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(2005) vol. 53, no 1 ■ 179

Residence-Based Taxation and FAPI:A World of Fictions

Julie Bouthillier*

A B S T R A C T

This paper covers two aspects of Canadian tax law—corporate residence and foreignaccrual property income (FAPI).

In the first part of the paper, the author reviews the development of the concept ofcorporate residence in tax law. She shows that the law is so loose that a corporationcan establish residence in a country without actually having any operations there.Parent corporations can set up subsidiaries that are resident in low-tax jurisdictions ortax havens, and then transfer some of their taxable income from high-tax jurisdictionsto those subsidiaries in order to avoid tax. To deal with this problem, Canada hasenacted anti-avoidance legislation, notably, in the case of passive income, the FAPI rules.

In the second part of the paper, the author provides a broad description of the FAPIsystem. The topics covered include FAPI as an anti-deferral measure; the controlledforeign affiliate concept; attribution of “tainted” income of a controlled foreign affiliate;the distinction between business income and property income, and between an activeand an inactive business; rules to deem income to be from a business other than anactive business; and the calculation of FAPI.

In the third part of the paper, the author briefly considers whether it would bepossible to amend the law of corporate residence to get rid of the legal fictions onwhich it relies and reduce the need for supplementary measures such as the FAPI rules.

KEYWORDS: INTERNATIONAL TAXATION ■ MULTINATIONAL CORPORATIONS ■ RESIDENCY ■ FAPI ■

TAX AVOIDANCE ■ TAX POLICY

* Articling at Paquette Gadler, Montreal.

C O N T E N T S

Introduction 180Corporations and Residence 181

Historical Context 181Residence: The Determination 182

Origins of the Test of Residence in UK Case Law 183Central Management and Control 184Incorporation 186

180 ■ canadian tax journal / revue fiscale canadienne (2005) vol. 53, no 1

I N T R O D U C T I O N

We live in a world where the law depicts reality through tales and legal fictions andtranslates complicated issues into legal subsets. To provide definite answers toconcrete questions, reality is simplified and rationalized. In some areas of the law,however, this process can create a distorted image of reality. As focus is adjusted inan incremental manner to reflect the multiple layers of reality, we can pass fromoversimplification to “overcomplexification.” The problems that can result areevident in the area of corporate taxation.

Indeed, the entire body of corporate tax law relies on a principle bearing norelation to economic reality: the legal personality of corporations. This principledisregards the fact that a corporation’s financial health affects its shareholders, andfails to recognize that a group of corporations may constitute a sole economicentity.1 Corporations, which are mere aliases, mere nominees and agents of theirshareholders, are considered to be separate legal entities,2 taxpayers in their ownright,3 subject to full tax liability on the basis of their residence.

The concept of residence, however, is elusive and may not be adapted to moderneconomic realities. Easily manipulated, it offers a myriad of possibilities for taxavoidance. It is also an inappropriate tool for implementing policy objectives.Indeed, the Canadian government must not only try to prevent erosion of the taxbase by elaborating complex anti-avoidance rules, but must also take into consid-eration the perverse effects that these rules may have on Canada’s ability to remaincompetitive, a balance that, owing to globalization and income mobility, is increas-ingly difficult to achieve.

These legal fictions were created for pragmatic reasons, but the notion that amultinational corporation should simply be taxed where it resides—that is, where its

Foreign Accrual Property Income Rules: Section 95 187FAPI: An Anti-Deferral Measure 187The Controlled Foreign Affiliates Concept 188

Definition 188Attribution of “Tainted” Income of the Controlled Foreign Affiliate 191

Foreign Direct Investment and Portfolio Investment 191Foreign Accrual Property Income 192Exclusions from FAPI: Active Business Income and Other Income 201Calculation of FAPI 201

Tax Reform: Is It Time To Get Rid of Fictions? 202Conclusion 204

1 Vern Krishna, The Fundamentals of Canadian Income Tax, 7th ed. (Toronto: Carswell, 2002), 559.

2 Salomon v. Salomon & Co., [1897] AC 22 (HL).

3 See the definitions of “taxpayer” and “person” in subsection 248(1) of the Income Tax Act,RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless otherwisestated, statutory references in this paper are to the Act.

residence-based taxation and fapi: a world of fictions ■ 181

central management and control is located—does not efficiently address Canadianconcerns. The Canadian government must prevent erosion of the tax base withoutcompromising fundamental principles of taxation such as neutrality, equity, sim-plicity, and equality, or infringing international conventions.

The foreign accrual property income (FAPI) system was designed to ensure thatthese objectives will be met in situations where treaties do not apply becausecorporations operate through subsidiaries rather than branches. By imputing FAPIto Canadian multinational corporations, the legislature attempted to resolve theproblems created by the inadequacies of residence as the tax nexus.

Some writers have suggested replacing or adapting the legal fictions at the heartof our corporate tax system.4 In my opinion, this would bring neither clarity norsimplicity to the tax law. Although the taxation of corporations as separate entitiesand on the basis of residence is a deeply flawed approach, reflecting the deficienciesof these concepts, the FAPI system constitutes an adequate, if imperfect, remedy. Bychanging the core tax rules, we would simply be trading a world of complexity foranother set of problems.

C O R P O R AT I O N S A N D R E S I D E N C E

In 1897, the House of Lords, in Salomon v. Salomon5 established the patrimonialautonomy of corporations,6 paving the way for decisions that would further shapedevelopments in the area of worldwide taxation. The idea that corporations werelegal persons permanently changed the legal landscape.

Corporations became taxpayers in their own right and could owe economicallegiance to any country in the world. The tax nexus was determined by analogyto individuals. A corporation was, and still is, considered to reside where its centralmanagement and control is located. However, without supplementary anti-avoidancemeasures, this test could be rendered virtually useless by the ingenuity of tax planners.

Historical Context

Multinational corporations are often erroneously considered to be a by-product ofmodern commerce, and their growth is generally associated with the recent devel-opment of new technologies for global communication. In fact, multinationalsalready existed when the courts developed the fictions that are at the core of ourcurrent corporate and international tax systems. Like multinationals today, theseearly corporations controlled assets throughout the world, but the way they didbusiness and the way they were organized were extremely different. Although aseries of inventions—first, cars, trucks, and airplanes, then television, the telephone,

4 See infra notes 86 to 90 and the accompanying text.

5 Supra note 2.

6 See Dominic C. Belley, “The Corporate Veil in Tax Law: In Praise of Judicial Circumspection(2000) vol. 48, no. 3 Canadian Tax Journal 929-78, at 932.


and the Internet—did account in part for the rapid globalization of business andthe transformation of these entities, the roots of multinational corporations arefirmly embedded in the 19th century.

Up to the 1930s, markets were highly receptive to multinational corporations;even the First World War could not halt their dynamic growth.7 Conversely,during the Great Depression, the decline of the gold standard (which facilitatedthe international mobility of capital), the drastic exchange measures adopted by anumber of countries, and the difficulty of repatriating capital created a severedisincentive to foreign investment.8 The level of foreign investment attained priorto the 1930s would not be reached again until the beginning of the 1980s. By then,however, new forms of foreign investment had been introduced and multinationaloperations had become highly integrated, reflecting major changes in the globaleconomic landscape.

It is now possible for a company to hold assets in a foreign jurisdiction and controlthem from another location, or to advertise and render services in a foreign jurisdic-tion, without an employee or any representative ever setting foot in that jurisdiction.The evolution of global communications technology has also changed the methodsused to control production processes and diminished the risks and costs of cross-border investment.

These gargantuan advances have further complicated the taxation of multina-tionals; however, the issues are not entirely new. They present the same challengesand hurdles, only faster,9 thus highlighting the acuteness of problems that are causedby the deficiencies of artificial concepts and that have existed from the outset.

