Canada: OECD Discussion Draft Considers Controlled Foreign Corporation Rules

On April 3, 2015, as part of its Action Plan on Base Erosion and Profit Shifting (BEPS), the OECD released a discussion draft entitled "BEPS Action 3: Strengthening CFC Rules" (the Draft) for comments. The Draft stresses the importance of CFC rules in countering base erosion and profit shifting, and makes several draft recommendations regarding the design of domestic CFC rules. Comments on the Draft will be accepted until May 1, 2015, followed by a public consultation on May 12, 2015.


The BEPS Action Plan, published in July 2013, identifies 15 actions to address BEPS and sets deadlines to implement these actions. Action 3 of the BEPS Action Plan relates to the design of domestic CFC rules to prevent BEPS.

Canada currently has a robust set of CFC rules. The "foreign accrual property income" or "FAPI" rules are a broad set of anti-deferral rules applicable to passive income earned by a "controlled foreign affiliate" of a Canadian taxpayer. Passive income for this purpose very generally includes income from property (such as rents, royalties, interest and non-foreign affiliate dividends) and income from certain businesses that either have a link to Canada or do not meet certain minimum employee and other requirements. FAPI does not include income from an active business carried on by a foreign affiliate. A Canadian shareholder is generally required to include, in its income for a taxation year, its share of any FAPI earned by any of its controlled foreign affiliates in such year, regardless of whether or not any amount is distributed by the controlled foreign affiliate to the shareholder. A deduction is available in respect of any foreign taxes attributable to FAPI. If FAPI in a controlled foreign affiliate is less than C$5,000, it is not required to be included in the shareholder's income. There is no "low-tax threshold" or "high-tax kick out" – the FAPI rules apply even if the controlled foreign affiliate is resident in a country that imposes tax at a rate that is equal to or exceeds the Canadian rate. Generally speaking, if FAPI, which is computed using the rules in the Income Tax Act (Canada) (the ITA) and in the Canadian taxpayer's functional currency, is subject to foreign tax of at least 25%, no additional tax should be payable in Canada.

A second set of rules relates to the treatment of dividends received by Canadian corporate shareholders from foreign affiliates, including dividends paid out of earnings generated from the conduct of an active business. Canada has a hybrid exemption and credit system for the repatriation of foreign affiliate earnings. Generally speaking, where earnings arise from an active business carried on by a foreign affiliate in a county with which Canada has entered into a tax treaty or tax information exchange agreement, such earnings are included in the foreign affiliate's "exempt surplus," which may be distributed as a dividend to Canada free of any additional Canadian corporate tax. Most other earnings are included in "taxable surplus," which is taxable upon distribution as a dividend to Canada, subject to a deduction in respect of any underlying foreign tax paid on the earnings that generated the surplus. Gains arising on the disposition of certain foreign affiliates (or partnerships) are added to a "hybrid surplus" account, which is half taxable upon distribution (subject to a deduction in respect of foreign tax) and which is meant to mirror the domestic taxation of capital gains.

The main foreign affiliate regime is supported by certain other rules with similar objectives and which apply depending on the circumstances. These rules include offshore investment fund property rules that may impute a return on certain non-controlled investments, non-resident trust rules which tax the earnings of certain trusts, and a rule that may impute interest income on certain direct or indirect low-interest loans to non-resident corporations. A separate "foreign affiliate dumping" regime may also apply to deem cross-border dividends to arise (or to suppress cross-border paid-up capital) in respect of certain direct or indirect investments in foreign affiliates by Canadian corporations that are controlled by a non-resident corporation.

Overview of the Draft

The Draft makes it clear that it does not reflect a consensus view of the BEPS participants, and that it rather reflects a preliminary consideration of the issues for the purpose of seeking public comments.

