Canada: Foreign Affiliate Dumping Rules Impact Multi-National Enterprises

Last Updated: January 8 2013
Article by Kathleen S.M. Hanly, Christopher Steeves and Kevin H. Yip

The foreign affiliate dumping rules originally introduced in the 2012 Federal Budget and contained in Bill C-45 tabled on October 18, 2012 (the "FAD Rules") are now law.1 

The Department of Finance ("Finance") introduced the FAD Rules to stop foreign-based multinationals with Canadian subsidiaries from eroding the Canadian tax base with investments in foreign subsidiaries.  In the Explanatory Notes to the FAD Rules (the "Explanatory Notes"), Finance says that this erosion can occur where: (1) interest deductions in Canada reduce income subject to Canadian tax while foreign source income is not taxed in Canada, or (2) surplus is taken out of Canada without being subject to Canadian non-resident withholding tax.

Generally speaking, the FAD Rules operate by triggering deemed dividends subject to non-resident withholding tax or reductions in share paid-up capital ("PUC").  The new provisions are extremely complex, apply very broadly and operate in situations that are outside the targeted tax erosion.

The FAD Rules may cause adverse tax consequences for foreign-controlled Canadian corporations with foreign subsidiaries and for acquisitions of Canadian companies with a substantial majority of foreign assets.  We encourage you to determine whether the FAD Rules apply to you by contacting a member of the Fasken Martineau Tax Group.

This Bulletin provides a simplified overview of the FAD Rules.

When do the FAD Rules Apply?

Generally speaking, the FAD Rules apply where a corporation resident in Canada ("Canco") controlled by a non-resident corporation ("Foreign Parent") makes an "investment" in a "foreign affiliate" ("Foreign Affiliate").2

The FAD Rules also apply where a "series of transactions" generates this structure.  Specifically, the FAD Rules apply where a foreign corporation becomes a Foreign Affiliate of a Canco with a Foreign Parent, or a Canco with one or more Foreign Affiliates becomes controlled by a Foreign Parent, as part of a series of transactions that includes the "investment."  Tax jurisprudence construes "series of transactions" very broadly, so the FAD Rules may apply even before the Foreign Parent has a controlling interest in Canco and even before the foreign corporation is a Foreign Affiliate of Canco.  That is, Canco may not even know that the FAD Rules apply to a particular investment at the time the investment is made.

A foreign corporation is generally a Foreign Affiliate of Canco if Canco owns (directly or indirectly) at least 1% of any class of the foreign corporation's shares and owns (directly or indirectly and together with related persons) at least 10% of any class of the foreign corporation's shares.

Three limited exceptions to the FAD Rules are available: (i) more closely connected business activities, (ii) certain internal reorganizations, and (iii) pertinent loans or indebtedness ("PLOIs").  We discuss these below.

What is an "Investment"?

The concept of "investment" is very broad and includes virtually any downstream value injection (subject to limited exceptions).  Specifically, Canco makes an "investment" in a Foreign Affiliate where:

(a) Canco acquires shares of the Foreign Affiliate;

(b) Canco contributes capital to the Foreign Affiliate. For this purpose, the conferral of a benefit is deemed to be a capital contribution;

(c) The Foreign Affiliate becomes indebted to Canco, unless the indebtedness arose in the ordinary course of Canco's business and is repaid (not as part of a series) within 180 days, or the indebtedness is a PLOI. Again, we discuss the PLOI exception below;

(d) Canco acquires a debt obligation of the Foreign Affiliate, unless Canco acquires the obligation from an arm's length person in the ordinary course of Canco's business or the debt obligation is a PLOI;

(e) The maturity date of a non-PLOI debt obligation owing by the Foreign Affiliate to Canco is extended, or the redemption, acquisition or cancellation date of Foreign Affiliate shares owned by Canco is extended;

(f) Canco acquires the Foreign Affiliate indirectly by acquiring shares of another Canadian resident corporation ("Canco Target") where the total fair market value ("FMV") of Canco Target's Foreign Affiliates is more than 75% of the FMV of all of Canco Target's properties (disregarding debt obligations of Canadian corporations in which Canco Target has a direct or indirect interest); or

(g) Canco acquires an option in respect of or an interest in shares of the Foreign Affiliate or an amount owing by the Foreign Affiliate (unless the amount owing comes within an exception in (c) or (d) above).

What Happens if the FAD Rules Apply?

If Canco is controlled by a Foreign Parent and makes an "investment" in a Foreign Affiliate, the tax consequences are generally a deemed dividend (which may be reduced or eliminated by a PUC reduction) or a PUC reduction.