Residence: The Determination

Regardless of the transformation the world has undergone, Canada’s tax law is stillgoverned by principles developed almost a century ago. Those principles were embod-ied in our first income tax statute, the Income War Tax Act, which was enacted in1917 to fund the extraordinary expenditures resulting from the First World War.Although it was meant to be a temporary war measure, that statute laid the foundationsof our modern system of international taxation10 and determined the “connectingfactors” giving Canadian authorities the power to tax corporations.

Inspired by principles developed in the United Kingdom, residence was chosenas the primary tax nexus, source taxation being used only as an adjunct to full taxliability.11 Both criteria indicate the existence of a connection between the taxpayer

7 See Geoffrey Jones, The Evolution of International Business (London: Routledge, 1996), 56.

8 Ibid., at 44-45.

9 See Jinyan Li, International Taxation in the Age of Electronic Commerce: A Comparative Study(Toronto: Canadian Tax Foundation, 2003), 1-2.

10 See Angelo Nikolakakis, Taxation of Foreign Affiliates (Toronto: Carswell, 2000), 1-4 to 1-5.

11 Krishna, supra note 1, at 70.


and the taxing jurisdiction. Residence-based taxation follows from the idea that aperson “owe[s] economic allegiance to the country with which he or she is currentlymost closely connected in economic and social terms,”12 whereas source-basedtaxation is territorial in nature, looking to the country in which income is earned.From a policy standpoint, the closer relationship that residents have with Canada,as compared with those who only carry on business here, explains in part the accruedtax liability incurred by residents. Indeed, residents are taxable on their worldwideincome, whereas non-residents are taxed, in Canada, only on their income earnedin Canada.

Origins of the Test of Residence in UK Case LawWhen Canada introduced its first income tax legislation in 1917, the UK courts hadalready dealt with the definition of the term “residence.” Indeed, the judicial testfor determining corporate residence dates back to 1906, when Lord Loreburnaffirmed, in De Beers Consolidated Mines Ltd. v. Howe,

that a Company resides, for purposes of Income Tax, where its real business is carriedon . . . and the real business is carried on where the central management and controlactually abides.13

The formulation of the test was greatly influenced by the legislative and histori-cal context in which it was developed. As Robert Couzin points out in his bookCorporate Residence and International Taxation, there is no common law of taxation;taxation is a statutory creature. Legislation therefore imposes the boundaries ofjudicial interpretation.14 The UK courts had already rejected the place of incorpora-tion as the test of residence because it was too easily manipulated15 when the “realbusiness” test was gradually developed within the limits imposed by the legislationuntil it was enunciated by Lord Loreburn in its definitive form. In elaborating theproper connecting factor, the courts could not ignore the principles enacted in the UKtax statute. The statute treated corporations as separate legal entities with the samerights and obligations as natural persons; thus, artificial persons were virtuallyassimilated with natural persons. The statute also provided that, while residentswould be taxed on their worldwide income, non-residents carrying on business inthe United Kingdom would be taxed only on income derived in the United King-dom.16 These provisions formed the background of any judicial attempt to define

12 Ibid.

13 (1906), 5 TC 198, at 213 (HL).

14 Robert Couzin, Corporate Residence and International Taxation (Amsterdam: International Bureauof Fiscal Documentation, 2002), 26-29.

15 See Royal Mail Steam Packet Company v. Braham (1877), 2 App. Cas. 381, at 386 (PC).

16 Couzin, supra note 14, at 26-29.


the term “residence.” Because the legislation did not distinguish between individu-als and corporations, the courts felt compelled to define corporate residence in amanner consistent with the case law on individual residence. According to LordLoreburn, we ought

[i]n applying the conception of residence to a Company, . . . to proceed as nearly aswe can upon the analogy of an individual. A Company cannot eat or sleep, but it cankeep house and do business.17

But, in determining a corporation’s way to eat or sleep, statute law closed off anavenue that might otherwise have been perfectly acceptable. It was not open to thecourts to determine that a corporation was resident in the United Kingdom merelyon the fact that it carried on business there, since this criterion was already theprimary determinant of source-based taxation. The courts must establish, in LordLoreburn’s words, “where the central management and control actually abides.”

Central Management and ControlAlthough the words used by Lord Loreburn offered some guidance, the courtsstruggled to determine the meaning of the expression “central management andcontrol” for some time after the famous judgment was rendered.

The place of central management and control must be determined on the factsof each case. Articles of incorporation indicating the location of the head office orthe seat of the corporation are not proper indicia of where the real business iscarried on.

Similarly, the place of central management and control is unrelated to certainformalities that must be observed under corporate law. The requirements that acorporation have an address, a place where it keeps its records and transcripts, andbank accounts appear to be inconsequential conditions of operating a company.Some judges, struggling with the concept of multiple corporate residences—a com-plication that was not contemplated by the court in De Beers—suggested that acorporation’s administrative acts were “vital organic operations incidental to itsexistence as a company”18 and sufficient, subject to incorporation in the jurisdiction,to establish residence. This proposed alternate test was considered for several yearsuntil it was definitively rejected in 1928 in Egyptian Delta Land and Investment.19

Correctly interpreted, central management and control requires more than theadministrative acts that are necessary to establish limited liability or maintain day-to-day operations. Such actions require a level of control that cannot be describedas central or anything more than doing business in a jurisdiction.

17 De Beers, supra note 13, at 212.

18 The Swedish Central Railway Company, Limited v. Thomson (1923), 9 TC 342, at 353 (KB).

19 Todd v. The Egyptian Delta Land and Investment Co., Ltd. (1928), 14 TC 119 (HL).


Ultimately, the courts appear to have adopted the “pinnacle” test: central man-agement and control is found at the highest level of the corporate structure. Withoutattempting to locate the intrinsic source of “final and supreme authority,”20 thecourts have determined that the real business of a corporation usually takes placewhere business policy and financial decisions are made. “Beyond that, the keyelements of direction of the ‘real business’ probably vary depending upon thenature of that business.”21

While the place of central management and control should always be deter-mined on the facts of each case “through the scrutiny of the course of business andtrading,” the courts generally consider the real business to be carried on where thedirectors hold board meetings and exercise their decision-making authority.22 In soruling, the courts are not departing from a presumably settled and fundamentalprinciple; on the contrary, their decisions have a strong factual basis. The controlstructure of a corporation is largely governed by the rules and requirements ofcorporate law. For example, under the Canada Business Corporations Act (CBCA),directors have the duty and authority to “manage, or supervise the management of,the business and affairs of a corporation”;23 shareholders, on the other hand, havedecision-making powers relating to the election of directors and the bylaws of thecompany, rather than its day-to-day business operations.24 Consequently, the CBCAcreates a set of facts that, absent special circumstances, leads to the conclusion thatthe real business of a corporation is carried on where directors’ meetings are held.The place where shareholders’ meetings are held is generally of little significance.

However, where evidence adduced at trial proves that the directors and officersof the company are mere puppets of the shareholders, the courts have held that theplace of residence of the corporation is the place where those who effectivelycontrol the corporation reside.25 This is one of the few instances where the identityof shareholders has been held to influence the tax treatment of the corporation.Indeed, reflecting the separate legal identity of corporations, the nexus betweenCanada and a corporation is not, in usual circumstances, determined by the nation-ality, residence, or domicile of the shareholders.26 Surprisingly, the non-residentstatus of subsidiaries is rarely contested by Canadian tax authorities.

20 Union Corporation, Ltd. v. Commissioners of Inland Revenue (1952), 34 TC 207, at 271 (CA); aff ’d.on other grounds at (1953), 34 TC 207, at 279 (HL).

