Canada: How The CRA’s New Assessing Position Can Reduce Your FAPI

The Income Tax Act (Canada) contains a foreign accrual property income (FAPI) regime that imputes "passive income" earned by a non-resident corporation (a controlled foreign affiliate) to its Canadian-resident controlling shareholders on an annual accrual basis, whether or not such income is distributed to the non-resident corporation's shareholders. Passive income earned by a controlled foreign affiliate includes income derived from an "investment business." Generally, an "investment business" will be any business that is carried on in a taxation year by a controlled foreign affiliate, the principal purpose of which is to derive income from property and other specified sources. However, such a business will not be an "investment business" if it can be established that ─ amongst other things ─ the controlled foreign affiliate, throughout the period during which the business is carried on, employs "more than five employees full time" (or the equivalent thereof provided by related corporations, certain members of partnerships, and, pursuant to a recent amendment, certain shareholders, corporations and partnerships) in the active conduct of the business.

Historically, the Canada Revenue Agency's (CRA) assessing practice has been to treat any business with less than six full-time employees and whose principal purpose is to derive "income from property" as an investment business.¹ The basis for the CRA's assessing practice was a number of cases that interpreted the phrase "more than five full-time employees," as used in connection with the small business deduction for Canadian corporations.²

Recently, however, the CRA has confirmed that it is changing its assessing practice for purposes of the FAPI regime³ such that a controlled foreign affiliate will now meet the "more than five full-time employees" exclusion in the investment business definition where the controlled foreign affiliate employs five full-time employees and one part-time employee in the active conduct of the business.⁴ Consequently, a Canadian shareholder of a controlled foreign affiliate that employs five full-time employees and one part-time employee in the active conduct of its business will not be subject to FAPI imputation, provided other requirements are satisfied.

This change to the CRA's assessing practice was prompted by the recent Tax Court of Canada decision in 489599 B.C. Ltd. v. The Queen.⁵ In this case, the issue to be determined was whether a taxpayer satisfied the "more than five full-time employees" requirement at a time when it employed five full-time employees and two part-time employees. The Tax Court of Canada concluded that the expression "more than five full-time employees" can be satisfied with the employment of five full-time employees and one part-time employee.

In reaching this conclusion, the Tax Court declined to follow the Federal Court Trial Division's decision in Hughes & Co. Holdings Ltd. v. The Queen,⁶ wherein the Federal Court held that "more than five full-time employees" means at least six full-time employees. Notwithstanding that the Hughes decision has been followed in other cases, the Tax Court's view in 489599 B.C. Ltd. was that the Hughes case was incorrectly decided because the Federal Court had relied on irrelevant precedents, adopted a method of statutory interpretation that was inconsistent with that established by the Supreme Court of Canada, and misinterpreted Parliament's intention with respect to the language used in the expression. Furthermore, the Tax Court found that it was not bound by the Hughes decision as the Federal Court's interpretation of the expression was obiter. In finding that the phrase "more than five" should not be equated as meaning "at least six," the Tax Court stated that had Parliament intended the provision in question to apply only to those businesses that employ at least six full-time employees, Parliament would have used such language.

Consequently, taxpayers who have imputed FAPI based on the CRA's past assessing practice should consider filing amendments to past returns based on the CRA's assessing practice.

Footnotes

1 This assessing practice is analogous to that adopted by the CRA in the context of the small business deduction. See Interpretation Bulletin IT-73R6, "The Small Business Deduction" (March 25, 2002) at para. 15. Also see CRA Doc. No. 2001-0110915 (December 4, 2001).

2 See Hughes & Co. Holdings Ltd. v. The Queen, 94 DTC 6511 (FCTD); Raedarc Holdings Ltd. v. the Queen, 98 DTC 1218 (TCC); and Woessner v. The Queen, 9 DTC 1039 (TCC). For an opposing view, see Lerric Investments Corp. v. The Queen, 2001 DTC 5169 (FCA), wherein the Federal Court noted in obiter that it was not convinced that the "more than five full-time employees" could not be satisfied with five full-time employees and one part-time employee.

3 CRA Doc. Nos. 2008-0300581C6 (March 5, 2009) and 2008-0299161I7 (December 14, 2008).

4 Ibid. The CRA has confirmed that its new position supersedes the position set out in Interpretation Bulletin IT-73R6 and any previous technical interpretations issued by the CRA on this matter.

5 2008 DTC 4107 (TCC).

6 Supra note 2.

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