Canada: Finance Comfort Letter On The 95(2)(F) And (F.1) FAPI Accrual Rules – A Comment On Its Implications For The Tax Cost Bump

Citation: Geoffrey S. Turner, "Finance Comfort Letter on the 95(2)(f) and (f.1) FAPI Accrual Rules – A Comment on its Implications for the Tax Cost Bump" International Tax, Report # 31 (CCH: December 2006)

A recent Department of Finance comfort letter publicly released November 1, 2006 (but dated September 1, 2006)1 recommends amendments to paragraph 95(2)(f) and to proposed paragraph 95(2)(f.1) of the Income Tax Act (Canada) (the "ITA"). The proposed changes relate to the postamble of paragraph 95(2)(f), and in particular to the circumstances in which the "FAPI accrual carryover" will apply when two Canadian corporations amalgamate and one of the predecessors has a foreign affiliate which owns capital property with an accrued gain or loss. The comfort letter is interesting in a number of respects, including the tax policy issues it engages in relation to the paragraph 88(1)(d) tax cost bump when applied to a Canadian target corporation's shares of a foreign affiliate. This article examines the issues addressed in the Finance comfort letter, and considers some of its implications and possible further circumstances in which the FAPI accrual carryover rules could be amended.

The 95(2)(f) and (f.1) FAPI Accrual Carryover Rules

Paragraph 95(2)(f) establishes the rules for calculating the taxable capital gains and allowable capital losses of a foreign affiliate of a Canadian taxpayer. These rules are relevant both for determining the FAPI of the foreign affiliate (where the property disposed of is not excluded property), and for determining the taxable surplus/deficit and exempt surplus/deficit balances of the foreign affiliate.

In general terms, paragraph 95(2)(f) provides that capital gains and losses of the foreign affiliate are to be determined using the Canadian rules set out in Part I of the ITA. Where the property disposed of is not excluded property and the foreign affiliate is a controlled foreign affiliate (i.e., where a gain would give rise to a FAPI inclusion for the Canadian taxpayer), the gain or loss is to be computed using Canadian dollars. In any other case, the gain or loss is to be computed using the appropriate foreign calculating currency.

However, the postamble of paragraph 95(2)(f) requires that the capital gain or loss calculation exclude the portion of the gain or loss that can reasonably be considered to have accrued during the period that the foreign affiliate was not a foreign affiliate of the particular Canadian taxpayer, a person with whom the Canadian taxpayer was not dealing at arm's length, or a predecessor of the Canadian taxpayer (or non-arm's length person) pursuant to a subsection 87(1) amalgamation. In other words, for purposes of computing the capital gain or loss of a foreign affiliate of the Canadian taxpayer, the adjusted cost base of the property subsequently disposed of should effectively be reset to its fair market value at the time the foreign affiliate becomes a foreign affiliate of the Canadian taxpayer, so that the accrued gain or loss before that time is ignored or disregarded, and only the gain or loss accruing after that time is taken into account for FAPI and surplus calculation purposes. Thus, paragraph 95(2)(f) can be said to effectively permit a "bump" in the foreign affiliate's adjusted cost base of its capital property, in a manner similar to the tax cost bump available to a Canadian corporation under paragraph 88(1)(d). However, in the case of an amalgamation of two Canadian corporations under subsection 87(1), the "FAPI accrual carryover" in the postamble of paragraph 95(2)(f) provides that the gain or loss realized on a disposition of capital property by a foreign affiliate of the amalgamated corporation must take into account the portion of the gain or loss that accrued prior to the amalgamation at any time when the foreign affiliate was a foreign affiliate of one of the predecessor Canadian corporations. In this amalgamation context, the tax cost bump of a foreign affiliate's capital property would not be available.

Proposed paragraph 95(2)(f.1) effectively extends the same accrual carryover concepts to FAPI calculations beyond the mere computation of capital gains and losses addressed in current paragraph 95(2)(f). In particular, the version of paragraph 95(2)(f.1) proposed in the February 27, 2004 draft legislation will require use of the Canadian rules in the Act and Canadian dollars for the more general purposes of computing a foreign affiliate's income from property or income from a business other than an active business, and will also require the exclusion of the portion of any such income or loss that can reasonably be considered to have been realized or accrued during any period in which the foreign affiliate was not a foreign affiliate of the particular Canadian taxpayer or any non-arm's length persons or predecessors referred to in the paragraph 95(2)(f) postamble.

