Canada: New Foreign Affiliate ‘Dumping’ Rules Constitute Major Canadian Tax Policy Change

If there is only one Canadian tax development for 2012 that foreign readers should be aware of, it is certainly the pending enactment of sweeping new rules directed at foreign-controlled Canadian resident corporations known colloquially as the "foreign affiliate dumping" rules (the FAD rules). While motivated by legitimate tax policy concerns, the FAD rules cast an overly broad net that goes far beyond the original mischief motivating their creation, and encompass many transactions that simply should not be caught. As such, the FAD rules are likely to create unpleasant surprises for taxpayers who are unaware of these rules, are unable or unwilling to spend the resources required to carefully work through them, or ignore them on the mistaken (but understandable) premise that these rules won't apply to taxpayers who are neither seeking nor obtaining any Canadian tax advantage or benefit.

For some years the Department of Finance has been troubled by transactions that, in their simplest form, involve a Canadian subsidiary of a foreign multinational group incurring intragroup debt to purchase shares (often fixed-value shares) of a foreign group member. Such "debt dumping" allowed the Canadian subsidiary to use the interest expense deduction on that debt to reduce Canadian tax payable, while creating little or no income that would be taxable in Canada, given that Canada's foreign affiliate rules largely exempt from Canadian taxation distributions received by a Canadian corporation from a corporation resident (and carrying on an active business) in a jurisdiction with which Canada has a tax treaty or tax information exchange agreement.1 Effectively Canada perceived its foreign affiliate regime and interest deductibility rules as being misused when interest expense arising from investments in foreign affiliates that had been "dumped" into Canada by their foreign parent reduced Canadian tax on Canadian-source income.2

The FAD rules go far beyond this relatively narrow (and legitimate) concern. Rather than simply limiting interest expense deductions, these rules effectively treat almost any transfer of property (or incurrence of a liability) by a foreign-controlled Canadian corporation as prima facie surplus stripping designed to sidestep dividend withholding tax, to the extent that it relates to a foreign affiliate of the Canadian corporation. As such, when applicable, the FAD rules often produce a deemed dividend subject to Canadian withholding tax, either immediately or in the future, even when the transaction in question is a value-for-value exchange resulting in no net extraction of assets from Canada.

Figure 1. Summary of Concerns With FAD Rules

Overreaching: charging provision far too broad; limited exceptions and relieving provisions too narrow and/or impractical:

  • rules apply even if no Canadian tax deductions created and even if Foreignco investment generates taxable income in Canada
  • value-for-value transactions (that is, no net value is being extracted from Canada) treated as distributions
  • no exclusion of transactions undertaken for legitimate business reasons with no tax motive, impeding bona fide business investment
  • anti-surplus-stripping rule applies whether or not Canco has any corporate surplus
  • transactions with arm's-length parties treated no differently than intragroup transactions
  • public corporations treated no differently than wholly owned subsidiaries
  • treating the conferral of benefits on foreign affiliates as "investments" is impractical
  • series of transactions" extensions of charging provision unjustified

Numerous possible instances of double taxation.

No grandfathering for pre-existing structures already under Canada.

Unclear policy objectives (stated objectives vs. what is actually caught).

Needless planning/compliance costs created for taxpayers without corresponding benefits to Canada. Treating investments "down" the chain as equivalent to distributions "up" and out of Canada contrary to existing tax policy and resulting in double taxation.

Will reduce the attractiveness of Canadian corporations to foreign buyers (particularly negative impact on mining sector, where is Canada commonly used as a base for foreign projects), and by extension to foreign investors choosing where to locate new holding/headquarters companies, since eventual takeover is exit strategy.

Foreign multinationals discouraged from holding/managing foreign subsidiaries through Canadian corporations.

Those responsible for designing and implementing tax policy at the Department of Finance do not have an easy job, and this relatively small group of dedicated public servants does a huge amount of work. It is difficult to achieve the right balance among the goals of raising the revenue that Canada needs, protecting the tax base from erosion, ensuring that compliance costs for taxpayers are kept to the minimum necessary for the proper functioning of the tax system, and encouraging (or at least not impeding) economic activity from which Canada benefits. Reasonable people can differ as to the choices that are made among these goals. That said, the FAD rules simply put too much emphasis on preventing base erosion, and all or substantially all of that objective could have been achieved with a more focused rule that would not create the undue tax costs and compliance/planning burden generated by the FAD rules or cause foreign groups and investors to reduce the economic activity they undertake in Canada, which is already occurring. The concerns with the FAD rules are summarized in Figure 1.

Originally announced in the federal budget of March 29, 2012,3 the FAD rules target Canadian resident corporations that are controlled by a foreign corporation and make "investments" in non-Canadian corporations (including the mere conferral of "benefits" on those foreign entities). When applicable, the FAD rules deem the Canadian resident corporation to have paid a dividend to the foreign parent corporation (triggering nonresident dividend withholding tax) or reduce the Canadian resident corporation's tax attributes, adversely affecting it in various ways. While the FAD rules include provisions that exclude or mitigate the effect of their application in some circumstances, these provisions are too narrowly drafted, too complicated in their operation, and insufficiently workable in practice to offset the adverse effects of the overbroad charging provision.

