This article will be the first in a series related to the Canadian tax implications of Canadians investing in foreign countries, with a particular emphasis on the United States. As the series develops we expect that updates will be made to the previously published articles.
Are you making corporate loans for foreign investments? Then, understanding “deemed interest” charges is critical. Frequently we see Canadian companies making investments in foreign countries, directly or indirectly, whether real estate investments, business activities, machinery and equipment, etc. The Canadian companies often loan funds to the foreign entities to acquire the target assets.
But, when a non-resident owes money to a Canadian corporation, the Canadian Income Tax Act requires that effectively the Canadian corporation must pay tax on interest income from the loaned funds, whether interest was formally charged or not. So, even if you don’t charge interest, you will still be taxed as if you did.
Prescribed interest rates – the minimum
If the funds owing have been outstanding for more than a year, the Canadian company must record a reasonable amount of interest income on the loaned funds. As a minimum, this interest is at the “prescribed rate.” The prescribed rate is set quarterly based on the yields of Government of Canada Treasury Bills. For the last few years, the rate has predominantly been 1%, and occasionally 2%.
The minimum prescribed rate is ignored when actual interest income has been included in the Canadian company’s taxable income, as long as that income is of an amount at least equal to the prescribed rate. Thus, in most cases we expect that the foreign entity would be better off to have a “real” tax deduction as compared to a “deemed” interest deduction within the foreign entity. In other words, ensure that on an annual basis interest income is recorded in the Canadian company and an interest expense/liability is shown (ideally paid at least annually) in the foreign entity. Depending on the country involved, tax withholdings may be applicable in the foreign country. There are no withholdings for interest paid from U.S. entities.
Foreign accrual property income (FAPI)
Further, in some situations the deemed interest income would not be applicable where the interest was already included into the income of the Canadian company through the “foreign accrual property income” (FAPI) rules. We’ll be discussing the basics of FAPI in a separate article as it is critical to understand the basics for Canadians investing abroad.
Controlled foreign affiliate
Another key exception to the interest rules relates to investments made to a “controlled foreign affiliate” of the Canadian company to earn income from an “active business.” While a slightly different definition of active business is used for foreign affiliates, it is very similar to the typical definition used elsewhere in the Canadian Income Tax Act.
A controlled foreign affiliate can be loosely defined as:
A foreign company of which the Canadian resident directly or indirectly owns sufficient shares of the foreign company to exercise control over the foreign entity’s activities.
We will be discussing active vs. inactive income in a separate article as well given its importance to Canadians investing in Canada and in foreign countries.
Anti-avoidance rules – no escaping the tax?
The Canadian Income Tax Act has various “anti-avoidance” rules that prevent escaping the deemed interest charge rules, such as from common situations where loans are made to different foreign entities, indirect loans, back-to-back loans etc. Draft legislation clarifying a variety of the detailed rules was introduced in July 2013.
Overall, the key to remember is that one way or another a Canadian corporation will be required to include into its taxable income a minimum amount of interest income annually from loans made directly or indirectly to foreign entities.
Related articles on investing in foreign countries
- Cross-border shopping: 7 tax tips for US investors
- US Tax Filing deadlines – a cheat sheet for Canadian
- Investing in the US: Who should own your property?
- New US tax filing rules on foreign assets
- “Tip #77 – There are foreign and domestic tax implications to buying foreign real estate.” 81 Financial and Tax Tips for the Canadian Real Estate Investor by Campbell, Dube and Murji: Wiley 2nd Edition
- Pages 160-162. Legal, Tax and Accounting Strategies for the Canadian Real Estate Investor by Cohen and Dube: Wiley
This article is brief in nature, omitting detailed information and exceptions such that the summarized information should not be relied upon without the advice of qualified advisors.
George E. Dube, CPA, CA