  • Deemed Dividend: Canco is deemed to pay a dividend to its Foreign Parent equal to the FMV of any consideration given by Canco (other than Canco shares) that can reasonably be considered to relate to the investment,3 except to the extent that the deemed dividend is reduced or eliminated via an automatic PUC reduction ("Automatic PUC Reduction") or an elective dividend allocation that, in turn, automatically reduces PUC provided that certain requirements are met ("Elective PUC Reduction"); and
  • PUC Reduction: Any increase in the PUC of Canco shares that would otherwise occur on the investment itself is eliminated.

The Explanatory Notes indicate that the PUC reduction consequence in the second bullet point applies only where Canco share PUC is created on the actual "investment" itself, for example, where the Foreign Parent transfers a foreign subsidiary to Canco in consideration for Canco shares.  The Explanatory Notes clarify that the deemed dividend rule applies where there is a subscription for Canco shares followed by a share investment by Canco in a Foreign Affiliate, subject to the Automatic PUC Reduction or Elective PUC Reduction (collectively, the "Automatic or Elective PUC Reduction").

In summary, a PUC reduction may occur because Canco shares are issued on the acquisition of Foreign Affiliate shares (second bullet point above) or because PUC is reduced under an Automatic or Elective PUC Reduction (first bullet point above).  A reduction of Canco's share PUC reduces Canco's ability to return capital to non-resident shareholders free of withholding tax and reduces Canco's equity base for the purposes of the thin capitalization rules.  Note that the debt to equity ratio in the thin capitalization rules is now 1.5:1 as a result of Bill C-45.4 

The FAD Rules provide for the reinstatement of the PUC of a class of shares of Canco or a qualifying substitute corporation ("QSC") (see the discussion of QSCs below) that was suppressed under the FAD Rules as a result of an investment in a Foreign Affiliate.  This PUC reinstatement is available in specified situations only, including where Canco distributes shares of the Foreign Affiliate or receives proceeds from the disposition of the Foreign Affiliate, or where the Foreign Affiliate makes certain distributions to Canco.  This ensures that while Canco share capital used to fund the investment cannot be used to return other Canco surplus, it can be used to return the initial investment in the Foreign Affiliate.5 

Any dividend that the Foreign Parent is deemed to receive (i.e. that is not reduced via an Automatic or Elective PUC Reduction) is subject to Canadian non-resident withholding tax at 25%, subject to reduction under any applicable tax treaty, typically to 5%.

Note that a deemed dividend is received only by the Foreign Parent,6 whereas a PUC reduction applies across the relevant class and affects all shareholders of the class on a pro rata basis.

When does the Automatic PUC Reduction Apply?

As indicated above, a deemed dividend that would otherwise arise may be reduced by an Automatic PUC Reduction.

Only Common Shares/No Non-Arm's Length Canadian Shareholder

The first situation where there is an Automatic PUC Reduction is where Canco has a single class of issued shares and no non-arm's length Canadian resident shareholders.  In this scenario, the deemed dividend is reduced automatically to the extent of Canco's share PUC.

This means, for example, that where Canco has a single class of common shares and no non-arm's length Canadian resident shareholders (such as a Canadian holding company), the deemed dividend is reduced to the extent of Canco's common share PUC.  If there is sufficient common share PUC, the deemed dividend is eliminated. 

Multiple Shares Classes but Traceable/No Non-Arm's Length Canadian Shareholder

The second situation where there is an Automatic PUC Reduction is where Canco has more than one class of issued shares but can trace the PUC of one or more classes to the investment in the Foreign Affiliate.  Again, Canco cannot have any non-arm's length Canadian resident shareholders for the Automatic PUC Reduction to apply.

When Does the Elective PUC Reduction Apply?

The FAD Rules permit an election to reallocate the deemed dividend (the "Dividend Allocation Election") as follows:

  • Allocate to Canco Shares or Change the Dividend Payor:  Canco can allocate the deemed dividend among its outstanding share classes where the Automatic PUC Reduction is not available7 and/or can allocate the deemed dividend among share classes of one or more corporations that are QSCs.  The allocated deemed dividend is then reduced to the extent of the PUC of the applicable classes, provided that certain ownership and maximum PUC reduction requirements are met as discussed below; and/or
  • Change the Dividend Recipient:  Canco can reroute the deemed dividend to a non-resident subsidiary of the Foreign Parent.  Canco would do this if the non-resident subsidiary qualified for a lower withholding rate by virtue of a tax treaty. 