21 Couzin, supra note 14, at 60.

22 See Jinyan Li, “Tax Jurisdiction,” Supplementary Course Material for International Tax(Osgoode Hall Law School of York University, Winter 2004), 16; Victoria Insurance Co. Ltd. v.MNR, 77 DTC 320 (TRB); and Birmount Holdings Ltd. v. The Queen, 78 DTC 6254 (FCA).

23 Canada Business Corporations Act, RSC 1985, c. C-44, as amended, section 102(1).

24 CBCA section 106(3).

25 See Bullock (HM Inspector of Taxes) v. The Unit Construction Co. (1959), 38 TC 712 (HL), and Li,supra note 22, at 16.

26 Bedford Overseas Freighters Ltd. v. MNR, 70 DTC 6072 (Ex. Ct.).


The judicial test of residence is fundamentally flawed. For example, in VictoriaInsurance,27 even though it was admitted that the Canadian-resident majority share-holders effectively controlled the subsidiary, evidence that all the regular boardmeetings were held in the Bahamas and the fact that reinsurance is for the mostpart a passive business were sufficient for the court to conclude that the subsidiaryresided in the Bahamas, not in Canada. This case is only one of many demonstrat-ing the inadequacy of the test established in De Beers.28

IncorporationSince the judicial test of residence was clearly unsatisfactory, in 1970 the IncomeTax Act was amended to include a provision deeming corporations incorporated inCanada after April 27, 1965 to be Canadian residents.29 Thus, the place of incor-poration, which was rejected by the courts as being too easily manipulated, wasintroduced as a determining factor by the Income Tax Act. Nevertheless, the judicialtest, as inept as it was, remained untouched. Principles laid down at the beginningof the 20th century still govern where a company is incorporated, or continued,outside Canada. Concerns linger about the elasticity of the concept of residence andthe consequent potential for double taxation and tax avoidance. As Vern Krishnahas observed,

[c]orporate taxpayers in particular may [still] derive all the economic, political, andlegal benefits of residence in a country and arrange their international transactions soas to source their income in low-tax countries or tax havens.30

Evidently, Canada’s modest attempt to clarify the conditions resulting in thetaxation of worldwide corporate income did not alleviate problems related to the useof residence as a tax-planning tool. It was equally unsuccessful in resolving theproblem of double taxation.

Even if a multinational corporation elected to reside in Canada,31 it would notautomatically be protected against another country’s exercise of tax jurisdiction.Not only has it long been established that a corporation can reside in more thanone country,32 but the mere fact of earning income in a foreign jurisdiction issufficient to trigger liability to tax in that jurisdiction. Consequently, absent anextensive network of treaties with trustworthy countries,33 multinational corporations

27 Victoria Insurance, supra note 22.

28 Supra note 13.

29 Subsection 250(4). Different rules apply to corporations incorporated before that date.

30 Krishna, supra note 1, at 70.

31 Ibid.

32 See Union Corporation, supra note 20.

33 Generally, Canada does not enter into tax treaties with tax havens, Barbados being a notableexception.


operating as single entities would be vulnerable to double taxation. Through attribu-tion rules and concepts such as permanent establishment, Canada recognizes thatother countries might, depending on their domestic tax rules, be entitled to tax amultinational corporation.

Multinational corporations can avoid the problem of double taxation throughthe use of non-resident subsidiaries. However, in order to shelter their income,multinationals residing in Canada must not only incorporate those subsidiaries out-side Canada, but also ensure that decision making permanently takes place outsideCanada.

In summary, no matter how diligently judges and legislators searched for a deter-minant of tax nexus that would prevent multinational corporations from shelteringprofit through the use of subsidiaries located in low-tax jurisdictions, tax havens, orcountries that engage in harmful tax competition, their efforts proved to be in vain.The inherent intangibility of the corporation frustrated attempts to impose thesimple rule that a corporation owes economic allegiance to the country where itscentral management and control is located. Economic allegiance and physicalboundaries can apply to physical persons, but appear to be irrelevant in the case ofartificial persons. Indeed, it would be ridiculous to presume that multinational cor-porations and individuals can be made subject to the same rules. The gap betweenthem appears even wider because of technological developments.

F O R E I G N A CCR U A L P R O P E R T Y

I N CO M E R U L E S : S E C T I O N 9 5

Judges and legislators strove to create a corporate residence test that would not beeasy to manipulate. Their intentions were noble, but their efforts proved futile.The ingenuity of tax planners, the proliferation of tax havens, and the existence ofharmful tax competition transformed a carefully elaborated test into an opportun-ity for tax avoidance.

The fictions devised to reduce reality to a simple equation failed to capture theversatile nature of corporations. The FAPI system provides an adequate, thoughimperfect, remedy.

FAPI: An Anti-Deferral Measure

The rules known as the FAPI system were adopted by Canadian tax authorities inthe 1970s to address the difficulties caused by the taxation of corporations both asseparate legal entities and on the basis of residence. The predecessor of the FAPIsystem combined an exemption for foreign-source income with a deduction forforeign taxes. Income earned by a foreign subsidiary was not included in theCanadian tax base until dividends were received by private shareholders, resultingin a substantial deferral benefit.34 Moreover, the lower the tax rate imposed by the

34 Nikolakakis, supra note 10, at 1-14.


foreign jurisdiction, the greater the incentive to leave the income within the subsidi-ary.35 The FAPI system was designed to rectify that situation by eliminating anyundue tax-deferral incentive.

Since non-resident corporations fall outside Canada’s tax jurisdiction, foreignsubsidiaries of Canadian residents are not taxed directly. Instead, subsection 91(1)includes in the computation of the income of the Canadian-resident taxpayer forthe year, the pro rata share of “the foreign accrual property income of any control-led foreign affiliate of the taxpayer.” Thus, the FAPI system attempts to remedy thefailure of the concept of residence by attributing to a Canadian resident incomethat, through the conjunction of the separate legal identity of corporations and theflawed definition of residence, would otherwise escape Canadian tax.

Subsection 91(1) extends the reach of the Canadian tax authorities to foreign-source income that would otherwise lie beyond their grasp. The inclusion of incomeunder this provision depends upon the type of income earned by the foreign cor-poration and the connection between the corporation and the Canadian-residenttaxpayer.

The charging provision refers to a number of defined concepts that interact toreflect the policy objectives of the tax authorities. Since their enactment, the FAPIrules have been amended in an attempt to achieve neutrality and equity. The defini-tion of “controlled foreign affiliate” has been tightened. The definition of “foreignaccrual property income” has been extended to include income deemed to have itssource from a “business other than an active business.” The definition of “activebusiness” has been refined.36 However, the core of the FAPI system and the compu-tation rules has remained unchanged.

The Controlled Foreign Affiliates Concept

DefinitionSince the introduction of the FAPI system, the existence of a “controlled foreignaffiliate” of a Canadian taxpayer has been central to the concept of FAPI. It is thefirst requirement in determining whether or not the income earned by a non-resident corporation will be caught by the FAPI rules. Under section 95 of the Act,the income earned by a non-resident corporation will be imputed to a Canadian-resident taxpayer only if, at any time during the taxation year, the non-residentcorporation could properly be described as a controlled foreign affiliate of thetaxpayer. Although the ownership thresholds were adjusted in 1994, to reflect moreaccurately the extent of the power exercised by shareholders over dividend income,

35 Jinyan Li, “Foreign Accrual Property Income (FAPI),” Supplementary Course Material forInternational Tax (Osgoode Hall Law School of York University, Winter 2004), 1.

