Canada: Foreign Affiliate Proposals - Some Welcome And Unwelcome Changes

On August 19,  2011, the Department of Finance (Finance) released extensive proposed amendments (2011 Proposals) to the foreign affiliate rules which, in some cases, replace a number of the more controversial amendments that were contained in the proposed amendments released on February 27, 2004 (2004 Proposals) and that may be viewed as a significant shift in tax policy. Many of the less controversial amendments contained in the 2004 Proposals, which replaced earlier proposals released in 2002, have been passed or included in other draft legislation packages. For a discussion of certain of the earlier proposals, see Tax Update dated January  22,  2010.

In the release accompanying the 2011 Proposals, Finance referred to the recommendation of the Advisory Panel on Canada's System of International Taxation (Advisory Panel) in December 2008 that changes be made to Canada's system of taxation to extend the exemption system to all active business income, regardless of the source country. If the recommendation were adopted, the system would be greatly simplified since there would be no need for the concept of taxable surplus. Finance expressly rejected this recommendation on the basis that access to exempt surplus treatment is being used as an incentive to encourage countries to enter into Tax Information Exchange Agreements (TIEAs) with Canada. TIEAs are a current priority of the Government.

What follows is a brief overview of selected amendments contained in the 2011 Proposals. The topics discussed include the new upstream loan rule, the new hybrid surplus rules, the new anti-avoidance rule with respect to surplus reclassification, the new return of capital regime with respect to foreign affiliates, amendments to the reorganization rules, the tightening of the foreign accrual property income (FAPI) regime with respect to FAPI capital losses, changes to the rules with respect to the calculation of a foreign affiliate's earnings and changes to foreign exchange gains and losses.

Finance is accepting comments on the 2011 Proposals until October 19, 2011. It remains to be seen whether these proposals are the last word on changes to the foreign affiliate rules. Canadian taxpayers who relied on earlier proposals in their tax planning will need to consider whether the 2011 Proposals give rise to adverse or beneficial treatment.

Upstream Loans

In what can only be viewed as a significant tax policy shift from the provisions of the Income Tax Act (Canada) (Act) and their application by the Canada Revenue Agency in published tax rulings, the 2011 Proposals contain a new upstream loan rule. This rule is modelled on existing subsection 15(2) of the Act (domestic shareholder loan rule). Under the upstream loan rule, Canadian taxpayers will be required to include in their income the amount of loans made by their foreign affiliates to them and to certain non-arm's length persons (other than controlled foreign affiliates of the taxpayers). Like the domestic shareholder loan rule, there are exceptions for indebtedness repaid within two years of the date the indebtedness arose, provided the repayment is not part of a series of loans or other transactions and repayments, and for indebtedness arising in the ordinary course of business of the creditor.

The income inclusion arising under the new upstream loan rule may be offset by any exempt surplus or taxable surplus with sufficient underlying tax on hand. This concession appears to have been made to allow taxpayers to avoid foreign withholding tax that might otherwise arise if the foreign affiliate pays a dividend. Interestingly, no such deduction is available in respect of pre-acquisition surplus.

The upstream loan rule was introduced as an anti-avoidance rule to prevent taxpayers from making synthetic dividend distributions from foreign affiliates in order to avoid what would otherwise be income inclusions that are not fully offset by the deductions referred to above. The explanatory notes state that the rule was needed "to protect the integrity of the existing taxable surplus and the new hybrid surplus regimes." Attempts to get around the rule will be subject to review under the general anti-avoidance rule (GAAR). In particular, back-to-back loans with arm's length persons would be considered a misuse of the rule and an abuse of the Act as a whole for the purposes of the GAAR.

The upstream loan rule generally applies to taxation years that begin after August 19, 2011. There is no grandfathering in respect of existing indebtedness but indebtedness in existence prior to August 19, 2011, is deemed to have come into existence on August 19, 2011, so that a taxpayer can rely on the two-year repayment window referred to above before being subject to the new rule.

Hybrid Surplus

As noted above, the Advisory Panel's recommendation that Canada extend the current exemption system to all active business income earned by foreign affiliates would have resulted in the repeal of the taxable surplus regime. Instead, the 2011 Proposals create a new surplus account known as hybrid surplus.

"Hybrid surplus" is a hybrid of exempt and taxable surplus in that one-half of any distributions from hybrid surplus will be treated as exempt and the other half will be treated as taxable, with allowance for a deduction reflecting grossed-up underlying foreign taxes. Hybrid surplus will generally include 100 per cent of any gains from the sale of shares of a foreign affiliate by another foreign affiliate, other than FAPI gains. Presently, these gains are divided evenly between exempt and taxable surplus, which allows for the repatriation of exempt surplus in advance of taxable surplus, which can be beneficial where there is no or little underlying foreign tax in respect of the taxable surplus. As noted below, the gains suspension rule previously contained in the 2004 Proposals has been replaced with the surplus reclassification rule.

Hybrid surplus will arise on internal dispositions occurring after August 19, 2011, and with respect to all other dispositions, after 2012.

Surplus Reclassification

The 2011 Proposals also contain a new anti-avoidance rule that reclassifies certain amounts from exempt to taxable surplus where the amounts arise from transactions that are avoidance transactions, within the meaning of the GAAR (i.e., a transaction that cannot reasonably be considered to have been undertaken or arranged for bona fide purposes other than to increase the exempt earnings or decrease an exempt loss). This rule replaces the gains suspension regime introduced in the 2004 Proposals, which was intended to apply to internal transfers of property. Interestingly, although the surplus reclassification rule is based on the GAAR, it does not contain an exemption for transactions that do not result in a misuse or an abuse of the Act. Consequently, it would seem that this new anti-avoidance rule will have a much broader application than the GAAR.