Figure 2. Canco Capital Contribution

In August 2012 the government released draft legislation setting out the FAD rules, which was followed by a further version in October 2012.4 While the later versions include some very meaningful improvements over the initial proposals, they also take a significant step backwards in some areas. In particular, the FAD rules are overly broad and capture many situations and produce many results that they should not, even after taking into account their relieving provisions. The combination of their breadth, their complexity, and the nonintuitive results they can produce make them particularly easy to run afoul of inadvertently. They constitute a dramatic shift in tax policy in the Income Tax Act (Canada), indeed going beyond the objectives stated by the government in enacting them.

By way of a simple example, when a foreign-controlled Canadian corporation contributes money to the capital of a wholly owned foreign subsidiary, the FAD rules treat this as prima facie equivalent to a dividend paid by the Canadian corporation to its foreign parent, and Canadian dividend withholding tax at a rate of 5 to 25 percent (depending on the facts) applies. (See Figure 2.) Moreover, there is no offsetting increase in the Canadian corporation's tax attributes, meaning that if the same money (or other property) is subsequently distributed by the Canadian corporation as an actual dividend, Canadian withholding tax will apply again, resulting in double taxation. An observer can be forgiven for finding this result to be something less than intuitive. While in some instances the FAD rules may allow such a deemed dividend to instead be treated as a reduction of the Canadian corporation's existing tax attributes (which also has adverse implications) to the extent such attributes exist, and in some circumstances a reduction of tax attributes occurring under the FAD rules may be reversed for limited purposes, the point is that this type of innocuous transaction is caught within the FAD rules, and the taxpayer is then left searching for an exception to their application (of which there are few) or a relieving provision that mitigates their effect.

Treating a payment "down" the chain to a wholly owned subsidiary "below" Canada (and hence completely within Canada's system for taxing foreign affiliates of Canadian corporations) as the equivalent of a distribution "up" the chain to a shareholder "above" Canada (that is, outside the Canadian tax system) is simply unprecedented and constitutes a major shift in Canada's international tax policy. The ITA recognizes that a Canadian corporation's foreign affiliates (or controlled foreign affiliates) remain within the Canadian tax system and accordingly it differentiates between the Canadian corporation's transactions with such foreign entities and its transactions with other nonresidents of Canada.5 However, the FAD rules ignore this principle for Canadian corporations that are foreign-controlled, effectively treating them as prima facie eroding the Canadian tax base by recharacterizing their transactions "down" the chain with foreign affiliates as distributions "up" the chain and out of Canada unless they fall within a narrow list of permitted exclusions or relieving provisions. This is a sub-optimal tax policy choice.

While the FAD rules are quite complex, at a very high level the process for working through them can be summarized as follows:

  • determine whether the charging provision applies to the transaction;
  • if so, consider whether the "investment" is excluded by virtue of one of the limited exceptions provided for in the FAD rules; and
  • if no exception applies, determine the consequences of the rules' application.


The FAD rules set out a charging provision that is fairly simple to express, although not necessarily to interpret. It applies when a corporation that is resident in Canada (Canco) and that is controlled by a nonresident corporation (Parent)6 makes an investment in a corporation not resident in Canada (Foreignco) that is a foreign affiliate of Canco.7 For this purpose, an investment includes an acquisition of debt of Foreignco8 and shares of Foreignco. The range of transactions caught by these rules is then broadened as follows:

  • Benefit Conferred on Foreignco: A contribution by Canco to the capital of Foreignco is treated as an "investment," which for this purpose is deemed to include any benefit conferred by Canco on Foreignco.
  • Options or Interests: The acquisition by Canco of an option regarding, or an interest in, any Foreignco shares or debt9 is deemed to be an investment.
  • Maturity/Redemption Date Extensions: If the maturity date of a debt owing by Foreignco to Canco (other than a "pertinent debt" described in Section III below) or the redemption date of Foreignco shares owned by Canco is extended, the extension is treated as an acquisition of such debt or shares.
  • Indirect Acquisitions: If Canco acquires shares of another Canadian corporation more than 75 percent of the value of whose assets is attributable to shares the other Canadian corporation owns (directly or indirectly) in its foreign affiliates, this too is caught as an indirect acquisition of the shares of those foreign affiliates (herein, an "indirect acquisition"; see Figure 3). Another rule further extends the net to cases in which property of the acquired Canadian corporation is later sold as part of the series of transactions that includes Canco's investment (the relevant series) and such sale results in the ">75 percent attributable" threshold being met at any time during the relevant series.
  • Relevant Series of Transactions: The charging rule extends to situations in which it would otherwise not apply because Foreignco is not a foreign affiliate of Canco or Canco is not controlled by Parent at the time of the Canco's investment, but at some other time during the relevant series, Foreignco becomes a foreign affiliate of Canco or Canco becomes controlled by Parent.
  • Acquisitions by Partnerships: Look-through rules attribute acquisitions made by a partnership to its partners.

