Surplus Accounts and Foreign Affiliate Tax Traps

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Surplus Accounts and Foreign Affiliate Tax Traps

Canadian corporations with subsidiaries in other countries (a “foreign affiliate”) could find themselves facing a nasty surprise tax bill from the Canada Revenue Agency (“CRA”) when they transfer funds back to Canada.

Aside from being located outside of Canada, a foreign affiliate is generally a non-resident corporation in which the taxpayer’s equity percentage is at least 1%, and the total equity percentage of the taxpayer and related persons is at least 10%.

Dividends received by a Canadian taxpayer from a non-resident corporation (foreign affiliate) must be included in the taxpayer’s income. Offsetting deduction is available for Canadian corporate taxpayers through a notional surplus account of a foreign affiliate. Canadian companies with foreign affiliates must maintain Surplus Account Calculations for each foreign affiliate. There are four possible Surplus Accounts that may be required; at a high level, these accounts are summarized as follows:

Exempt Surplus

Comprised of the earnings from an active business carried on by the foreign affiliate in a designated treaty country or country under a Tax Information Exchange Agreement (TIEA), less any income taxes paid by the foreign affiliate. Dividends paid out of this surplus account would not be taxable to the Canadian parent corporation (excluding any withholding tax requirements in foreign jurisdictions).

Taxable Surplus

Consists of the earnings from an active business carried on by the foreign affiliate in a non-designated treaty country or country with which Canada does not have a Tax Information Exchange Agreement (TIEA), plus any foreign property income, less any income taxes paid by the foreign affiliate. Dividends paid out of this surplus account will be taxable in Canada if the foreign tax paid by the foreign affiliate is lower than Canada’s tax rate.

Hybrid Surplus

This account includes any capital gain from the sale of foreign affiliate shares and/or partnership interest. Dividends paid out of this account will be included in income at 50%, further reduced by any foreign income taxes already paid by the foreign affiliate on the resulting capital gain in question. This mirrors the current Canadian tax treatment of capital gains.

Pre-Acquisition Surplus

This account is not defined for tax purposes, but can be thought of as a return of capital from the foreign affiliate. Dividends from this surplus account would also not be taxable. However, any payment from this account would also reduce your Adjusted Cost Basis (“ACB”) of shares held by the Canadian Parent Corporation. The downside is that if the ACB of the foreign affiliate shares becomes negative, there will be a resulting taxable capital gain to be included in income.

These various surplus accounts are needed to determine the correct tax treatment when the foreign company looks to transfer funds back to the Canadian parent company.

While dividends paid from a foreign affiliate (located in a country with which Canada has a tax treaty) by an active business are usually exempt from additional corporate income taxes due to having exempt surplus available; it is not enough in the eyes of the CRA to ignore computing these surplus accounts with the thought of “the amount will not be taxable, so why bother making this complex calculation?”.

The CRA is of the opinion that it is the taxpayer’s duty to maintain all records of surplus accounts in order to support the tax treatment of any fund repatriations from foreign affiliates. If the CRA requests support of these surplus accounts and you cannot provide them on request, the ramifications can be severe: all deductions denied in respect to the funds in question, full inclusion into income as ordinary foreign investment income, along with interest and penalties.

Failure to provide the information would likely constitute gross negligence, allowing CRA to go beyond the normal reassessment period, triggering larger penalties of up to an additional 50% of any tax that is now due in each year, and even imprisonment in extreme cases.

For foreign affiliates, surplus accounts are a highly complicated area of cross-border tax.  If your business has operations in the United States or any other foreign country, it is advisable to speak with a member of our tax team to ensure you avoid costly surprises when repatriating funds back to Canada.

This article was updated in November 2023.

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