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Federal Tax - Foreign Accrual Property Income (FAPI)

. Canada v. Loblaw Financial Holdings Inc.

In Canada v. Loblaw Financial Holdings Inc. (SCC, 2021) the Supreme Court of Canada considered 'FAPI' (foreign accrual property income):
A. FAPI Regime

[28] The FAPI regime is regarded as one of the most complex tax schemes, with hundreds of definitions, rules, and exceptions that shift regularly. Given this complexity, I will limit myself to a broad description of this regime, and some intricate subtleties will be omitted in the process.

[29] Some Canadian taxpayers find it more attractive to park their passive investments in low-tax jurisdictions and earn income there through non‑resident corporations, rather than to earn investment income directly in Canada and be subject to higher taxes (N. Pantaleo and M. Smart, “International Considerations”, in H. Kerr, K. McKenzie and J. Mintz, eds., Tax Policy in Canada (2012), 12:1, at p. 12:14). The FAPI regime seeks to remove this advantage by requiring Canadian taxpayers to include, as income from their shares, certain types of income earned by their CFAs[2] in their annual tax returns in Canada on an accrual basis (s. 91(1) of the ITA; B. Holmes and I. Gamble, The Foreign Affiliate Rules (2020), at p. 81). The ITA provides, however, for several mechanisms to prevent double taxation (e.g., ss. 91(4) and 91(5)).

[30] Because FAPI is calculated on an accrual basis, the regime creates an exception to the deferral approach to the taxation of shareholders. Shareholders do not ordinarily pay tax on income earned by the corporation whose shares they own until this income is distributed as dividends. Under the FAPI regime, however, shareholders are taxed on the undistributed income earned by their CFAs as it is earned. They are thus denied the benefit of deferral (V. Krishna, Halsbury’s Laws of Canada: Income Tax (International) (2019 Reissue), at HTI-15).

[31] Importantly, the FAPI regime does not apply to all types of income. Broadly speaking, the ITA considers passive income (e.g., dividends, interests, royalties, and capital gains) to be FAPI and active income not to be FAPI. The interplay between the principle of capital export neutrality and the protection of the competitiveness of Canadian businesses operating internationally explains this distinction (Office of the Auditor General, Report of the Auditor General of Canada to the House of Commons, 1992 (1992), at pp. 51‑52). Capital export neutrality seeks to make “[i]nvestors . . . pay the same rate of tax on income from foreign investment as on income from domestic investment” (Pantaleo and Smart, at p. 12:25). As a consequence, taxpayers face neither an advantage nor a disadvantage in investing locally or abroad, as the two are fiscally equivalent. If this principle were applied absolutely, however, it would cripple the competitiveness of Canadian businesses and weaken Canada’s economic prosperity. Indeed, imposing an extra layer of Canadian taxes in addition to foreign taxes on Canadian corporations conducting business abroad could place them at a competitive disadvantage in comparison to other foreign corporations paying only local, foreign taxes (Department of Finance, Tax Measures: Supplementary Information (1994), at p. 33).

[32] However, this distinction between active and passive income is not watertight, with certain active income considered to be FAPI and certain passive income excluded (Pantaleo and Smart, at pp. 12:11 and 12:13). Moreover, the ITA provides detailed definitions of types of income, whose meaning may sometimes differ from their ordinary meaning (Holmes and Gamble, at p. 187). It is therefore crucial to focus the analysis on the specific requirements that apply under the relevant definitions and exclusions to determine whether income is FAPI (CIT Group Securities (Canada) Inc. v. The Queen, 2016 TCC 163, [2016] 6 C.T.C. 2013, at para. 89).

[33] FAPI encompasses four broad categories of income earned by CFAs: (1) income from property; (2) income from a business other than an active business; (3) income from a non‑qualifying business; and (4) taxable capital gains realized on the disposition of non‑excluded property (s. 95(1) “foreign accrual property income”). The relevant categories here are the first two.