A few narrowly drafted exceptions are carved out of the FAD rules. As discussed in Section III below, in the case of an acquisition of Foreignco debt by Canco, there are exclusions for:

  • debt incurred in the ordinary course of business (for example, trade debt) and repaid within 180 days; and
  • debt arising after March 28, 2012, that Canco elects to make subject to a new rule requiring the inclusion in its income of at least a minimum amount of interest.

An exception is also provided for Canco acquisitions of Foreignco shares as part of some (but not all) intragroup corporate reorganizations (discussed in Section IV below). A smaller number of corporate reorganization exemptions apply to indirect acquisitions, that is, acquisitions of shares of another Canadian corporation passing the ">75 percent attributable" threshold. A further exception meant to allow for investments in foreign affiliates made as part of a strategic business expansion (discussed in Section V below) is so narrowly drafted and unclear in scope as to be of little practical use in all but a handful of cases. Figure 4 summarizes the analysis for assessing whether the FAD rules apply.

A. Consequences of Application

When the FAD rules apply to Canco's investment, they potentially have two effects:

Figure 3. Indirect Acquisition Rule (Takeover)

  • To the extent that in relation to its investment Canco has transferred any property (other than Canco shares), incurred any obligation or received any property reducing an amount owing to it, the value thereof is treated as a dividend paid by Canco to Parent, triggering Canadian dividend withholding tax at a rate of 25 percent (subject to treaty reduction). Thus, for example, Canco making a loan to Foreignco or paying the purchase price for Foreignco shares in cash or a promissory note is treated as a dividend, even when Canco is acquiring property of equal value and even if the seller is an arm's-length party.
  • To the extent that Canco has increased the paid-up capital (PUC) of its shares in relation to the investment (such as by issuing new Canco shares), that increase is reversed. This suppression of PUC reduces the amount Canco can distribute to nonresident shareholders as a return of invested capital without those shareholders incurring no-nresident dividend withholding tax,10 and so effectively amounts to a deferral of the deemed dividend rather than its elimination (subject to the potential PUC reinstatement described below). Moreover, suppressing Canco's PUC limits Canco's ability to deduct interest expense on intragroup debt owing to nonresidents of Canada under Canada's thin capitalization rules.11

There are then three further rules that may or may not mitigate the adverse effects of the FAD rules applying (depending on the facts), as discussed in Section VI:

  • In some cases, an election may be made to treat a dividend that would otherwise be deemed to have been paid by Canco to instead be paid by another related Canadian resident corporation (a qualifying substitute corporation, or QSC), if this would produce a less disadvantageous result (for example, a treaty-reduced dividend withholding tax rate lower than the rate applicable to a dividend deemed to be paid by Canco to Parent).

Figure 4. Foreign Affiliate Dumping Rules: Application

  • In some cases, some or all of a deemed dividend (including one resulting from a QSC election) is replaced with a reduction in the PUC of the shares of Canco (or a QSC). While typically preferable to an immediate deemed dividend, such a PUC reduction has both immediate and future adverse effects and so constitutes only partial relief.
  • When PUC has been reduced under the FAD rules, in some circumstances the PUC so reduced can be reinstated solely for the purpose of distributing out of Canco (or the QSC) any Foreignco shares Canco's investment in respect of which triggered the application of the FAD rules, any shares of another foreign affiliate substituted for those Foreignco shares, or sale proceeds from or distributions received on such shares.12

Effectively, the FAD rules treat any investment by a foreign-controlled Canadian corporation relating to a foreign affiliate as either:

  • an immediate deemed dividend (requiring prepayment of dividend withholding tax and likely resulting in eventual double taxation); or
  • a deemed return of capital distribution (causing future Canco distributions to trigger dividend withholding tax and reducing Canco's ability to debt-finance from foreign group members in the interim), unless:
    • the investment is a debt owing by Foreignco that either bears a sufficiently high rate of interest or is a short-term trade payable;
    • the investment occurs on a permitted intragroup corporate reorganization that does not amount to an incremental investment outside of Canada by Canco; or
    • the investment occurs within the narrow confines of a complex and unworkable exception requiring that:
  • the business activities of Foreignco and its subsidiaries be "more closely connected" with the business activities in Canada of Canco (or related Cancos) than with the business activities of other non-Canadian group members; and
  • Canco officers (a majority of whom are resident and working in Canada or certain other countries) have and maintain principal control over the investment in Foreignco.13

If the investment is one to which the FAD rules apply initially to reduce Canco's PUC (as opposed to deeming a dividend to occur), and if subsequent events cause such PUC reduction to be reversed under the PUC reinstatement rule described in Section VI solely for the purpose of allowing Canco to emigrate from Canada or make certain distributions out of Canada, the initial PUC reduction should not result in double taxation.