36 Recently, the regime was extended in order to apply to income earned through foreign trustsand other such entities. See section 94.1.


this basic principle and the scope of the controlled foreign affiliate concept haveremained unchanged.37

In essence, for a foreign corporation to be a controlled foreign affiliate, the Actrequires that connected Canadian-resident taxpayers own a certain proportion ofshares in the foreign corporation. The foreign corporation must also be controlledby persons residing in Canada.38 More precisely, a “foreign affiliate” is generallydefined as a corporation in which a Canadian-resident taxpayer owns directly atleast 1 percent and together with other related persons at least 10 percent of a classof shares.

Simply holding shares in a foreign affiliate does not trigger the application ofthe FAPI rules. Control is a prerequisite. In the original FAPI legislation, control wasnot a prerequisite; a 25 percent voting participation in a foreign corporation, througheither direct or indirect ownership, was sufficient to trigger the application of therules if other conditions were met. This aspect of the FAPI system was stronglycriticized, and the rules were amended in 1994.

Under the current rules, the taxpayer must exercise de jure control. De jurecontrol exists where one or more persons hold a sufficient number of sharescarrying voting rights to constitute a majority in the election of the board ofdirectors.39 Such control need not be exercised by the taxpayer alone. The defini-tion of “controlled foreign affiliate” provides that control with no more than fourother Canadian residents with whom the taxpayer deals at arm’s length, or with anynumber of persons with whom the taxpayer does not deal at arm’s length, is capableof triggering the taxation of the foreign corporation’s income on an accrual basis.40

Under the earlier version of the rules, Canadian multinational corporations couldcircumvent the control requirement and escape the attribution of FAPI by holdingproperty in an offshore investment fund; however, section 94.1 was enacted in1985 to close this loophole.

To summarize, income from outbound foreign investment constituting FAPI istaxed on an accrual basis only when a Canadian resident controls, directly or indi-rectly, the management of the foreign entity. In other words, “tainted” outboundforeign investment income is taxed whenever a Canadian resident has de jure controlof the corporation as opposed to de facto control. Consequently, where a foreigncorporation has a significant connection with Canada through its shareholders, butwould otherwise escape Canadian tax jurisdiction because of the deficiencies of thecorporate residence concept, the FAPI system applies.

Conversely, portfolio investment, which, by definition, does not result in con-trol of the foreign corporation by a Canadian resident, does not constitute a


38 See the definitions of “foreign affiliate” and “controlled foreign affiliate” in subsection 95(1).

39 Buckerfield’s Ltd. et al. v. MNR, 64 DTC 5301 (Ex. Ct.).

40 See the definition of “controlled foreign affiliate” in subsection 95(1).


sufficiently strong connection between the Canadian-resident shareholder and thecorporation to justify taxation of the corporation’s income on an accrual basis.Small shareholders of a widely held foreign corporation could not comply with therequirement to include their share of the corporation’s income as they would notbe in a position to access the necessary information.41 In addition, when shareholdersdo not have control over the election of the board of directors, they have extremelylimited influence over the management of the company. They have no control overthe distribution of retained earnings and thus no way to recover their investment,other than by selling their shares. If they were taxed on an accrual basis, theseinvestors could be faced with serious liquidity problems and might have to borrowor sell their shares to pay Canadian tax.

While this liquidity problem is not intrinsically tied to the lack of control, thosewho hold control have remedies that are unavailable to small shareholders. Direc-tors are expected to take decisions in the best interests of the corporation and arenot bound by the suggestions of the shareholders. For a variety of reasons, thedirectors of a foreign affiliate may choose not to distribute income as it accrues. Ifthey retain it, the controlling shareholders will encounter the same cash flow prob-lems. However, those problems are not necessarily solved only by borrowing or byselling the shares. For example, controlling shareholders can remove and replaceunsatisfactory directors.42 Unlike shareholders who lack control, they do havealternative ways to recover their investment.

Thus, there are compelling policy reasons not to tax income on an accrual basisin all cases where a taxpayer holds shares in a non-resident corporation.

It follows from the definitions of “foreign affiliate” and “controlled foreignaffiliate” that the FAPI system applies only to outbound foreign investment. For-eign investors can make investments in Canadian subsidiaries without risk of beingtaxed on FAPI earned through branches or other subsidiaries located anywhere inthe world. Inbound foreign investment income is taxed on a strictly territorialbasis. Not only is there no rationale for accrual taxation of non-residents makinginbound investments, but such a practice would go against established interna-tional taxation principles and would divert foreign direct investment from Canada.

In such a situation, if the parent corporation operated through a branch, it wouldnot be considered a resident of Canada under the De Beers test, nor should it be.Given the true nature of the corporate tax—a mere proxy permitting the govern-ment to tax residents on their worldwide income and non-residents on their incomeearned in Canada—income from investment from a foreign source, made by per-sons who owe no economic allegiance to Canada, should be subject to tax only on aterritorial basis. If the FAPI system reached up to tax a foreign parent corporation

41 Brian J. Arnold, “A Tax Policy Perspective on Corporate Residence” (2003) vol. 51, no. 4Canadian Tax Journal 1559-66, at 1560.

42 CBCA section 106(3).


simply because it had a Canadian subsidiary, it would be perceived as an inequita-ble and “colourable attempt to tax non-residents on foreign income.”43

Thus, the rules that rely on the definition of “controlled foreign affiliate”require a substantial connection between the Canadian parent and the foreignsubsidiary for the FAPI system to apply.

Attribution of “Tainted” Income of theControlled Foreign Affiliate

Foreign Direct Investment and Portfolio InvestmentAlthough the principle underlying the taxation of income earned by a controlledforeign affiliate has a strong policy basis—namely, that Canada clearly cannot,through inaction, provide an incentive for Canadian-resident corporations to in-vest in low-tax jurisdictions or tax havens—the FAPI system raises serious questionsthat are not unfamiliar in the area of residence-based taxation. In particular, itraises questions about the desirability of foreign investment.

Whether a corporation earns income in a foreign jurisdiction directly or througha subsidiary, to the extent that its income is taxable on an accrual basis, doubletaxation becomes a predominant concern. It can dissuade corporations from engag-ing in any type of foreign direct investment. Such a disincentive is not consideredto be a desired result of worldwide taxation. Opportunities for foreign investment arevirtually unlimited, and foreign direct investment—that is, foreign investmentinvolving management control44—is perceived as both an engine of economicgrowth45 and a vehicle for the transfer of technology. The transfer of technologyresulting from foreign direct investment is not necessarily restricted to technolo-gies specific to the activities of multinational corporations. Indeed, in developingcountries lacking adequate infrastructure, “social technologies” such as telephone,police, and postal services and an education system might be introduced.46 Increasesin employment and living standards, cost reduction, and economic and industrialstrength are also often attributed to foreign direct investment.47 The value of foreigndirect investment is potentially gigantic. In contrast, portfolio investment is gener-ally not perceived in such a favourable light. Because of its passive nature, theadvantages that are believed to follow from foreign direct investment are not associ-ated with portfolio investment.

Furthermore, because other countries do not adopt an aggressive approach,levying taxes on foreign income regardless of its source and regardless of theconnection between the affiliate, the taxpayer, and the taxing jurisdiction could


44 Jones, supra note 7, at 5.

45 Ibid., at 234.

46 Ibid., at 235.

47 Organisation for Economic Co-operation and Development, Corporate Tax Incentives for ForeignDirect Investment, Tax Policy Study no. 4 (Paris: OECD, 2001), 19.


greatly impair the ability of Canadian corporations to remain competitive. Theywould be faced with a burden that foreign multinationals would not have to bear,and foreign investors would flee the Canadian market.

