Canada: Tracking arrangement proposals: the foreign affiliate rules and segregated portfolio companies

April 30 2018

Under existing rules, foreign accrual property income (FAPI) earned by a controlled foreign affiliate (CFA) of a Canadian resident taxpayer generally will be taxed in the taxpayer's hands in the year it is earned, regardless of whether such earnings are distributed to the Canadian resident. Foreign accrual property income includes passive investment income and certain other stipulated amounts. This tax treatment is intended to prevent Canadian residents from earning passive income through an offshore subsidiary in a low tax jurisdiction while deferring the income recognition for Canadian purposes until distributions are made. If FAPI is earned in a foreign affiliate of a Canadian resident taxpayer and that affiliate is not a CFA, the earnings may not be subject to Canadian tax until distributed to the Canadian taxpayer.

There is also an exception to exclude from income that would otherwise be considered to be FAPI certain income earned by a foreign affiliate employing more than five full-time employees in the business giving rise to the relevant income (the 'six employees threshold'). This exception is also based on the total activities of the foreign affiliate.

The Canadian government was concerned that foreign companies that permitted the establishment of separate cells or segregated accounts within a single legal entity were being used by Canadian taxpayers to earn passive investment income without such income being appropriately taxed. Segregated cell or segregated portfolio companies (SPCs) allow a number of investors to pool their funds in the SPC. Each investor may effectively control its segregated portfolio, however, the investor would not control the SPC. Consequently, the SPC would not be a CFA of any Canadian resident investor, and, as such, passive investment income earned in the Canadian resident's segregated portfolio would not be taxed as FAPI on a current basis in the Canadian resident's hands.

Furthermore, as the six employees threshold described above is determined on a legal entity basis, an SPC could meet this threshold and income earned in a segregated portfolio of an investor might be excepted from being FAPI, even though such employees of the SPC may devote only a small fraction of their time to each segregated portfolio of the SPC.

The 2018 Canadian federal budget introduced rules to address both of these concerns. First, where income from an activity of a foreign affiliate of a Canadian resident taxpayer is earned through a 'tracking arrangement' (which should include income earned through a segregated portfolio of an SPC), such foreign affiliate would be deemed to be a CFA of the Canadian resident in respect of the activities of the foreign affiliate that are undertaken on behalf of that investor. Second, the activities undertaken in connection with a particular tracking arrangement would be deemed to be a separate business, such that the six employees test would be applied separately to each segregated portfolio or cell of an SPC that was a foreign affiliate of a Canadian resident taxpayer.

The tracking arrangement proposals will be effective for taxation years of a foreign affiliate beginning on or after February 27 2018. As specific draft legislation addressing these proposals has not yet been released, and the full breadth of these measures is not yet known. One issue to monitor is whether foreign investment funds structured as corporations that offer different classes of shares could potentially be caught by these proposals.