Foreign Accrual Property Income

Foreign Accrual Property Income, usually known as FAPI, is a tax term meaning the government will tax foreign earnings, regardless of tax treaties, if it deems the source of earning to only be "investment activity". It is a law applied in countries such as Canada.

Definition

Let's say you're a Canadian and you buy bonds from Hong Kong. The interest you receive from those bonds are considered a profit to you, and so would be taxed by the Canadian government. What if you want to avoid those taxes?

You would set up a foreign company, let’s say in Barbados, to buy bonds for you; what then? Barbados' corporate tax rate is 2.5%, compared with Canada's 35% tax rate. And, since there is a Double Taxation Avoidance Agreement (DTAA) between Canada and Barbados, your profit is repatriated in the form of tax free dividends. Therefore, instead of paying 35% on profit to the Canadian government, you only pay 2.5% on profit to the Barbados government. So the question to ask is: why would the Canadian government allow that?

Well, the simple answer is it doesn't. If the sole purpose of you setting up that company in Barbados is to avoid Canadian taxation, your operation is deemed a sham. In this case, the Canadian government will treat the Barbadian income as Canadian income, and will tax it at 35%, even though there is a DTAA with Barbados. This is called the FAPI regulation.

Avoiding FAPI

But the reality is that companies are running front operations in countries such as Barbados or Ireland for the purpose to save on taxes. And so, how do they do it? The answer is beyond the scope of this article, but the simple answer to avoiding FAPI is this: you must set up an "economic business" and not an "investment business".

Investment Business

An "investment business", as described earlier, is a business where the sole purpose is to make money from domestic or foreign ownership of stocks, bonds, and other investments. The business does not "make" anything. Plus, it could be easily run by only one person at the incorporated location, while in reality actually being operated by a foreign company. An "investment business" could be used for the sole purpose of avoiding FAPI.

Economic Business

An "economic business" is a business that actually generates economic activity such as manufacturing a product, conducting a service, and so on. It is the only way a company can avoid FAPI. For example, Microsoft makes money through royalties of licensed software. To save on tax, it has opened a subsidiary in Ireland. This subsdiary has a R&D operation and is responsible for licensing its software throughout Europe and Africa, which thereby makes it a bona fide "economic business". In turn, by going through Ireland, a tax haven, and taking advantage of its low corporate tax rate, Microsoft effectively saves US$ 500 million in yearly global taxes.

References

* Xilinx Inc. v. C.I.R. 125 T.C. No. 4 (Filed 8/30/2005)

ee also

* Tax avoidance and tax evasion
* Income taxes in Canada