The Draft begins with a review of various policy considerations relating to CFC rules, including the prevention of profit shifting and long-term base erosion. The Draft notes the importance of striking a balance between taxing foreign income and maintaining competitiveness. In particular, parent country taxes imposed on the income of a CFC result in a competitive disadvantage relative to a competitor of the CFC based in the same foreign jurisdiction that does not have to pay an equivalent tax. A particular concern arises in the context of the European Union, since EU law imposes limitations on CFC rules that apply within the EU. For example, the European Court of Justice has stated that CFC rules must "specifically target wholly artificial arrangements which do not reflect economic reality and whose only purpose would be to obtain a tax advantage."1 The Draft also notes the importance in limiting administrative and compliance burdens in a manner that does not create opportunities for avoidance.

The Draft breaks down the constituent elements of CFC rules into the following seven "building blocks" for effective CFC rules:

  • Definition of a CFC
  • Threshold requirements for the application of CFC rules
  • Definition of control
  • Definition of CFC income
  • Rules for computing income
  • Rules for attributing income
  • Rules to prevent or eliminate double taxation

1. Definition of a CFC

The Draft recommends broadly defining entities that are within scope of the rules so that, in addition to including corporate entities, CFC rules would also apply to partnerships, trusts and permanent establishments (PEs) when those entities are either owned by CFCs or treated in the parent jurisdiction as taxable entities separate from their owners.

The Draft also recommends including a modified hybrid mismatch rule that would prevent entities from circumventing CFC rules by being treated differently in different jurisdictions. Specifically, this rule would require an intragroup payment to a CFC to be taken into account in calculating CFC income. The Draft considers both a "broad option" and a "narrow option." Under the broad option, a payment would be included in CFC income if it is not otherwise included in CFC income, and would have been included if the parent jurisdiction had classified the entities and arrangements in the same way as the payer or payee jurisdiction (i.e., if there had not been a hybrid entity or instrument). The narrow option is similar except that such a payment would only be included in CFC income if it results in base erosion (i.e., deductible in one jurisdiction and subject to no or low taxes in the other jurisdiction). This rule appears to target the U.S. "check the box" election rules, which otherwise allow certain payments between foreign entities to be disregarded for CFC purposes.

Canada's FAPI rules apply to income earned by non-resident corporations, including where such income is earned through a partnership or foreign PE. Similarly, Canada's worldwide taxation rules generally also include income earned by a Canadian resident through a foreign PE or a partnership earning income outside of Canada. Canada's non-resident trust rules apply in certain circumstances to either treat the trust like a non-resident corporation (in which case its income is subject to the FAPI rules) or to deem the trust to be resident in Canada (in which case its worldwide income is taxable in Canada).

Canada's current rules also contain a restriction on the use of certain hybrid instruments. Where applicable, these rules deny recognition of foreign taxes paid by a foreign affiliate.

2. Threshold requirements for the application of CFC rules

The Draft recommends that CFC rules should include a low-tax threshold which must be satisfied before the rules apply. Applying such a threshold, the rules would only apply where a CFC's effective tax rate (as opposed to its nominal tax rate) is meaningfully lower than the parent country's tax rate. Low-tax thresholds are intended to ensure that CFC rules are targeted at companies that pose the greatest risk of profit shifting and reduce overall administrative burdens. Annex II to the Draft sets out various low-tax thresholds used by different countries. Many of these are based on an effective tax rate that is less than a fixed rate or a percentage of the parent's domestic rate. Others use lists of "good" or "bad" jurisdictions to determine whether the threshold is met.

Canada's current rules do not include a low-tax threshold. Such a threshold would be welcome, particularly as it could reduce the burden of having to consider or comply with the FAPI rules in respect of investments by Canadian residents in "high-tax" jurisdictions such as the United States or many European countries.

The Draft also notes that many countries have de minimis thresholds, without providing a general recommendation for or against such thresholds. Annex I to the Draft sets out various de minimis thresholds in different countries.

Canada's current exemption for FAPI of less than C$5,000 is significantly lower than the de minimis thresholds used by many other jurisdictions. For example, the U.S. threshold is the lesser of 5% of gross income or US$1 million. Any expansion to Canada's threshold would also be welcome as it could provide more meaningful relief from the administrative burden of calculating and reporting relatively small amounts of FAPI.