As described earlier, the main problem with the FAD rules is that the charging provision is simply too broad and captures far more than it should. While a few exceptions and alleviating mechanisms are provided in the rules, they are narrowly drafted and substantively inadequate to fix a charging provision that needs to be more precise and more focused on what the policy concern is. There simply is not an appropriate degree of linkage between when the rules apply and the tax results they seek to prevent. The government's objective in enacting the FAD rules is stated to be countering erosion of the Canadian tax base arising from:

  • the exemption from Canadian taxation of most foreign affiliate dividends in combination with the deductibility of interest expense incurred to make investments in foreign affiliates; and
  • the extraction of corporate surplus from Canada free of dividend withholding tax.14

The following are significant ways in which the charging provision as drafted (and even after taking the exceptions and alleviating provisions into account) overreaches this objective:

  • It applies regardless of whether Canco's investment produces any deductions from income (interest expense or otherwise) in Canada.
  • It can apply even when Canco's investment produces (or could produce) income that would be taxable in Canada (that is, something other than distributions from a foreign affiliate that benefit from a 100 percent dividends-received deduction).15
  • It deems Canco to have made distributions even when no net assets have been extracted from Canada, for example, when Canco has participated in a value-for-value transaction, which is difficult to reconcile with the stated objective of preventing the extraction of corporate surplus. In fact, its application does not depend on the existence of any Canco corporate surplus, an odd feature of rules stated to be directed at preventing the tax-free extraction of such.
  • It applies without regard to whether the investment has any Canadian tax purpose (or achieves any Canadian tax advantage), which is particularly troubling since the business purpose test in the original proposed version of the FAD rules was the primary filter for preventing that version of these rules from applying to transactions that should not be caught. The result is that the FAD rules may impede, for example, the legitimate diversification of the business activities of Canco's foreign affiliates.
  • It can clearly apply in many instances to create double taxation, as is discussed further below. For example, double taxation will frequently occur whenever the FAD rules apply to deem a dividend to have been paid or deem a PUC reduction to occur that is not subsequently reversed under the rule allowing PUC reinstatement in limited circumstances.
  • As noted earlier, it does not meaningfully differentiate between Canco investments made "down" the chain to closely controlled foreign affiliates (including those completely under Canadian ownership), and other investments made above Canco or outside the cone of Canco and its closely controlled foreign affiliates, contrary to established tax policy elsewhere in the ITA. In the context of preventing surplus stripping, these are simply not equivalent situations, since the former remain within Canada's system for taxing controlled foreign affiliates and any related corporate surplus remains in or below Canco.16
  • It does not differentiate between investment transactions with arm's-length third parties (which are much less likely to involve base erosion) and intragroup transactions (which were the original source of the avoidance prompting the government to act).17
  • A Canco that has arm's-length minority shareholders or that is a public corporation is treated the same as a Canco that is a wholly owned subsidiary of a multinational group, even though Canadian corporate law generally prevents Canco from unfairly favoring the controlling shareholder over minority shareholders, and a public corporation would be seriously constrained under Canadian corporate and securities laws from engaging in substantially all of the tax-motivated transactions that the FAD rules are directed at.
  • Treating the conferral of benefits on a foreign affiliate (guaranteeing debts, providing management and related services, legal and accounting advice, and so forth) as an investment is quite impractical, and is something better left to transfer pricing rules rather than rules treating the conferral of such benefits as deemed dividends triggering immediate taxation.
  • As is discussed below, the extension of the FAD rules to include indirect investments (acquisitions of shares of Canadian corporations more than 75 percent of whose property consists of shares of foreign affiliates) is especially unfortunate and will have a number of adverse effects.
  • The use of the series of transactions concept to expand the reach of the charging rule is especially objectionable, given the broad and uncertain scope of that term, as is discussed below. There is no apparent justification for applying the FAD rules whenever Canco becomes controlled by Parent or Foreignco becomes a foreign affiliate of Canco as part of the same series of transactions as the investment (possibly occurring years apart), given how tenuous a connection is required between the two events in order for them to constitute part of the same series of transactions.
  • The lack of any differentiation in the charging provision between investments in Foreigncos that were already Canco foreign affiliates on March 28, 2012, and investments in new foreign affiliates unfairly prejudices foreign groups that have inherited Canadian foreign affiliates following the acquisition of a Canco or that have made Canada a regional headquarters or product center for perfectly valid business reasons.

The approach taken in the FAD rules is to ensure that virtually every possible objectionable transaction is caught, and then rely on some very limited and inadequate relieving provisions to prevent inappropriate results, or simply assume that taxpayers will plan their arrangements so as to steer a very wide berth around the FAD rules. This is unfortunate, as there are significant detriments to having a charging provision that is too broad and captures more than it should:

  • It clearly makes the FAD rules more complex than they need to be to achieve their objectives.
  • It makes foreign investors more apprehensive about change of law risk in Canada, that is, the likelihood that there will be further adverse changes in Canadian tax law in the future affecting foreign investments made through Canada.
  • It greatly increases the planning and compliance costs for taxpayers beyond what they should be, without generating any significant benefits. It is not appropriate to draft tax legislation on the assumption that all taxpayers will be aware of, and will have the time and resources to plan around, the overbreadth of the charging provision (to the limited extent such is possible).
  • Ultimately, it makes Canada less attractive than it otherwise would be for foreign investors who have a choice between using Canada or another jurisdiction as a base for managing foreign operations, potentially diverting away economic activity that would otherwise occur in and benefit Canada.