What is a QSC?

A corporation must be a Canadian resident to qualify as a QSC in respect of Canco.  In addition: (i) the corporation must be controlled by the same Foreign Parent as Canco, (ii) its shares must be owned by the Foreign Parent or a non-resident non-arm's length corporation, and (iii) it must have a direct or indirect equity interest in Canco. 

Thus, for example, a Canadian resident holding company that owns all of Canco's shares is a QSC.

Requirements for Elective PUC Reduction

In order for a Dividend Allocation Election in respect of a class of Canco or QSC shares to reduce the PUC of that class, there are two requirements that must be satisfied.  Firstly, the Foreign Parent, or a non-resident person that does not deal at arm's length with the Foreign Parent, must own shares of that class.  Secondly, the election must maximize the PUC reduction for shares held by the Foreign Parent or such non-arm's length non-resident.  That is, a deemed dividend must be allocated in a manner that maximizes the reduction of cross-border PUC.

A Dividend Allocation Election must be filed jointly by Canco, every QSC in respect of Canco and the Foreign Parent (or the Foreign Parent and any substitute non-resident corporation controlled by the Foreign Parent, if applicable).

The Dividend Allocation Election means, for example, that if Canco has multiple classes of shares and cannot satisfy the tracing requirement for the Automatic PUC Reduction, Canco can still reduce the deemed dividend on an elective basis to the extent it has PUC, provided that it meets the two requirements referred to above.8

As indicated above, Canco can change the deemed dividend payee to a non-resident corporation controlled by the Foreign Parent in order to access a more favourable withholding tax rate.  For example, if the Foreign Parent is not resident in a treaty jurisdiction but has a US resident subsidiary that is a sister of Canco, the deemed dividend could be routed to the US subsidiary to reduce the withholding rate from 25% to 15%.


The following examples demonstrate certain aspects of the FAD Rules.

Foreign Parent Transfers Foreign Affiliates to Canadian Subsidiary

Assume that a US corporation ("USco")9 carries on business in Canada through a single direct wholly-owned Canco and carries on business in other countries through a number of direct wholly-owned foreign subsidiaries in those countries.  Assume that USco transfers the shares of its foreign subsidiaries to Canco in exchange for shares of Canco.  The FAD Rules deny any increase in the PUC of the Canco shares issued on the transfer.  This reduces the amount that Canco can distribute to USco as a return of capital free of withholding tax and limits Canco's ability to leverage its Canadian operations by borrowing internally within the confines of the thin capitalization rules.10  If instead USco took back both shares and debt on the transfer of the foreign subsidiaries to Canco, USco would be deemed to receive a dividend from Canco equal to the FMV of the debt, subject to withholding tax at 5%, except to the extent that the deemed dividend was reduced under the Automatic or Elective PUC Reduction. 

Acquisition of Canco Target with Foreign Affiliates

It is standard tax planning for a non-resident corporation ("NRco") that wishes to acquire a Canadian corporation ("Canco Target") to form a wholly-owned Canadian acquisition company ("Cdn Acquisitionco") to acquire the Canco Target shares.  Where Canco Target owns shares of Foreign Affiliates and the FMV of the Foreign Affiliate shares is more than 75% of the FMV of Canco Target's properties (disregarding debt of non-arm's length Canadian resident corporations), the portion of the Target Canco purchase price allocable to the Foreign Affiliates will trigger a deemed dividend from Cdn Acquisitionco to NRco that is subject to withholding tax, except to the extent that the deemed dividend is reduced under the Automatic or Elective PUC Reduction.  If Cdn Acquisitionco has only common shares issued and received equity funding at least equal to the portion of the Canco Target purchase price allocable to the Foreign Affiliates, the Cdn Acquisitionco PUC will be reduced and there will be no deemed dividend.11

Acquisition of 10% Interest in Canadian Pubco

Assume that a TSX-listed Canadian resident corporation ("Cdn Pubco") with only common shares issued invests in the resource sector outside Canada and all of its value is attributable to wholly-owned foreign subsidiaries.  Assume further that a Canadian corporation ("Canco Purchaser") wholly-owned by a Foreign Parent acquires 10% or more of Cdn Pubco's shares.  This will cause the foreign subsidiaries to become Foreign Affiliates of Canco Purchaser and will trigger a deemed dividend from Canco Purchaser to its Foreign Parent equal to the acquisition price, except to the extent that the deemed dividend is reduced under the Automatic or Elective PUC Reduction. 