3. Definition of control

The Draft notes that "control" requires two different determinations: (i) the type of control that is required, and (ii) the level of that control. The recommendation is for control to be based on direct or indirect legal or economic control, with the satisfaction of either test resulting in control. Countries may also include de facto control tests (or a test based on consolidation for financial accounting purposes) where they achieve the same effect. Secondly, a CFC should be treated as controlled where residents hold more than 50% control, although jurisdictions may set their control threshold at a lower level. The level of control could be established through aggregating interests of related parties or unrelated resident parties, or by aggregating interests of taxpayers that are found to be acting in concert.

Canada's current rules are based on legal or de jure control, using a control threshold of more than 50%. In determining control, the interests of non-arm's length persons are aggregated, as are the interests of up to four arm's-length Canadian residents. Thus, controlled foreign affiliate status may arise where a foreign corporation is owned by a small group of otherwise unrelated Canadian residents. In addition, an anti-avoidance rule may apply to deem controlled foreign affiliate status to arise where, for example, shares are acquired or disposed of principally for the purpose of avoiding, reducing or deferring the payment of Canadian income tax.

4. Definition of CFC income

The Draft does not include recommendations on the definition of CFC income that is subject to attribution in the parent's hands (referred to as "CFC income"). Instead, it discusses several options that jurisdictions could implement in order to address BEPS concerns. The OECD is encouraging comments and suggestions during the public consultation about the design of the recommendations that will be included in the final report in September 2015.

The Draft suggests two possible approaches for defining CFC income: (i) a categorical approach, and (ii) an excess profits approach. Under the categorical approach, certain categories of income are included in computing CFC income (such as dividends, interest and other financing income, insurance income, sales and services income, and royalties and other IP income). The Draft acknowledges that interest and other financing income could be excluded from CFC income if the CFC carries on an active financing trade or business and is not overcapitalized. It also notes that such an approach could be combined with a look-through rule that treats interest paid out of active earnings as being active. Generally speaking, this is the approach that Canada has adopted.

Under the excess profits approach, CFC income would include certain excess profits in low-tax jurisdictions. Under this approach, a "normal rate of return" would be identified, and profits in excess of such return would be included in CFC income. The Draft specifically notes the absence of consensus on the excess profits approach. Some countries believe that such an approach would capture income irrespective of whether it arises from genuine economic activity of the CFC with appropriate substance. Other countries believe that excluding a normal return on eligible equity is effective for identifying CFC income that is appropriately attributable.

The Draft also considers whether to attribute income based on a transactional approach or an entity approach.

Canada's FAPI rules are based on a categorical approach, which has been refined over several decades. There does not appear to be any clear policy reason why Canada should abandon such an approach in favour of a more arbitrary or formulaic approach to computing FAPI.

5. Rules for computing income

The fifth CFC "building block" is the manner in which CFC income should be computed. The Draft recommends that the rules of the parent jurisdiction should be used. The Draft also recommends specific rules relating to CFC losses, so that they may only be used against the profits of the same CFC or against the profits of CFCs in the same jurisdiction.

Canada requires that FAPI be computed in accordance with the rules in the ITA, and in the Canadian parent's functional currency (i.e., Canadian dollars absent a valid foreign functional currency election). In addition, Canada has several rules limiting the application of FAPI losses. For example, generally speaking, FAPI losses may only be used to offset FAPI realized in the same controlled foreign affiliate, although there are rules that allow FAPI losses to survive certain corporate reorganizations, such as a merger or winding-up, involving the FAPI loss entity. In addition, FAPI losses that are on capital account may only be used to offset FAPI capital gains, in order to appropriately reflect the domestic loss regime.

