation, to take advantage of tax-deferral by only immediately being taxed at the corporate tax rate, will now be included in the shareholder’s income in Canada; thereby defeating the purpose of the structure. A deduction would only be provided when the investment income is distributed as a dividend to the Canadian shareholder.

To avoid these onerous rules, the shareholder could structure the business as an LLC to flow through the income directly to themselves. Or, they could distribute all of the income to themselves in each year. Fortunately, these recourses can be avoided since the ITA rules include prescribed factors, applied to the foreign accrual tax paid, which help to limit the net FAPI to be included in income of the Canadian resident taxpayer. However, to fully offset the FAPI for a Canadian individual, the foreign accrual tax paid by the US corporation would have to be at least 52.63%.

Planning solutions do exist to help avoid the unfavourable FAPI rules. Setting up a Canadian holding corporation to own the shares of the US corporation can potentially fully eliminate FAPI if the foreign accrual tax paid by the US corporation is at least 25%; a far more manageable tax rate to plan for. However, setting up a Canadian holding company may create their own set of issues such as triggering the Controlled Foreign Company or Passive Foreign Investment Company rules.

Considering the complex nature of these rules, it can be difficult for US citizens living in Canada to benefit from tax deferral by using a corporation. US citizens who own, or plan to own, shares of a US corporation while living in Canada should seek out professional cross-border advice to plan for their corporate structure to limit the effects of negative effects of FAPI.

MCA Cross Border Advisors Inc. has extensive experience and expertise in transitioning accounts and portfolios between Canada and the US.  With expertise in portfolio construction, manager search and selection, tax strategy, and financial planning, our team of experts can help create and structure a Canada/US cross-border optimized portfolio that remains aligned with your investment objectives and risk tolerance.