A prime example of the last point is the Canadian mining industry. Canada possesses a world-leading infrastructure of geologists, lawyers, accountants, bankers, and financiers with mining sector expertise, well-known and accepted corporate law, stock exchanges (TSX and TSX-V) that have more mining listings than any other in the world,18 and the world's most stable banking system.19 These have contributed to make Canada the center of the world's mining industry, and Canadian corporations are frequently used as head office entities for mining projects in Latin America, Africa, Asia, or elsewhere in the world.

Investors deciding where to set up mining companies generally presume that using Canada in this way will be tax-neutral, since they have no material Canadian-source income, aren't seeking to generate any tax deductions or advantages in Canada, and typically view the sale of the Canadian company itself as the most likely exit strategy. As such, they start from the presumption that they will not have material Canadian tax issues when choosing to use a Canadian holding company for foreign investments, and to date they have generally been correct. The FAD rules change this paradigm, and the danger is that such investors will not be aware of how broad these rules are or (if they are) have any willingness to expend time and resources planning around them: They will simply go elsewhere.

The risk to Canada is the erosion of its dominant position in the mining sector, through the unintended creation of a tax issue that causes foreign investors to locate elsewhere high-value economic activity that:

  • would otherwise occur in Canada; and
  • does not constitute the kind of inappropriate tax planning that the FAD rules are directed at.

Most foreign investors undertaking projects that could be, but need not be, headquartered in Canada (especially junior mining companies with very limited management and financial resources) simply will not spend time or money to deal with complicated rules that do or may apply but possibly can be managed around in the right circumstances.

The government's view appears to be that potentially affected taxpayers will be aware of the scope of these rules, and either expend the resources required to plan their way through them or simply steer far wide of them by not involving Canadian corporations in foreign activities. In many cases the latter will be the more likely result, with a significant loss of economic activity (in mining and other sectors) that would otherwise be of benefit to Canada. This will potentially manifest itself in numerous ways:

  • As noted above, foreign investors looking for a suitable holding company jurisdiction as a base for foreign projects (as often occurs in the natural resources sector) may choose a country that does not involve any risk of double taxation or require any significant tax planning or compliance to be tax-neutral, and that is perceived as having less change-of-law risk.
  • Multinationals choosing a country as a headquarters for particular geographic regions or business functions (thereby creating many significant high-value jobs) are far less likely to choose Canada, since doing so creates tax risks and compliance costs due to the FAD rules that simply don't exist in other jurisdictions. Canada thereby risks becoming a "branch plant" economy except to the extent of Canadian-controlled enterprises, instead of a group hub for particular geographic regions or business functions within a multinational group.
  • Foreign companies considering the purchase of a Canadian corporation that owns significant foreign affiliates (even less than the 75 percent threshold necessary to make the acquisition itself an investment) may be willing to pay less than would otherwise be the case, since they will essentially be incurring a risk of double taxation and acquiring an ongoing Canadian tax problem after making the acquisition due to the FAD rules.
  • As discussed below, foreign companies that do acquire Canadian corporations will now have a strong tax bias to strip all foreign subsidiaries out of the Canadian target to the greatest degree possible, again reducing the Canadian operations to branch plant status.

A. Inadequate Grandfathering Treatment

The fact that the charging provision does not differentiate between investments in Foreigncos that were already Canco foreign affiliates on March 28, 2012, and investments in new foreign affiliates is a further example of its overreach. The result is to penalize foreign multinationals that have chosen to locate foreign group members under Canada for business reasons or that inherited a "below Canada" foreign affiliate structure following the direct or indirect acquisition of a Canadian corporation that had foreign affiliates. It will now be dramatically more difficult to manage the funding of these foreign affiliates going forward, and there are no special accommodations offered for removing from under Canada foreign affiliates that would not have been placed (or left) under Canada had the FAD rules existed at that earlier time.

Transitional relief under the charging provision is very limited. It applies to all transactions occurring after March 28, 2012, except transactions between arm's-length parties that were the subject of a binding written agreement on or before that date and that are completed by the end of 2012. Given the magnitude of the FAD rules and the absence of any relief for existing Canco foreign affiliates, it would certainly have been desirable to allow multinational groups more time to consider the implications of these rules and (when appropriate) restructure foreign affiliates out from under Canadian group members. Indeed, the Canadian Bar Association-Canadian Institute of Chartered Accountants Joint Committee on Taxation (CBA-CICA Joint Committee) has noted that there is no obvious reason for the 2012 completion deadline for a transaction that is the subject of an otherwise legally binding agreement, and further suggested that transitional relief be extended to non-arm's-length transactions made to consummate an arm's-length agreement that meets the transitional relief rule.20

B. Arm's-Length Acquisitions of Canadian Corps.

Under the charging provision there is no business purpose test, and arm's-length transactions are treated no differently than intragroup investments. While these facts contribute to the overbreadth of the charging provision in many ways, one of the most serious is in the acquisition by foreign investors of Canadian resident corporations owning foreign affiliates. While only the acquisition of Canadian resident corporations whose assets are more than 75 percent attributable to shares of foreign affiliates constitutes an investment under the indirect acquisition element of the investment definition, a broader problem exists on all foreign acquisitions of Canadian corporations with foreign affiliates, whether or not reaching the 75 percent threshold.