6. Rules for attributing income

With respect to the attribution of CFC income, the Draft recommends an attribution threshold tied to a minimum control threshold, without specifying what that threshold should be. In this regard, before an entity can be considered a controlled foreign affiliate of a Canadian taxpayer, it must be a "foreign affiliate" of such taxpayer, which generally requires a minimum equity investment of 10% of any class of shares.

With respect to the amount of attributed income and the timing of its inclusion, the Draft recommends an attribution rule that reflects both proportion of ownership and actual period of ownership. The Draft makes no recommendation as to timing of inclusion. Canada's attribution rules generally look to ownership of the controlled foreign affiliate at the end of its taxation year in order to determine both the quantum and the timing of FAPI inclusion. Recently proposed amendments would refine these rules to take into account ownership changes occurring in the controlled foreign affiliate's taxation year.

The Draft makes no recommendation with respect to the characterization of attributed CFC income for domestic law purposes. Canada treats such income as being income from property, in respect of the shares of the directly held foreign affiliate in the corporate chain in which the FAPI arises.

With respect to the tax rate that should apply to CFC income, the Draft contemplates a "top-up" tax that would apply a set rate, perhaps tied to the low-tax threshold referred to above. For example, if a jurisdiction applied its CFC rules only where a CFC were subject to an effective tax rate of less than 15%, CFC income would only be taxed to a maximum of 15%, regardless of the parent's otherwise applicable rate. The Draft notes that such a top-up tax may not meet all of the policy objectives of the CFC rules, such as their anti-deferral element, and therefore only considers it as an option while preferring (and recommending) that CFC income be subject to the ordinary rate applicable in the parent country. In Canada, FAPI is subject to tax at the taxpayer's ordinary rate (after taking into account the deduction relating to foreign tax, discussed in greater detail below).

7. Rules to prevent or eliminate double taxation

CFC rules must contain protections against double taxation since their effect is to subject income earned in one entity to taxation in the hands of another entity. The Draft recommends that countries provide a credit for foreign taxes actually paid, including CFC tax assessed on intermediate companies. The Draft also recommends that dividends and gains be exempt from taxation to the extent that CFC taxation has previously applied.

Canada's CFC rules generally correspond with the recommendations. A credit for foreign tax paid in relation to FAPI is effectively granted by grossing up such foreign tax to provide for an amount of income that would have generated such tax, had tax at a notional rate (25%) that approximates the Canadian rate applied. The grossed-up amount is then allowed as a deduction in determining the amount of FAPI to be included in the Canadian shareholder's income. As a consequence, if FAPI has borne foreign tax at a rate equal to or in excess of 25%, no part of such FAPI is generally included in net income. Canada's rules currently do not contemplate the scenario where FAPI has been subject to CFC tax in an intermediate jurisdiction – as recommended by the Draft – although in our experience such a situation very rarely arises in practice.

When previously taxed FAPI is distributed as a dividend, Canada's regime generally ensures that such amount is not subject to tax again. Prior to distribution, the amount of FAPI included in income increases the shareholder's cost base in the shares of the controlled foreign affiliate, so that if the shares are sold prior to distribution, the amount of the gain subject to tax in Canada does not include the previously taxed FAPI.


The views and proposals included in the Draft do not yet reflect the consensus views of the OECD or its subsidiary bodies, but are intended to reflect preliminary consideration of the issues for public comment. Canada's FAPI rules appear largely compliant with the preliminary recommendations contained in the Draft. However, Canadian taxpayers and their investors should consider responding to the questions and issues raised in the Draft to ensure that their concerns are taken into account in the final report on Strengthening CFC Rules. While the recommendations in the final report are not binding on Canada or any other country, they may be taken into account by Canada and other countries when deciding on future domestic legislative amendments.


1. Haribo Lakritzen Hans Riegel BetriebsgmbH and Österreichische Salinen AG v. Finanzamt Linz, Joined Cases C‑436/08 and C‑437/08, paragraph 165.

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
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 you may opt out by clicking here

    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.

    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.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    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.

    By clicking Register you state you have read and agree to our Terms and Conditions