Consequently, taxation should not create a disincentive to foreign direct invest-ment. Portfolio investment, on the other hand, does not require such deference. Atthe international level, through an extended treaty network allocating the tax baseand providing for recognition of foreign taxes, countries attempt to remove thebarrier to foreign investment raised by worldwide taxation. At the domestic level,the FAPI rules attempt to achieve a similar result. When the FAPI system was firstelaborated, neutrality between the taxation of foreign subsidiaries and the taxationof foreign branches was not one of the guidelines. However, Canadian tax author-ities could not avoid grappling with policy questions raised on the internationalscene about foreign branches, nor could they ignore the results that inevitablyfollow from the need to prevent double taxation.

Not unlike what is accomplished by treaty, the definition of FAPI is designed to, ineffect, allocate the tax base. Each inclusion in and exclusion from FAPI aims toachieve a proper balance between competing policy objectives that sometimes appearirreconcilable. By including in the computation of income a percentage of the“tainted” income of any controlled foreign affiliate of a Canadian taxpayer, Canadaattempted to respond to the erosion of the tax base that resulted from the blurringof commercial boundaries.

In order to avoid double taxation, the FAPI system also takes into accountforeign accrual taxes paid by the controlled foreign affiliate with respect to amountsincluded in FAPI and the effect of taxation on an accrual basis when a controlledforeign affiliate distributes its earnings.

Foreign Accrual Property IncomeThe FAPI system, through the definitions contained in section 95, establishes adistinction between active and passive income. Recognizing the importance andthe value of foreign direct investment, the FAPI system considers income from suchinvestment to be income from an active business and excludes such income earnedby a controlled foreign affiliate from attribution to the Canadian parent. Conversely,passive income, which generally arises from portfolio investment, constitutes FAPIand is thus attributed to the Canadian-resident taxpayer.

More specifically, the term “foreign accrual property income” encompasses twotypes of income: property income and income from a business other than an activebusiness.48 Conceptually, property income and inactive business income are theopposite of active business income. The distinction between these sources ofincome is fundamental to the effective operation of the FAPI system. It is throughthe determination of the source of earnings that policy concerns are addressed andattribution is determined.

48 Li, supra note 35, at 11.


Property Income and Business Income: The Distinction

Dividends, interest, rent, and royalties are typical examples of property incomethat, when earned by a controlled foreign affiliate, will be subject to taxation on anaccrual basis. However, there is no single definition of property income. It is onlyby way of contrast with business income that characterization can be achieved.

One of the defining features of property income is that it is earned in a passivemanner. Unlike business income, it can be earned without investing in labour andcapital, and without the need for extensive organization of the affairs of the corpor-ation. The required level of intervention is extremely low.49 It does not involve thetransfer of technology, even of a social type, or of organizational structures betweenjurisdictions. While earning this type of income, investors are “passive,” contributingonly funds to the foreign economy. Consequently, investment that generates prop-erty income does not appear to carry any of the benefits of foreign direct investment.

Business income, on the other hand, requires a higher level of intervention. InWertman v. MNR,50 for example, Justice Thurlow considered that the nature and theextent of services provided were relevant in determining whether rental incomeearned from leasing premises was income from property or business income. Ac-cording to this decision, providing linen and maid service could transform whatwould otherwise be property income into business income.

Courts have consistently held that the characterization of income as propertyincome or business income should always be “made from an examination of thetaxpayer’s whole course of conduct viewed in the light of surrounding circum-stances.”51 By considering the level of services, the number and value of transactions,the time devoted to investment activities, etc., judges distinguish income from prop-erty from income from a business.52 However, corporations incorporated for thepurpose of earning profits for their shareholders are presumed to carry on businessactivities whenever they put their assets to any “gainful use.”53

Canadian Marconi v. The Queen54 and Canada Trustco Mortgage Company v. MNR55

are classic cases. While Marconi did not involve FAPI, it is nonetheless relevant. Inthat case, the judge had to determine whether the management of short-termsecurities bought in order to earn interest income while maintaining a certain levelof liquidity could constitute business income. Relying on the aforementionedpresumption, the Supreme Court held that surrounding factors were not sufficient

49 Krishna, supra note 1, at 241-42.50 64 DTC 5158 (Ex. Ct.).51 Canadian Marconi v. The Queen, 86 DTC 6526, at 6529 (SCC), citing Cragg v. MNR, 52 DTC

1004, at 1007 (Ex. Ct.).52 Krishna, supra note 1, at 245-46.53 American Leaf Blending Co. v. Director-General of Inland Revenue, [1979] AC 676, at 684 (PC).

There is some doubt with regard to the application of the presumption when no object is statedin constating documents: Marconi, supra note 51.

54 Marconi, supra note 51.55 91 DTC 1312 (TCC).


to overturn the presumption even though the Federal Court of Appeal found thatfew employees were involved in investment activities.

In Canada Trustco, the judge held that an extremely low level of activity wassufficient to characterize the income as income from an active business; in fact, theforeign affiliate appeared to carry on an even lower level of activity than the Canad-ian Marconi Company. Whereas Marconi was described by the Supreme Court asconducting a “large scale investment activity,”56 the foreign affiliate in CanadaTrustco simply explored opportunities for investment and eventually bought a limitednumber of mortgages in Canada. After referring to the presumption set out above,the court came to the conclusion that unsuccessful exploration of new businessopportunities could constitute an active business. Although the court did not referexpressly to the presumption, it must have greatly influenced the court’s decision.

Thus, even in the context of FAPI, the threshold for income to be characterizedas business income rather than property income is relatively low. It appears fromthe case law that as long as some activity is carried on, as long as income is notearned in a completely passive manner, income earned by corporations will becharacterized as business income. Consequently, business income does not neces-sarily have the attributes that render foreign direct investment valuable. Nothingensures that technology will cross borders and that wealth will be produced as aresult. Reflecting the fact that the concept of business investment does not neces-sarily imply a bona fide purpose for engaging in offshore investment, businessincome is not automatically excluded from the FAPI calculation under section 95. Itwill be excluded only if it can properly be described as active business income.

Active Business and Inactive Business:

Misinterpreted Concepts

After struggling with the distinction between property income and business income,the courts eventually arrived at a definition that was accepted by the Canadian taxauthorities in most areas of the tax law. However, when it came to the distinctionbetween an active business and an inactive business, their interpretation was farremoved from what was intended by the tax authorities. Indeed, the courts’ defini-tion of active business effectively eviscerated the concept of inactive business. Thedecision in Canada Trustco is a blatant example of this error of interpretation.

In Canada Trustco, the judge not only had to determine whether income earnedby the wholly owned foreign subsidiary constituted business income, but also hadto determine whether the income was active business income. When we look at thefacts of the case, it is obvious that, but for tax considerations, the foreign affiliate,Canada Trust Company BV (“BV”), would likely not have chosen the Netherlands asits country of residence and would not have acquired a portfolio of mortgages fromits parent. It is also clear that the few investments that were made could neverqualify as a type of investment that would create employment and enrich society.

56 Marconi, supra note 51, at 6531.


BV was a wholly owned subsidiary of Canada Trustco Mortgage Company(“Canada Trustco”) and incorporated under the laws of the Kingdom of the Neth-erlands. BV had three managing directors, one of whom was a Canadian citizenresiding in Amsterdam. He had been posted to the Netherlands by Genstar Cor-poration to work for the company’s offshore affiliates and, throughout the entirecommercial venture, was remunerated by Genstar Corporation.