[34] The category of “income from a business other than an active business” covers any business that is deemed by s. 95(2) not to be active (s. 95(1) “income from an active business”). The only relevant deeming provision here is s. 95(2)(b)(i), which deems the provision of services to related entities for a fee to be a separate business and the income derived from that business to be FAPI. Managing assets of related entities for a fee would be captured by this rule (s. 95(3)). The purpose of this deeming provision is “to eliminate any tax advantage that might otherwise be obtained by (i) having a foreign affiliate provide services to a Canadian business, thereby shifting a portion of the business’s profits to another jurisdiction, or (ii) having one foreign affiliate provide services to another foreign affiliate that earns FAPI, thereby reducing the FAPI” (Holmes and Gamble, at p. 274).

[35] The main category at issue in this appeal is “income from property”, which includes a CFA’s income from an investment business (s. 95(1) “income from property”). The definition of “investment business” was added in 1995 amendments to the FAPI regime. Prior to the amendments, the distinction between active and passive income was left to the courts to define, a situation that was criticized in a 1992 Auditor General Report as providing “no reasonable assurance that the [FAPI] rules will apply in all circumstances where they should” (Office of the Auditor General, at pp. 48-49). Parliament responded by introducing the concept of “investment business”, the income from which would be included in income from property. What constitutes an investment business is defined broadly, encompassing any “business carried on by the affiliate . . . the principal purpose of which is to derive income from property (including interest, dividends, rents, royalties or any similar returns or substitutes therefor)” (s. 95(1), definition of “investment business”).

[36] Parliament created safe harbours or exceptions to this broad definition of “investment business”, including the financial institution exception at issue in this appeal. As I will discuss further below, Parliament must have been aware, however, that treating all income earned from an investment business carried on by a CFA as FAPI risked crippling the international competitiveness of Canadian financial institutions. Therefore, Parliament enacted the financial institution exception to exclude investment income realized by a CFA that is a financial institution from FAPI, provided that the following requirements are met:
1. Type of financial institution: The CFA carries on business as a foreign bank, a trust company, a credit union, an insurance corporation, or a trader or dealer in securities or commodities.

2. Oversight by a regulatory body: The CFA’s activities are regulated under foreign law.

3. Threshold level of activity: The CFA employs more than five full‑time employees or the equivalent thereof in the active conduct of the business.

4. Arm’s length requirement: The CFA’s business is not “conducted principally with persons with whom the [CFA] does not deal at arm’s length”.

(s. 95(1), definition of “investment business”)
[37] When these four requirements are met, the income from the investment business retains its character as active business income and is therefore not FAPI. However, satisfying these four requirements may not always be sufficient to avail oneself of the financial institution exception. Where the CFA is a regulated financial institution and carries on a business the principal purpose of which is to derive income from trading or dealing in indebtedness, the income derived from these activities is deemed to be income from property and thus FAPI, unless the Canadian taxpayer is a financial institution resident in Canada or the parent or subsidiary of such a Canadian financial institution (s. 95(2)(l)(iv); see J. Yeung, “Trading or Dealing in Indebtedness Offshore: Paragraph 95(2)(l) Revisited” (2011), 59 Can. Tax J. 85, at pp. 89-90). In effect, only CFAs related to Canadian financial institutions are permitted to deal in indebtedness without attracting the FAPI rules.

[38] In 2014, Parliament revisited the financial institution exception and preferred to toughen its requirements instead of repealing it (s. 95(2.11); see Holmes and Gamble, at pp. 1361-65). The condition that the taxpayer be a Canadian financial institution, or be related to such an institution, that was applicable only when the CFA was trading or dealing in indebtedness was extended to every case where a taxpayer invokes the exception. Additionally, the Canadian financial institution must either (1) have a minimum of $2 billion in equity, or (2) have more than 50 percent of its taxable capital employed in Canada in business activities regulated by a financial authority. This amendment limits access to the exception to taxpayers that are heavily involved in financial affairs, thereby excluding those for whom it is mostly a side business. However, these amendments were not retroactive and do not apply to this case.

[39] It is not disputed that s. 95(2)(l) does not preclude Loblaw Financial from availing itself of the financial institution exception, because Loblaw Financial is the parent of a Canadian bank, the President’s Choice Bank. Nor are the financial institution, oversight, and activity level requirements of that exception disputed. Therefore, this appeal concerns only the interpretation and application of the arm’s length requirement under s. 95(1).


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