Canadian residents carrying on business outside of Canada are subject to Canadian income tax on all profits earned in the course of that business. For example, where a Canadian corporation earned business income from a business carried on in the United States, all profits earned by the Canadian corporation in the U.S. will be subject to Canadian taxation. In computing the amount of Canadian income tax payable on the profits earned abroad, the Canadian corporation may claim a credit (deduction from the Canadian tax payable) for the income and other similar taxes paid on those profits to foreign governments. In the example above, in computing its Canadian tax liability, the Canadian corporation should be able to reduce its Canadian income tax payable by the amount of U.S. federal and state income taxes.
A Canadian taxpayer may also carry on business abroad through a foreign business corporation established in a foreign country or, in some cases, in a tax haven. Where a Canadian resident owns more than 10 percent of value and equity in a foreign corporation, the foreign corporation becomes a foreign affiliate of the Canadian resident. The Canadian tax laws afford significant tax preferences to the income of foreign affiliates repatriated back to Canada in the form of dividends paid out of so called exempt surplus of foreign affiliates. Generally, such dividends are not subject to Canadian income taxation when paid by a foreign affiliate to a Canadian corporation.
However, the design of the Income Tax Act contemplates that, as anti-avoidance measure, any passive income earned by a foreign affiliate is included proportionally in the income of the Canadian shareholder. The income, known as foreign accrual property income, or FAPI, of a foreign affiliate includes passive income, such as interest, royalties, portfolio dividends, as well as other income, including certain active business income from Canadian sources.
Canadian shareholders owning shares in foreign affiliates are required to file information returns with Canadian tax authorities in the Form T1134. The failure to file an information return may result in penalties.
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