In 1984, when the mortgage loans were remitted to the Netherlands, intereston such loans was not subject to Canadian withholding tax, nor was it subject to taxin the Netherlands, by virtue of the Canada-Netherlands treaty. Dividends re-ceived by the parent corporation from its foreign affiliate were also exempt fromCanadian tax. It is particularly significant that, when the Canada-Netherlandstreaty was renegotiated and the terms were changed, allowing the Netherlands totax interest on such loans, the agreements between BV and Canada Trustco “werethen no longer financially attractive on an after tax basis.”57 It appears from thejudgment that, aside from the mortgage loans, BV was not doing any businesswithin the jurisdiction in which it was incorporated. Hence, it seems that the onlypossible explanation for BV’s choice of the Netherlands as its country of residenceis tax planning. By their interpretation, the judges reinstated a flaw inherent in theconjunction of separate legal entity and residence that the FAPI system had tried tocorrect.

Property Income: A Revisited Definition

Following the Marconi and Canada Trustco decisions, the definition of “incomefrom property” in section 95 was amended to clearly indicate that income earnedby foreign affiliates should not be presumed to be income from an active business.58

Overturning the rebuttable presumption and the favourable treatment of incomeearned by corporations, income from property, in the foreign affiliate context,includes income derived from an “investment business” and from an adventure orconcern in the nature of trade as long as it is not deemed to be income from anactive business or income from a business other than an active business.

The use of the term “investment business” was inspired by the “specifiedinvestment business” rules applicable in the context of the small business credit.59

An “investment business” is a business the principal purpose of which is to deriveincome from property or “from the factoring of trade accounts receivable.” It alsoincludes businesses that derive profits from the disposition of “investment prop-erty”—that is, shares, an interest in a partnership or a trust, currency, real estate,etc.60 However, in some circumstances, activities that would otherwise fall within

57 Canada Trustco, supra note 55, at 1317.

58 Li, supra note 35.


60 See the definitions of “income from property,” “investment business,” and “investment property”in subsection 95(1).


the scope of the definition are excluded.61 Qualifying businesses that were con-ducted principally with persons with whom the affiliate deals at arm’s length andemploying at least five full-time employees in the active conduct of business areexcluded from the definition.

According to Angelo Nikolakakis, two broad categories of qualifying businessescan be identified: regulated and unregulated businesses.62 Indeed, the definition ofan investment business specifically excludes income derived from a business carriedon by a foreign bank, a trust company, a credit union, an insurance corporation, ora trader or dealer in securities or commodities that is regulated in the country inwhich it operates. The definition also excludes, regardless of the existence of regula-tion, income from a business where the business carried on is the development ofreal estate for sale, the lending of money, the leasing or licensing of property, or theinsurance or reinsurance of risks.63

Regulated businesses falling within the scope of the exclusion, either because oftheir level of activity or because of the existence of rules restraining their opera-tions, are presumed by the Act to have features indicating that tax avoidance is notthe sole purpose of their activities. Qualifying unregulated businesses with at leastfive full-time employees benefit from the same presumption. However, as Nikolakakispoints out, the rationale for the restriction of the “five full-time employees” require-ment to certain types of businesses is unclear.64

Business Other Than an Active Business

In the context of inactive business income, the difficulties encountered by the courtsled to further refinement. In 1994, the rules were amended to resolve certain issuesarising from decisions that were not always in harmony with the policies underly-ing the FAPI system. Five deeming rules were added to the Act. Income from thesale of property, income from insurance, income from Canadian debt and leaseobligations, income from partnership debt and lease obligations, and income fromcertain services rendered by a controlled foreign affiliate is deemed to be incomefrom a business other than an active business and, as such, cannot be recharacterizedas active business income under paragraph 95(2)(a) of the Act.65

Income from the Sale of Property

Under paragraph 95(2)(a.1), income earned through a foreign affiliate from thesale of property or from services related to a purchase or sale of property is deemedto be income from a business other than an active business when it is reasonable to


62 Ibid., at 3-31.

63 See the definition of “investment business” in subsection 95(1).


65 Li, supra note 35, at 19-20.


conclude that the cost of the property is relevant in computing the income of thecorporation residing in Canada or of any person with whom the corporation doesnot deal at arm’s length.

The provision was enacted in reaction to the Federal Court of Appeal decisionin The Queen v. Irving Oil Limited.66 At a time when transfer-pricing rules had notyet been enacted, Irving Refinery Ltd., concerned with the tax consequences of anarrangement with Standard Oil of California, incorporated an offshore subsidiaryin Bermuda for the purpose of acquiring crude oil. The subsidiary purchased thecrude oil at a price 60-65 percent below its market value and immediately resold itto the parent corporation at fair market value. The subsidiary did not even have tobear the cost of delivery, which was assumed by Standard Oil. An extra step in thechain of operation, an extra transaction, and an extra subsidiary were created forthe sole purpose of avoiding tax. Even though the court came to the conclusionthat the offshore subsidiary did not have a bona fide business purpose and the onlyreason for its existence was tax avoidance, it refused to apply section 245, the generalanti-avoidance rule.

There was no transfer of wealth or knowledge, or any of the benefits that makeforeign direct investment so valuable. In fact, no benefit to society could ever begenerated by such transactions. Given the court’s failure to apply the general anti-avoidance rule, paragraph 95(2)(a.1) was enacted to act as a backstop to the newtransfer-pricing rules.

Paragraph 95(2)(a.1), however, permits exceptions. Income earned from the saleof property that is “manufactured, produced, grown, extracted or processed” in thecountry under whose laws the foreign affiliate was constituted,67 or in Canada,68 isnot included in the computation of FAPI.

While the exclusion of income earned by a foreign affiliate from the sale ofproperty it manufactured seems in accordance with the general principles govern-ing the FAPI system, since manufacturing and processing seem to imply a bona fidepurpose, this is not the case for foreign affiliates that can buy property fromanother manufacturer located in the same jurisdiction and then sell the property ata higher price, or for foreign affiliates that manufacture property in other jurisdic-tions.69 The wording of subparagraph 95(2)(a.1)(ii) does not appear to effectivelytarget tainted income in all cases, as the tax treatment of income from the sale ofproperty “manufactured, produced, grown, extracted or processed” by foreign affili-ates depends upon the place of origin of the product and not upon the possibility ofmarkup.

On the other hand, the exclusion of income from the sale of property “manu-factured, produced, grown, extracted or processed in Canada” by the Canadian

66 91 DTC 5106 (FCA).

67 Subparagraph 95(2)(a.1)(ii).

68 Subparagraph 95(2)(a.1)(i).



taxpayer or by a person with whom the taxpayer does not deal at arm’s length,provided that the property is sold to non-residents other than the foreign affiliate(whether or not the latter acted as intermediary), was probably meant as a conces-sion to Canadian exporters.

Currency transactions of certain regulated businesses, such as Canadian-residentbanks or insurance corporations, benefit from special status. Under subsection 95(2.3),income derived from the sale or exchange of currency is excluded from FAPI when-ever certain conditions are met.70

Paragraph 95(2)(a.1) also includes a de minimis provision intended to achieveadministrative efficiency. Where such property sales are considered to be insignifi-cant—that is, where more than 90 percent of the gross revenue of the foreignaffiliate from the sale of property is derived from the sale of property manufacturedby Canadian businesses or in the affiliate’s home jurisdiction—those transactionsare disregarded in the computation of FAPI.71

Income from Insurance

Income from insurance is also deemed to constitute income from a business otherthan an active business. Under paragraph 95(2)(a.2), unless more than 90 percentof the gross premiums are in respect of the insurance of non-Canadian risks ofpersons with whom the affiliate deals at arm’s length, when a foreign affiliate insuresa Canadian-resident person, property located in Canada, or a business carried onin Canada, income that pertains or is incident to the insurance business must beincluded in the computation of FAPI.

Where most premiums relate to Canada, there is no purpose for operating thebusiness from a foreign jurisdiction other than tax avoidance. Furthermore, asmentioned in Victoria Insurance,72 once contracts are drafted and concluded, theinsurance business becomes dormant. Nothing happens aside from premium pay-ment unless there is realization of an insured risk. Consequently, when a Canadiancorporation operates the insurance business through a foreign affiliate, there is nopolicy rationale for excluding the income from the business from FAPI.