Acquisition of 10% Interest in Canadian Pubco as Part of Series

In the previous example, if Canco Purchaser acquired 9% of Cdn Pubco's shares, the FAD Rules at first blush would seem not to apply because the foreign subsidiaries would not be Foreign Affiliates of Canco Purchaser.  However, if Canco Purchaser, as part of a series of transactions that included the 9% acquisition, subsequently acquired additional Cdn Pubco shares to bring itself to a 10% (or greater) interest in Cdn Pubco, then the 9% acquisition would result in a deemed dividend from Canco Purchaser to its Foreign Parent, except to the extent that the deemed dividend was reduced under the Automatic or Elective PUC Reduction.

Benefit Conferral

A benefit conferred on a Foreign Affiliate by a Canco controlled by a Foreign Parent is deemed to be a capital contribution, and therefore, an "investment" for the purposes of the FAD Rules.  A situation where this might arise is where Canco guarantees project financing obtained by the Foreign Affiliate in its home jurisdiction from a third party financial institution.12  If the Foreign Affiliate does not compensate Canco for providing its guarantee, then Canco may be considered to have conferred a benefit on the Foreign Affiliate equal to the amount of an arm's length guarantee fee.  If this were the case, a dividend equal to such fee would be deemed to be paid by Canco to its Foreign Parent and subject to Canadian withholding tax, except to the extent that the deemed dividend was reduced under the Automatic or Elective PUC Reduction.

QSC Election

Assume that a US resident parent ("US Parent") owns all the shares of a Canadian resident holding company ("CanHoldco") and that CanHoldco, in turn, holds all of the shares of a Canadian operating company ("CanOpco"). Assume that US Parent also owns all of the shares of a foreign subsidiary ("Foreign Sub").  CanOpco acquires 10% of the shares of Foreign Sub from US Parent for cash consideration using its retained earnings.  Subject to the Elective PUC Reduction, this share acquisition triggers a deemed dividend from CanOpco to US Parent equal to the FMV of the Foreign Sub shares, subject to 15% withholding tax under the Canada-US tax treaty.

The Automatic PUC Reduction does not apply in these circumstances because of the presence of CanHoldco (a non-arm's length Canadian resident shareholder).  Nonetheless, because CanHoldco is a QSC in respect of CanOpco (a Canadian resident corporation controlled by US Parent that owns all of the shares of CanOpco), US Parent, CanHoldco and CanOpco can jointly elect to deem the dividend to be paid by CanHoldco (instead of CanOpco) to US Parent and reduce the dividend by any CanHoldco PUC and then, to the extent of any remaining deemed dividend, qualify for a 5% withholding rate on the dividend under the Canada-US tax treaty.


As indicated above, there are three exceptions to the FAD Rules.

More Closely Connected Business Activities

This first exception is intended to allow Canco to invest in Foreign Affiliates in circumstances where Canco would have made the investment even if Canco had not been foreign-controlled.  However, the exception is onerous and is unavailable in many circumstances where Canco would have made the investment in any event.13

For the exception to apply, Canco must establish that it satisfies certain detailed tests in respect of the investment.  To illustrate the rule, assume for simplicity that the only corporations in a corporate group are a Foreign Parent, the Foreign Parent's direct wholly-owned Canco, and foreign subsidiaries ("Foreign Subsidiaries") directly owned by the Foreign Parent.  Assume that Canco acquires a single foreign subsidiary from a third party, thereby making an "investment" in a Foreign Affiliate.  Assume that Canco has no other foreign subsidiaries.  In these circumstances, Canco must demonstrate that it satisfies the following tests at the time of the investment:

(a) The business activities of the Foreign Affiliate are expected to remain more closely connected to Canco's Canadian business activities than to business activities of the Foreign Parent or Foreign Subsidiaries;

(b) Officers of Canco had and exercised the principal decision-making authority in respect of making the investment in the Foreign Affiliate and a majority of those officers are Canadian residents working principally in Canada; and

(c) It is reasonable to expect that: (i) officers of Canco will have and exercise the ongoing principal decision-making in respect of the investment, (ii) a majority of those officers will be Canadian residents working principally in Canada, and (iii) the performance evaluation and compensation of the Canadian resident officers working principally in Canada will be based on the Foreign Affiliate results of operations to a greater extent than the performance evaluation and compensation of any officer of the Foreign Parent or Foreign Subsidiaries.

It will be very difficult in many situations for Canco to satisfy these tests in this simple scenario.  The statutory exception itself is more complicated because it references certain controlled foreign affiliates of Canco and addresses persons who are officers of both Canco and other entities.