At present, foreign purchasers of Canadian resident corporations owning foreign affiliates essentially have three options for dealing with those foreign affiliates post-acquisition:

  1. Leave them in place under Canada.
  2. Extract them from Canada by disposing of them to a foreign group member (the potential for this generally depends on the Canadian and foreign tax cost of disposing of the shares of the relevant foreign affiliate).
  3. Move Canco's fiscal residence out of Canada to a foreign jurisdiction (that is, emigrate).

Before the enactment of the FAD rules, many foreign acquirers were content to choose option 1. Indeed, in some cases the government requested (or insisted) that foreign acquirers make Canada a regional or global headquarters for particular business lines as a condition for approval of the acquisition, which would typically involve leaving the Canadian target's relevant foreign affiliates beneath it.21 Following the introduction of the FAD rules, however, it will generally be much more costly and inconvenient to leave existing foreign affiliates "beneath" Canada, since the FAD rules will apply to any subsequent investments made by the Canadian entity in its foreign affiliates, even if occurring for perfectly legitimate business reasons.22 This is so whether or not the initial acquisition of the Canadian target was itself an investment under the FAD rules, that is, whether foreign affiliate shares exceeded 75 percent of the Canadian target's assets. As a result, foreign acquirers will now have a much greater Canadian tax incentive to pursue options 2 or 3 whenever possible, thereby reducing the amount of activity in Canada relating to the management, financing, and support of foreign affiliates. This would not seem to be to Canada's economic benefit.

There is more, however. While options 2 and 3 will be available as an alternative to option 1 in some circumstances (and indeed the PUC reinstatement rule facilitates their use),23 the fact is that in many cases they will not be. Option 2 is possible in some circumstances without incurring unmanageable tax costs, when (1) there is little or no Canadian tax on the accrued gains on the foreign affiliate shares,24 and (2) the foreign affiliate's home jurisdiction does not (or under an applicable tax treaty cannot) tax those accrued gains. However, in a significant number of cases this will not be the case; for example:

  • the section 88(1)(d) ITA cost basis "bump" used to eliminate accrued gains on the Canadian target's foreign affiliate shares (and thereby Canadian tax on the disposition of those shares) will generally not be available when, for example, the foreign purchaser uses consideration other than cash to pay the Canadian target's shareholders, or when some other technical requirement of the cost basis bump is not met, as often occurs; or
  • when the foreign affiliate shares derive their value primarily from local real property (as will typically be the case in the real estate, mining, and oil and gas sectors), the foreign affiliate's home country will usually tax any accrued gain on the disposition of the foreign affiliate's shares.

Similarly, because a corporate emigration involves a deemed fair market value disposition of all of the Canadian resident corporation's property and a notional dividend of its corporate surplus, it generally is viable as an alternative to option 1 only when the section 88(1)(d) cost basis bump is available, where its property consists entirely of shares of foreign affiliates and other "bump-eligible" property, and where the home countries of its foreign affiliates do not treat the merger or wind-up required to produce the "bump" as a taxable transaction. As such, the practical result of including bona fide business investments in foreign affiliates that have been acquired on a previous arm's-length acquisition of a Canadian resident corporation within the scope of the charging provision is that foreign purchasers of Canadian corporations will generally either (1) strip out of Canada as many foreign affiliates as they can to the extent possible without significant tax costs, and (2) discount the purchase price they are willing to pay to reflect the costs of (1) and the costs of the Canadian tax problem they are thereby inheriting under the FAD rules for all other foreign affiliates. Both of these results seem adverse to Canada's interest, and it is not apparent what offsetting benefit Canada is enjoying by not excluding from the FAD rules transactions that are sourced from arm's-length acquisitions and/or have no Canadian tax avoidance motive.

C. Indirect Investments

The extension of the charging provision to include indirect acquisitions (that is, acquisitions of Canadian corporations more than 75 percent of whose property is shares of foreign affiliates) is especially problematic. It is doubtful that such transactions produce any material surplus stripping that the FAD rules are stated to be directed at. Arm's-length acquisitions of Canadian corporations owning foreign affiliates are invariably transactions undertaken by the purchaser for business reasons, not to engage in surplus stripping.25 As such, the benefits of including an indirect acquisition element in the investment definition are hard to see.

Including such indirect acquisitions as an investment greatly increases the scope of the FAD rules, often (as noted by the CBA-CICA Joint Committee) in completely inappropriate situations when the transaction has no tax motivation and is simply a capital markets or an ordinary-course business transaction.26 Foreign acquirers of a Canadian corporation that owns shares of foreign affiliates representing more than 75 percent of the Canadian corporation's assets (as often occurs in the natural resources sector) will generally fall within this element of the charging provision simply by following the standard (and completely benign) practice of using a Canadian corporation (that is, a Canco) to make the acquisition.