Income from Canadian Debt and Lease Obligations

The rule encompassing the tax treatment of income from Canadian debt and leaseobligations was enacted as a further reaction to the decision in Canada Trustco.Pursuant to paragraph 95(2)(a.3), income derived from indebtedness and leaseobligations of persons resident in Canada or in respect of businesses carried on inCanada must be included in the computation of income from a business other thanan active business unless it is specifically excluded by this provision. Again, theincome of Canadian taxpayers is protected by a de minimis exclusion.

70 For an explanation of those conditions, see Nikolakakis, supra note 10, at 3-48.

71 Ibid., at 3-49 to 3-50.

72 Victoria Insurance, supra note 22.


Under the current definition, controlled foreign affiliates managing short-termsecurities73 or a portfolio of mortgages74 will be subject to this provision. Evenincome earned by a capital-intensive firm whose employees devote a large percent-age of their time to the day-to-day management of investments could be caught bythe FAPI rules.

Services Deemed Not To Be Active Business

Not unlike the rules pertaining to the tax treatment of income derived from the saleof property, paragraph 95(2)(b) was designed to act as a backstop to the transfer-pricing rules. It provides that where payments for services rendered by a foreignaffiliate are deductible in computing the income of a business carried on in Canadaby any person in relation to whom the affiliate is a controlled foreign affiliate or bya person related to that person, income pertaining or incident to those services isdeemed to constitute income from a business other than an active business.

The rationale underlying the enactment of this provision differs slightly fromthe rationale for the other provisions discussed above. In contrast to the sale ofproperty, insurance, or Canadian debt or lease obligations, there may be a validreason for rendering services through a controlled foreign affiliate. The provisionof services may require technology and managerial expertise to cross jurisdictionalboundaries. Outsourcing services could definitely be an engine of growth. YetCanadian-resident corporations could be taxed on an accrual basis on this type ofincome. This rule reflects the importance of services in the Canadian economy.Indeed, in this case, the FAPI rules depart from neutrality to ensure that a foreignaffiliate will not take advantage of the development of communications technologyto offer services from a distance.

It is of particular significance in this regard to note that paragraph 95(2)(b) isone of the few elements of the FAPI system to stray from the tax base allocation underthe model tax convention of the Organisation for Economic Co-operation andDevelopment (OECD),75 which does not distinguish between income from an activebusiness and income from services. Article 7 of the model convention concedes theright to tax business income to the contracting state in which the business is carriedon if it is carried on through a permanent establishment.

In the case of the provision of services, there is little doubt that a permanentestablishment exists in the jurisdiction in which the business is carried on. Pursuantto article 5 of the model convention, a permanent establishment is defined as a“fixed place of business through which the business of an enterprise is wholly orpartly carried on.” Generally, when services are provided, there will be such a fixed

73 See Marconi, supra note 51.

74 See Canada Trustco, supra note 55.

75 Organisation for Economic Co-operation and Development, Model Tax Convention on Incomeand on Capital: Condensed Version (Paris: OECD, January 2003) (herein referred to as “the modelconvention”).


place of business. Indeed, employees will give the business a physical presence.Furthermore, where there are employees, the place of business cannot easily bemoved and will thus be fixed.76

In contrast, in the case of the other sources of income discussed above, a perma-nent establishment will probably not exist, either because of the truly passive natureof the investment or because the definition of permanent establishment under themodel convention excludes certain types of facilities and activities.77 In the case ofinsurance or debt and lease obligations, there is no need for physical presence.Furthermore, this type of activity will almost always lead to activities that areauxiliary in nature. The sale of property, on the other hand, could not give rise to apermanent establishment because the use of facilities for the sole purpose of storageor delivery of goods, the maintenance of merchandise for the purpose of process-ing by another enterprise, and the maintenance of a fixed place of business for thesole purpose of selling and reselling goods are excluded.

Capital Gains

The taxable portion of capital gains, to the extent that they accrued after theaffiliate’s 1975 taxation year, is also included in FAPI unless the gains accrued fromthe disposition of “excluded property.” The definition of “excluded property” insubsection 95(1) is particularly concerned with the active nature of a business. Thedestination of the property sold determines whether or not the capital gain will betaxable in Canada. Excluded property includes property used or held by a foreignaffiliate principally for the purpose of gaining or producing income from an activebusiness.78 It also includes shares of the capital stock of another foreign affiliate ofthe taxpayer where all or substantially all of the property of the other foreignaffiliate is excluded property,79 and an amount receivable the interest on which is,or would be if interest were payable thereon, income from an active business.80

These exceptions reflect the particular importance of active business. Relief fromtax encourages the purchase of machinery and equipment that can contribute tothe creation of global wealth.

Summary

The foregoing review of the deeming rules indicates that whenever the sole raisond’être of a controlled foreign affiliate is to shelter income from Canadian tax, when-ever the affiliate has no bona fide business purpose, the Act deems the income from thebusiness to be income from a business other than an active business.

76 Li, supra note 9, at 467-73.

77 Article 4(4) of the OECD model convention.

78 See paragraph (a) of the definition of “excluded property” in subsection 95(1).

79 See paragraph (b) of the definition of “excluded property” in subsection 95(1).

80 See paragraph (c) of the definition of “excluded property” in subsection 95(1).


Exclusions from FAPI: Active BusinessIncome and Other IncomeUnlike passive or “tainted” income, active business income is excluded from FAPI.As defined in subsection 95(1), active business income is income other than incomefrom an investment business or from a business deemed to be a business other thanan active business. It also includes certain types of income that would otherwisequalify as income from property. When the taxpayer has a qualifying interest,income derived from activities that can reasonably be considered to be directlyrelated to an active business carried on in a foreign jurisdiction and income derivedfrom interaffiliate payments, from the factoring of accounts receivable, or fromloans and lending of assets is deemed to be active business income.81 Interaffiliatedividends are also excluded from FAPI.82

Calculation of FAPIWith regard to the tax treatment of foreign direct investment made throughforeign subsidiaries, Canada adopted an exemption and credit system. Active busi-ness income is exempt, thus reflecting capital import neutrality, whereas FAPI, afterdeduction of foreign accrual tax, is included in the income of the multinationalcorporation residing in Canada.

The amount of FAPI, calculated separately for each controlled foreign affiliateand on a share-by-share basis, depends upon the participating percentage of thecontrolled foreign affiliate at the end of the affiliate’s taxation year. “Participatingpercentage” is defined in subsection 95(1). Although “participating percentage” isnot synonymous with “equity percentage,” the “participating percentage” will beequal to the “equity percentage” where there is only one class of shares and theFAPI of the affiliate for that year exceeds $5,000. Below this threshold, the partici-pating percentage is nil.83

The system also provides relief for foreign taxes paid by a particular affiliate orany other foreign affiliate of a taxpayer in respect of a dividend received from theparticular affiliate. Calculated separately in respect of each controlled foreignaffiliate, the deduction is limited to the lesser of two amounts: the amount of FAPIimputed to the parent corporation in respect of the particular affiliate for the yearand for the five preceding years, and the amount of Canadian tax the affiliate wouldhave paid had it earned its income in Canada. Consequently, where an affiliate paysmore tax in the foreign country than it would have paid in Canada, the excessamount cannot be used by the parent corporation to reduce the amount of Canad-ian tax payable in respect of income earned directly or through other affiliates.

81 See the definition of “active business income” in subsection 95(1) and paragraph 95(2)(a); and Li,supra note 35, at 13-14.