This new anti-avoidance rule will apply to transactions entered into after August 19, 2011.

Returns of Capital

In a welcome change, the 2011 Proposals abandoned the foreign affiliate paid-up capital (FPUC) rule introduced in the 2004 Proposals and refined in subsequent comfort letters, in favour of a simplified regime. Instead, all distributions received on shares of a foreign affiliate will generally be considered dividends notwithstanding their legal form as capital or other amount. Recipients of such distributions will be able to treat the "dividends" as having been paid from pre-acquisition surplus and will thus be entitled to a deduction under paragraph 113(1)(d) of the Act. Pre-acquisition surplus dividends reduce the taxpayer's adjusted cost base in its foreign affiliate shares, thus allowing the taxpayer to access its cost base in its shares of a foreign affiliate, as a surrogate for FPUC. Where such an election results in the taxpayer realizing a capital gain because its cost base in the shares of the foreign affiliate is reduced to a negative amount, the taxpayer will be required to treat all or a portion of the capital gain as a dividend paid out of exempt, hybrid or taxable surplus.

These rules generally apply to dividends paid after August 19, 2011. However, a taxpayer may elect to have these rules apply to dividends paid after February 27, 2004, by all foreign affiliates in its corporate group.

Foreign Affiliate Reorganizations

The 2011 Proposals amend various provisions of the Act that deal with liquidations and dissolutions of foreign affiliates, mergers or combinations of foreign affiliates and certain share-for-share exchanges.

With respect to liquidations, the 2011 Proposals contains two sets of rules, one that applies to a liquidation of a foreign affiliate into a Canadian shareholder and one that applies to a liquidation of a foreign affiliate into another foreign affiliate. Both rules have been simplified and are welcome changes. The 2004 Proposals with respect to the liquidation of a top-tier foreign affiliate will now apply to all properties received by the Canadian parent corporation on the liquidation and allow for a rollover of all properties, rather than just shares of another foreign affiliate, where certain conditions are met. Essentially, this rule will now mirror the requirements and results of the tax deferred liquidation rules with respect to Canadian corporations. A second set of rules applies a similar tax-deferred treatment where the requisite ownership requirements are met (at least a 90 per cent surplus entitlement percentage or other conditions are satisfied). If none of the conditions are satisfied, the liquidation will be a taxable event. The first set of rules generally applies to liquidations that begin after February 27, 2004, while the second set of rules generally applies to liquidations that begin after August 19, 2011.

The 2011 Proposals with respect to foreign mergers remove the 90 per cent surplus entitlement percentage requirement and the foreign tax law non-recognition requirement as pre-conditions to the application of the broad rollover rule. Further, the rollover will now apply to all property, not just capital property. The 2011 Proposals contain a so-called "absorptive merger" rule which will extend the beneficial treatment associated with qualifying "foreign mergers" to absorptive style mergers where one of the predecessor corporations is the survivor to the amalgamation (common in U.S. amalgamations). These amendments generally apply to mergers or combinations that occur after August 19, 2011. However, taxpayers may elect to have the amendments apply to mergers or combinations that occur after December 20, 2002.

Lastly, the tax deferred share-for-share rollover rule is being amended so that it will no longer apply where the shares being transferred have an inherent loss. The loss will be suspended and released only in certain circumstances. These amendments apply to dispositions that occur after August 19, 2011.

FAPI Capital Losses

The 2011 Proposals will amend the definition of FAPI so that the allowable portion of capital losses of a foreign affiliate from dispositions of non-excluded property will no longer be deductible against ordinary FAPI income. As in the domestic context, FAPI capital losses will only be deductible against FAPI capital gains with any unapplied FAPI capital losses being carried forward for 20 years and carried back three years.

This amendment will generally be effective for taxation years of foreign affiliates that end after August 19, 2011, with certain of these amendments applying to dispositions that occur after February 27, 2004. Transitional rules also exist with respect to dispositions occurring in taxation years of a foreign affiliate that end on or before August 19, 2011.

Earnings Calculations

In our Tax Update dated March  8,  2011 we commented on a foreign affiliate's calculations of its "earnings" where it is not required to compute its income or profits under the taxation laws of its country of residence or the country in which it carries on its active business. In such circumstances a foreign affiliate is required to compute its earnings under Canadian rules. This provided for a planning opportunity in that a foreign affiliate could choose not to take discretionary deductions such as capital cost allowance in computing its earnings, thus maximizing its exempt surplus.

The 2011 Proposals have put an end to such planning by introducing a rule which requires the maximum amount of any discretionary deductions to be claimed in computing the earnings of a foreign affiliate who is required to compute such earnings under Canadian income tax rules. This new amendment will apply to taxation years of a foreign affiliate that end after August 19, 2011.

Foreign Currency Debts

In addition to various amendments to the rules on the computation of income, gains or losses, the 2011 Proposals amend the rule in subsection 39(2) of the Act, which currently applies where a taxpayer makes a gain or sustains a loss from foreign currency fluctuations, to restrict its application to foreign currency debt owing by a taxpayer. Thus, foreign exchange gains or losses in respect of dispositions of property, including dispositions of foreign currency, will now be determined under subsection 39(1) and there will not be any rule permitting a corporation to recognize foreign exchange gains made, or losses sustained, in respect of its own shares, such as on a redemption of foreign currency denominated shares.

This amendment generally applies to taxation years that begin after August  19, 2011, except that in the case of a foreign affiliate, it applies to taxation years that end after August  19, 2011.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.