When the indirect acquisition rule may apply, one would expect the foreign acquirer to price the transaction accordingly, potentially discounting the price that it would otherwise be willing to pay to reflect:

  • the risk of double taxation arising from the initial acquisition, to the extent that the FAD rules produce either a deemed dividend or a reduction of PUC that is not later reinstated under the PUC reinstatement rule;
  • the same costs (Canadian and foreign) of extracting the Canadian target's foreign affiliates out from under the Canadian tax system, and ongoing costs of financing any Canadian target foreign affiliates that do remain under Canada as apply to all foreign acquirers of Canadian corporations with foreign affiliates (described above in Section II.B); and
  • further adverse change-of-law risk.

Foreign investors choosing where to locate a headquarters or holding company for foreign operations (in particular junior mining companies) will often view an eventual takeover as a likely exit strategy. As such, a Canadian tax issue that causes a potential acquirer to pay less for the Canadian corporation will in turn make it less likely that the initial investors choose to use a Canadian corporation at the outset.

D. 'Series of Transactions'

The liberal use of the term "series of transactions" to further broaden the charging provision is particularly troubling. The result is that the general rule can apply when as part of the relevant series Canco becomes controlled by Parent or Foreignco becomes a foreign affiliate of Canco, or when shares of a Canadian corporation have been acquired and as part of the same series of transactions some of its property is subsequently sold such that its remaining property is more than 75 percent attributable to shares of foreign affiliates. In other contexts in the ITA, the term "series of transactions" has been interpreted by Canadian courts quite broadly, to include within a series of transactions a transaction that occurred either before or after the other elements of the series, if the parties "knew of the . . . series, such that it could be said that they took it into account when deciding to complete the transaction."27 The degree of linkage required between two events to make them both part of the same series of transactions is surprisingly low.28

As a result, it will be necessary for Canco to employ some degree of clairvoyance when making its investment, if the basis for concluding that the FAD rules do not apply is that Canco is not controlled by a non-resident corporation or that Foreignco is not at that time a foreign affiliate of Canco. If either of those events occurs subsequent to the investment, the fact that such subsequent event was not anticipated at the time of the investment is not by itself enough to conclude that the subsequent event is not part of the relevant series.29 As such, the use of the "series" concept to expand the charging provision to capture later events creates a significant degree of uncertainty for taxpayers.30 No justification has been put forward to explain why the government's policy objectives require such a tenuous connection between the "investment" and the related event. If an antiavoidance measure is required to prevent multi-step transactions from circumventing the FAD rules when they should apply, a much more focused rule should be employed (as occurs elsewhere in the ITA and the FAD rules).31

To read this article in full, please click here.

The author acknowledges with appreciation the thoughts of Douglas McFadyen of Shearman & Sterling LLP in New York on the subject of this article. However, any errors or omissions are entirely the responsibility of the author.


1 Foreign affiliate status causes distributions from Foreignco to come within Canada's exemption and credit system of dealing with distributions received by a Canadian corporation from a foreign corporation. See

2 That debt might arise directly as balance-of-sale owing for the purchase price of the shares of the foreign affiliate or debt incurred to fund the purchase price, or indirectly through an increase in the paid-up capital of the shares of the Canadian corporation (which allows increased cross-border intragroup financing into Canada under Canada's thin capitalization rules).

3 For prior coverage, see Steve Suarez, "Canadian 2012 Federal Budget: Tightening the Screws," Tax Notes Int'l, Apr. 16, 2012, p. 247, Doc 2012-6875, or 2012 WTD 73-17.

4 For prior coverage, see Patrick Marley, "Canada Revises Proposed Foreign Affiliate Dumping Rules," Tax Notes Int'l, Aug. 27, 2012, p. 805, Doc 2012-17369, or 2012 WTD 160-1; and Marley and Firoz Ahmed, "Canada Approves New Foreign Affiliate Dumping Rules," Tax Notes Int'l, Nov. 12, 2012, p. 607, Doc 2012- 22330, or 2012 WTD 213-2. In fact, an earlier version of the present article was a few days away from publication when the October 15 draft legislation was released.

5 For example, the income imputation regime for amounts owing by nonresidents includes an exemption for many controlled foreign affiliates of the taxpayer (section 17(8) of the ITA), the shareholder loan rules for amounts owing to a corporation from a person "connected" to a shareholder exclude foreign affiliates of the corporation (section 15(2.1) of the ITA), and Canada's transfer pricing rules have special exclusions for loans to (and guarantees of the debt of) most controlled foreign affiliates of the taxpayer (sections 247(7) and 247(7.1) of the ITA).

6 The rule does not apply when Parent is itself controlled by a Canadian resident person that is not controlled by a nonresident corporation. If there are multiple nonresident corporations in the corporate chain "above" Canco, the rules essentially deem the lowest-tier such nonresident corporation to be the one that "controls" Canco, and to be the sole "Parent."