82 Li, supra note 35, at 18.

83 See paragraph (a) of the definition of “participating percentage” in subsection 95(1).


Since the very basis of the FAPI system is taxation on an accrual basis, relievingprovisions were inserted in the Act to ensure that, in the event that shares wereredeemed or sold, no double taxation would be incurred. Thus, the cost base of theshares held by the taxpayer is adjusted to reflect the fact that income derived fromthose shares has already been taxed. On the other hand, when retained earnings ofthe controlled foreign affiliate are ultimately distributed, the cost base has to beadjusted again to reflect the tax treatment of dividends paid out of previously taxedFAPI.84

Consequently, the FAPI system, through complex rules, ensures that taxpayers willnot suffer the sting of double taxation. Through a system of inclusion and exclusionbased on the source of income, Canada strove to provide tax treatment that wouldprevent tax avoidance, preserve export and import neutrality for income that Canadabelieves to be beneficial, and preserve Canada’s competitiveness.

T A X R E F O R M : I S I T T I M E T O G E T

R I D O F F I C T I O N S ?

But for the obvious inefficiency of the corporate residence test, the FAPI systemwould never have been created. Its adoption exemplifies the incremental approachpreferred by Canada’s tax authorities. Instead of revising the flawed concept that isat the heart of the corporate tax system, they fashioned a set of rules that wouldminimize the significance of its failures. Nonetheless, any attempt to defeat thecleverness of tax planners or to better accomplish policy objectives should not be builtupon existing principles simply because they are recognized and well established.

The analogy on which Lord Loreburn relied in setting out the residence testmight have had some value and some grounding in reality when he proposed italmost a hundred years ago; it might have been the result of a legitimate intent torespect the boundaries imposed by the tax legislation that then prevailed. However,without the adoption and constant modification of compensating measures, theresidence test appears to be ill suited to the complexities of global commerce andthe high level of integration of multinational corporations in the 21st century.

Indeed, there appears to be an inherent contradiction in the idea that a multina-tional corporation that extends its reach throughout the world could have a singleresidence. This notion does not reflect economic reality. The disconnection is onlyincreased by the separate legal identity of corporations, which means that multina-tional corporations can consist of many separate entities. The number of subsidiariesin relation to the number of multinational corporations is evidence of this fact;according to UNCTAD, a United Nations agency, in 2003 there were 64,000 inter-national corporations with 175,000 subsidiaries.85

84 See subsection 91(1), and Li, supra note 35, at 39. For further information concerning the costbase adjustment of shares and the distribution of retained earnings in the context of FAPI, seeNikolakakis, supra note 10.

85 Reported in “Corporate Tax: A Taxing Battle,” The Economist, January 31, 2004, 71.


Some commentators, despairing of a solution to the problems raised by corpor-ate residence, go so far as to call for the abandonment of worldwide taxation andthe adoption of territorial systems. Brian Arnold is skeptical about the feasibility ofsuch proposals.86 In his view, residence-based taxation should not be discarded soreadily. Even if it causes tax lawyers, tax planners, and tax authorities headaches,Arnold believes the corporate residence test can be “tweaked or supplemented” toensure that it can no longer be used as a tax-avoidance tool.87

Couzin suggests that new tests could be added to the existing tests of place ofincorporation and central management and control.88 Day-to-day management,among other things, is suggested as a proper nexus. Michael McIntyre, on the otherhand, considers that the central management and control test should be redefinedin terms rendering the test less open to manipulation.89 To him, “ceremonial events,”such as the annual shareholders’ meeting, should not be considered central to thedetermination of place of management.90 However, as Couzin himself underscores,treaty tie-breaker rules could defeat such attempts at redefinition since they couldstill work in favour of the other country.91

Controlled foreign affiliates could also be deemed to reside in Canada. How-ever, as Arnold points out, enforcement difficulties could arise for tax authorities ifthose foreign entities did not have assets in Canada. Thus, the Canadian share-holders would have to be taxed, but instead of paying tax “on their pro rata share of[the] FAPI [of the subsidiary], they would be liable for their pro rata share of theforeign corporation’s Canadian tax on its worldwide income.”92 Under such aregime, problems relating to the characterization of income and tax base allocationwould not be eliminated. Rules adopted under the FAPI system would simply haveto be modified to reflect this reality.

Another possibility would be to adopt worldwide combined reporting withformulary apportionment.93 McIntyre suggests that the system in place in Californiacould be adapted to the national context. Political and economic decision makers,however, may not be ready to take such a radical step.

Although redefining the corporate residence test appears to be necessary, con-sidering how flawed it is and how easily tax can be avoided, certain factors supportthe status quo. There is an unavoidable risk in tax law that any change designed tosolve existing problems may create new ones. Furthermore, as Arnold suggests, the

86 Arnold, supra note 41, at 1564-65.

87 Ibid., at 1561.


89 Michael J. McIntyre, “Determining the Residence of Members of a Corporate Group” (2003)vol. 51, no. 4 Canadian Tax Journal 1567-73, at 1570-71.

90 Ibid., at 1571.

91 Couzin, supra note 14, at 265-66.

92 Arnold, supra note 41, at 1563.

93 See McIntyre, supra note 89, at 1570-71, and Li, supra note 9, at 599.


defects of the residence concept may not significantly affect the ability of tax author-ities to maintain tax neutrality and meet other policy objectives.94 The FAPI systemwas developed in this context, and its scope in preventing tax avoidance is extensive.However, if the tax authorities opt to retain the present approach, the rules will haveto be strengthened to ensure that further developments in global commerce and theinexhaustible creativity of tax planners do not defeat the purpose of the regime.95

C O N C L U S I O N

Foreign direct investment can serve as a potential engine of growth for economiesaround the world. It allows technology to cross jurisdictional boundaries and reducesproduction costs. It distributes knowledge and stimulates creativity, pushing ourworld a little bit further every day. It has the potential to improve the standard ofliving in distant, and even remote, regions of the globe. Canada should therefore notimpose unnecessary constraints by placing an undue tax burden on Canadian invest-ments in foreign jurisdictions; at the same time, it cannot allow Canadian residentsto escape tax through the use of non-resident subsidiaries.

In a world governed by ingenuity and competitiveness, either course of actioncould have fatal and unwanted consequences. It would create a strong and destruc-tive incentive to export capital, to earn income in a foreign jurisdiction rather thaninvest in the Canadian market.96 It could potentially undermine the Canadianmarket. It could destroy the base of any income tax levied by tax authorities. Itwould jeopardize programs that are the pride of Canadian society and that couldnever exist without wealth and complementary tax measures designed for efficientrevenue collection.

The concept of corporate residence, based on the tests of place of incorporationand central management and control, is unable to ensure the viability of our systemwithout recourse to anti-avoidance measures. The FAPI system is an example ofsuch measures. In effect, it both lifts the corporate veil and allocates the tax basethrough a complex set of rules. It permits the identification of the real beneficiariesof corporate earnings and ensures that they are taxed in a way that respects policyconcerns relating to competitiveness, economic growth, and prevention of erosionof the tax base. The foreign investment entity (FIE) regime, in section 94.1 of the Act,is intended to complete the FAPI system by preventing deferral where a Canadianresident invests in a foreign entity that is not a controlled foreign affiliate.

Some argue that the concept of residence-based taxation should be revisited andpropose a variety of alternatives. Others vouch for the status quo as long as the FAPIsystem, completed by the FIE regime, and treaty networks are reinforced. Whichavenue tax authorities will choose, only time will tell.

94 Arnold, supra note 41, at 1565-66.

95 See Li, supra note 9, at 533.

96 See Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department ofFinance, April 1998).

residence-based taxation and fapi: a world of fictions · residence-based taxation and fapi: ... in...

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