Finance states in the Explanatory Notes that "business activities" are active business operations and do not include investing in shares in other companies and managing those investments.  Accordingly, it appears that a Canadian holding company with all of its operations in offshore subsidiaries could never qualify for this exception.


The second exception category exempts certain internal reorganization and distribution transactions.  These include Canco acquiring Foreign Affiliate shares from a related Canadian resident corporation or acquiring Foreign Affiliate shares as a result of certain share exchanges, reorganizations, foreign mergers, liquidations and distributions.

Pertinent Loan or Indebtedness

The third exception category is the PLOI exception.  Under this exception, the Foreign Parent and Canco can elect to treat an amount owing by the Foreign Affiliate to Canco as a PLOI.  This means that Canco must include in its income imputed interest at a prescribed quarterly rate (now 5%) or, if Canco or a non-arm's length person has borrowed to fund the PLOI, the amount of interest payable on that borrowing (if higher). The imputed interest is reduced by the amount of interest actually payable on the PLOI and otherwise included in Canco's income.

When do the FAD Rules Start to Apply?

The FAD Rules generally apply to transactions and events that occur after March 28, 2012. As the FAD Rules in the August 14, 2012 draft legislation differ from the original March Budget version of the FAD Rules, an election may be available to have the original proposals apply if the relevant transaction or event occurred between March 29, 2012 and August 13, 2012.  Certain transactions may be grandfathered if they were in progress at the time the proposals were first announced and are completed before 2013.


The FAD Rules introduce a complex new cross-border taxation regime that may impact foreign-controlled Canadian corporations with foreign operations as well as takeovers of Canadian corporations with substantial foreign operations.   

We acknowledge and respect Finance's efforts to protect the integrity of the Canadian tax system and recognize the immense challenge of tailoring rules to address debt dumping.  Nonetheless, we are concerned that the FAD Rules may have a negative impact on legitimate commercial activity that has nothing to do with debt dumping or surplus stripping.  For example, Canada's capital markets have to date been a mecca for resource companies with foreign projects.  These companies often have no Canadian operations and hence no opportunity to dump debt into Canada or surplus strip, yet they are caught by the FAD Rules.  We believe that Finance should consider further amendments to the FAD Rules to ensure that they do not have a detrimental impact on the Canadian economy that outweighs the tax revenues generated by the rules.

For further information on the FAD Rules, please contact a member of the Fasken Martineau Tax Group.


1 The Department of Finance originally announced the FAD Rules in the March 29, 2012 Federal Budget.  The Department released draft legislation on August 14, 2012 and then released revised FAD Rules legislation in Bill C-45 on October 18, 2012.  Both the August 14 draft legislation and Bill C-45 contained changes relative to the previous release.  Bill C-45 received Royal Assent on December 14, 2012 and is now in force.  Please refer to the Fasken Martineau Tax Bulletin on the August 14 draft proposals.

2 The FAD Rules clarify that if, for example, Canco is wholly-owned by a foreign parent corporation and the foreign parent is, in turn, wholly-owned by another foreign corporation, then the parent (and not the grandparent) is the Foreign Parent for the purposes of the FAD Rules even though both the parent and grandparent control Canco.

3 The consideration given by Canco is: (i) any property (other than Canco shares) transferred by Canco, (ii) any obligation assumed or incurred by Canco, (iii) any benefit otherwise conferred by Canco, or (iv) any property transferred to Canco that reduces an amount owing to Canco, that in each case can reasonably be considered to relate to the investment.

4 Previously the ratio was 2:1.

5 Note that there are still technical deficiencies in the PUC reinstatement rule.  For example, it does not apply where the "investment" takes the form of debt rather than equity.

6 Or a non-resident subsidiary of the Foreign Parent under the Dividend Allocation Election.

7 Finance has confirmed verbally that the election is available in respect of Canco shares even if no portion of the dividend is being allocated to a QSC.

8 See prior footnote. 

9 It is assumed that USco and other US entities in this Bulletin are residents of the United States for the purposes of the Canada-US tax treaty and entitled to the benefits of the treaty.

10 This is because the equity of Canco is reduced by the FAD rules which, in turn, impacts Canco's equity for the purposes of the 1.5:1 debt to equity ratio in the thin capitalization rules.

11  In this example, there are no non-arm's length Canadian resident shareholders of Cdn Acquisitionco.

12 The project financing itself is not an "investment."

13 This exception generally does not apply in respect of a preferred share investment.

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.

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