Cross-Charges for Real Estate in the International Context

Canadian-based entrepreneurs commonly use separate companies to hold real estate and active businesses, and cross-charge rents to active businesses using that real estate in their business. This is typically done to separate the financial risks associated with the real estate and the business. Whether this planning is used in the domestic Canadian context or the international context, there are rules that, in particular cases, allow for the recharacterization of passive (rental) income as active business income, which is taxed under Canadian rules at a lower effective tax rate. However, applying a standard domestic structure in the international context can result in FAPI instead of active business income, with unfortunate tax results.

Canadian Domestic Context

In the figure below, in the typical Canadian context, Mr. X is a resident of Canada who owns all the shares of both Holdco and Restaurantco. The latter company operates a restaurant in Canada. Holdco owns all the shares of Rentalco, which owns a building that it rents to Restaurantco in return for an appropriate FMV rental charge. All three companies are incorporated and resident in Canada.

As is well known, the rental income earned by Rentalco from Restaurantco is income from property, which would normally be taxed at the high investment income rate of a CCPC. However, because Rentalco and Restaurantco are associated corporations (pursuant to paragraph 256(1)(b)), this rental income is recharacterized as income from an active business (pursuant to paragraph 129(6)(b)). This allows for some or all of the corporations' $500,000 small business limit to be allocated to Rentalco, and for Rentalco's rental income to be taxed at a lower rate (for example, in Ontario, at 12.5 percent rather than 50.17 percent).

International Context

As before, assume that Holdco is incorporated and resident in Canada. But now assume that Rentalco and Restaurantco are foreign corporations by incorporation, residence, and the location of their operations. Rentalco is therefore a controlled foreign affiliate of Holdco (and, as such, is subject to the FAPI regime). However, Restaurantco is not a foreign affiliate of Holdco because Holdco does not have a direct equity percentage in Restaurantco.

The rental income earned by Rentalco from Restaurantco meets the definition of FAPI in subsection 95(1) and will be taxed as FAPI of Holdco. For the rental income to be recharacterized as active business income under subparagraph 95(2)(a)(ii), Holdco must have a "qualifying interest" in the payer foreign affiliate (that is, Restaurantco). In addition, Restaurantco must be resident or doing business in a country with which Canada has a tax treaty or tax information exchange agreement (TIEA). Unlike in the Canadian context described above, having common control by Mr. X does not result in Holdco having a qualifying interest in Restaurantco, because there is no direct share ownership by Holdco in Restaurantco. Therefore, the rental income will not be eligible for recharacterization as active business income and will remain FAPI to Holdco.

Unless there are non-tax reasons to hold Restaurantco in this manner, Mr. X should remedy this situation by either transferring his shares of Restaurantco to Holdco on a tax-deferred basis or arranging for at least 1 percent of Restaurantco's shares to be transferred to Holdco.

John Tang
Burlington, ON

Jody Wong
MNP LLP, Toronto

Canadian Tax Focus
Volume 9, Number 4, November 2019
©2019, Canadian Tax Foundation