7 Generally, Foreignco will be a foreign affiliate of Canco if Canco has direct or indirect ownership of 10 percent or more of any class of shares of Foreignco.

8 Subject to two exceptions discussed in Section III below.

9 Other than debt, the direct acquisition of which is excluded from these rules under the exceptions discussed in Section III.

10 A Canadian corporation can generally make non-dividend distributions on its shares as a tax-free return of capital to the extent of the PUC of those shares. PUC is meant to represent amounts invested in Canco as share capital by persons purchasing newly issued shares from Canco, and so PUC returns constitute a distribution of previously invested capital, not profits.

11 Canada's thin capitalization rules apply to restrict the amount of interest-deductible debt owing by a Canadian resident corporation (Canco) to "specified non-residents": nonresidents of Canada who either are 25-plus percent shareholders of Canco (by votes or value) or do not deal at arm's length with those 25- plus percent shareholders. Currently, these rules prevent Canco from deducting interest expense on debt owing to specified nonresidents that exceeds twice the sum of (1) Canco's unconsolidated retained earnings at the start of the taxation year, and (2) PUC attributable to Canco shares owned by (and contributed surplus received from) a nonresident 25-plus percent shareholder of Canco. This 2-1 ratio is being changed to 1.5 to 1, effective 2013. See Steve Suarez and Stephanie Wong, "Canadian Year- End Tax Planning Deadlines for 2012," Tax Notes Int'l, Nov. 19, 2012, p. 747, Doc 2012-22478, or 2012 WTD 223-18.

12 A largely comparable PUC reinstatement also applies for purposes of computing the departure tax applicable upon Canco emigrating from Canada.

13 A further requirement exists regarding the compensation and evaluation of such Canco officers.

14 See the explanatory notes to section 212.3 of the ITA produced by the Department of Finance. These explanatory notes do not constitute part of the legislation but rather are an interpretational aid that a court may choose to consider in interpreting it.

15 Such income might arise directly or as income earned by Foreignco that is imputed to Canco under Canada's anti-deferral (FAPI) rules, or when Foreignco uses funds from Canco to make certain intragroup loans.

16 The "closest business connection" exemption discussed in Section V, which is intended to allow for business investments "down" the chain, is unworkable, complex, and uncertain to the point of being of very little practical value for most taxpayers.

17 Indeed, in the case of shares issued by Canco to a third party in an arm's-length transaction, the adverse impact of the rules' application is borne wholly or partly by the third party, in terms of reduced PUC of the Canco shares they acquire.

18 See

19 See World Economic Forum,

20 See submission of the CBA-CICA Joint Committee on the Draft Legislation dated September 13, 2012, pp. 24-25, at Doc 2012-19263 or 2012 WTD 180-26 (the "Joint Committee submission").

21 In Vale's acquisition of Inco Limited, for example, the Brazilian purchaser agreed to make Canada its worldwide nickel headquarters; see

22 As discussed in Section V, while there is an exception to the charging provision intended to allow for certain strategic investments in Canco's foreign affiliates, this exception is flawed to the point of being of very little practical use.

23 Both options generally require that the Canadian corporation's PUC be as high as possible.

24 In particular, when a foreign acquirer is able to use the section 88(1)(d) cost basis bump described in Section IV, it may be possible to eliminate accrued gains for Canadian tax purposes on the shares of the Canadian target's top-tier foreign affiliates.

25 Existing cross-border surplus stripping rules already apply to certain non-arm's-length transactions; see section 212.1 of the ITA.

26 Joint Committee submission, pp. 16-18.

27 Canada Trustco Mortgage Co. v. The Queen, 2005 SCC 54, at para. 26, available at The Supreme Court went on as follows: Section 248(10) extends the meaning of "series of transactions" to include "related transactions or events completed in contemplation of the series". . . . We would elaborate that "in contemplation" is read not in the sense of actual knowledge but in the broader sense of "because of " or "in relation to" the series. The phrase can be applied to events either before or after the basic avoidance transaction found under s. 245(3).

28 According to the Supreme Court of Canada in Copthorne Holdings Ltd. v. The Queen, 2011 SCC 63, at para. 46: a "strong nexus" is not necessary to meet the series test set out in Trustco. The court is only required to consider whether the series was taken into account when the decision was made to undertake the related transaction in the sense that it was done "in relation to" or "because of " the series. See

29 This was specifically decided by the Supreme Court of Canada in Copthorne at para. 56:

The fact that the language of s. 248(10) allows either prospective or retrospective connection of a related transaction to a common law series and that such an interpretation accords with the Parliamentary purpose, impels me to conclude that this interpretation should be preferred to the interpretation advanced by Copthorne.

30 Indeed, the fact that the FAD rules rely heavily on the accompanying Explanatory Notes to explain what is meant and how the rules are intended to operate further increases the apprehension of taxpayers and their advisers.

31 See, for example, section 212.3(21) of the ITA, which deems two persons not to be "related" to one another for purposes of the corporate reorganization exemption if one of the main purposes of a transaction or event is to cause them to be related.

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