Maintaining Foreign Affiliate (FA) Surplus Account Balances
Absent the FAPI rules, Canada will generally only tax the profits of an FA upon a repatriation of such profits in the form of a dividend (or a deemed dividend triggered by the upstream loan rules) to a corporation resident in Canada (CRIC). The surplus and underlying foreign tax account balances of an FA in respect of a CRIC effectively determine the Canadian tax treatment of a dividend (or a deemed dividend) paid by the FA to the CRIC and the tax treatment of a disposition of shares of an FA. Surplus account balances are also relevant in the context of the application of certain other provisions of the Income Tax Act (the Act), including paragraph 55(5)(d) (safe income) and paragraph 93(1.1)(b) (negative ACB deemed gains). From a tax compliance perspective, Form T1134: Information Return Relating To Controlled and Not-Controlled Foreign Affiliates, requires a CRIC to report dividends received in a taxation year from an FA and the corresponding surplus account balances.
At the 2019 Annual International Fiscal Association (IFA) Conference, the CRA indicated that it would deny a deduction claimed under section 113 of the Act in respect of a dividend received by a CRIC from an FA if detailed surplus account computations were not provided to support the deduction. Specifically, the CRA stated:
The calculation of the surplus accounts is required, amongst others, to substantiate the claim of a deduction under subsection 113(1). Detailed rules in Part LIX of the Regulations … determine how those surplus accounts are to be computed and the amount prescribed to have been paid out of each of those accounts and the pre-acquisition surplus (“PAS”) for purposes of the different paragraphs of subsection 113(1) … It is the duty of taxpayers and their representatives to use due care in claiming that the amount of a dividend is deductible under subsection 113(1) of the Act and that accurate allocations are made under the related Regulations … If complete surplus computations are not provided to the CRA, the current CRA general practice is to deny the deduction under subsection 113(1) of the Act.
In addition, taxpayers are responsible for documenting their own affairs in a reasonable manner. In that respect, subsection 230(1) of the Act specifically requires taxpayers to maintain records and books of account, in such form and containing such information as will enable the determination of taxes payable under the Act. Pursuant to paragraph 231.1(1)(a) of the Act, the books and records of a taxpayer may also be inspected, audited, or examined, by an authorized person of the CRA.
An unsupported claim of a deduction under subsection 113(1) of the Act could be subject to the application of subsections 152(4), 163(2), or 163.2(2) and 239(1) of the Act, among others, depending on the circumstances.
The CRA’s response implies a deduction will be denied even if partial support is provided that ample surplus is available to claim a full deduction.
A pre-acquisition surplus (PAS) election can be filed to deem a dividend paid by an FA of a CRIC to have been paid in whole or in part out of the affiliate’s PAS and not out of the FA’s other surplus accounts. In the question posed at the 2019 IFA Conference, the CRA further stated that it would not accept a late-filed PAS election in cases where a deduction was denied under section 113.
In the coming years, there is likely to be additional audit activity by the CRA in respect of FAs. As proposed in the 2018 federal budget, the Act was recently amended to extend the normal reassessment period by three years if the assessment is made in respect of any income, loss or other amount in relation to an FA of a taxpayer. The Department of Finance stated that this amendment was made to “ensure that the Government has a reasonable opportunity to properly examine all activities in respect of foreign affiliates of a taxpayer that are relevant to the Canadian tax base”. Also, during 2021, the CRA released a revised Form T1134 that requires the disclosure of additional information respecting the FAs of a CRIC. The revised form is effective for taxation years or fiscal periods that begin after 2020 and must be filed within 10 months after the year-end (formerly, the filing deadline was 15 months after year-end). New questions were also added that relate to the upstream loan rules, FA dumping, tracking interests, and pertinent loan or indebtedness (PLOI) elections. FA audits can be complex and time-consuming. If the CRA is not satisfied with responses/documentation provided, including in respect of FA surplus balances, it is not uncommon for the CRA to issue requirements for extensive information located in foreign jurisdictions or to request the exchange of information from a tax treaty or TIEA partner.
In addition to taking into consideration the CRA’s section 113 deduction policies/audit activities, there are other compelling reasons to keep up-to-date surplus account computations. For example, even if there are no current plans for an FA to pay a dividend or make an upstream loan to a CRIC, surplus account balances are important in the context of structuring an FA reorganization or M&A related transaction.
Surplus calculations can be time-consuming, particularly if many years are involved, reorganizations have been undertaken in prior years, there has been staff turnover or change in advisors, or the FA’s tax returns and financial statements must be translated into English. Furthermore, the computation of surplus accounts is not an exact science; the Regulations contain complicated interpretational issues that require the exercise of professional judgment (limited administrative and judicial guidance is available). Our team of experienced international tax experts would be happy to prepare or review your FA surplus account computations and to explore related tax planning opportunities.
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