The effect of the FAPI carryover principles in paragraphs 95(2)(f) and (f.1) is that, for all relevant FAPI calculation purposes, unrealized FAPI that accrues to a foreign affiliate of a Canadian corporation will not be disregarded, and will instead carry over, when that Canadian corporation amalgamates under subsection 87(1). The amalgamated corporation will, in essence, inherit the accrued FAPI (or FAPL) in a foreign affiliate of its predecessor.

Notably, however, this carryover principle will not apply where a Canadian corporation acquires a foreign affiliate from a subsidiary Canadian corporation on a winding-up of the subsidiary pursuant to subsection 88(1). In the case of a winding-up, the accrued capital gain or loss or property income or loss of the foreign affiliate of the subsidiary will be disregarded and will not carry over to or be inherited by the Canadian parent corporation.

The Comfort Letter Recommendations

The facts considered in the September 1, 2006 Finance comfort letter are fairly straightforward and are illustrated below. Target is a taxable Canadian corporation that owns all of the shares of FA1, a controlled foreign affiliate of Target. FA1 in turn owns shares of FA2, another foreign affiliate of Target, but these shares are not excluded property and there is an accrued capital gain which, if realized, would give rise to FAPI in FA1.2 In addition, FA1 has accrued property income that will be FAPI.3

Parent (also a taxable Canadian corporation) wishes to acquire all of the Target shares, and incorporates Acquisitionco (another taxable Canadian corporation) for this purpose. Acquisitionco acquires the Target shares, and following the acquisition of control, Acquisitionco and Target amalgamate to form Amalco pursuant to section 87. Amalco uses the tax cost bump permitted by subsection 87(11) and paragraph 88(1)(d) to increase its adjusted cost base of the FA1 shares acquired on the amalgamation. FA1 then disposes of the FA2 shares and distributes the cash proceeds to Amalco, presumably in a manner that utilizes the bumped tax cost of the FA1 shares and the February 27, 2004 proposed version of subsection 88(3) to avoid or minimize adverse tax consequences for Amalco.

The key issue is this – is it appropriate that the FAPI accrual carryover rule in the postamble of paragraph 95(2)(f) should require Amalco to compute FA1's capital gain on the sale of the FA2 shares in a manner that includes the gain that accrued while FA1 was owned by Target, a predecessor of Amalco by amalgamation? Stated another way, should Amalco enjoy a "fresh start" allowing it to reset or bump FA1's adjusted cost base of the FA2 shares to their fair market value when Acquisitionco acquires control of Target, thereby excluding the accrued FAPI gain on the FA2 shares? Similarly, should Amalco be taxed on the FAPI that accrued to FA1 before Acquisitionco acquired control of Target?

The comfort letter refers to the submission of the taxpayer that, because Acquisitionco acquired control of Target4 in an arm's length transaction, the FAPI capital gain (and the property income) that accrued to FA1 prior to the acquisition of control of Target should be excluded in computing FA1's FAPI in respect of Amalco. Finance agreed with the taxpayer, and indicated that it would recommend that paragraphs 95(2)(f) and (f.1) be amended to achieve these results in the circumstances described in the letter. The proposed amendments would be applicable in computing FAPI of a foreign affiliate of a Canadian taxpayer for taxation years of the foreign affiliate beginning after the announcement date of draft legislation incorporating the amendments, although the taxpayer would be permitted to elect to have the amendment apply to taxation years of all of its foreign affiliates beginning after February 27, 2004.

The Unstated Tax Cost Bump Policy Rationale

As noted above, the comfort letter does not provide an explicit tax policy reason for the proposed amendments, apart from repeating the taxpayer's suggestion that the arm's length acquisition of control of Target justifies excluding the FAPI that accrued to FA1 while it was a foreign affiliate of Target prior to the acquisition of control. This argument seems to be based on the notion, perhaps imported from the exempt surplus and taxable surplus rules in Regulation 5907(1), that the relevant time for earnings and FAPI computations begins with the time a non-resident corporation first becomes a foreign affiliate of the particular Canadian taxpayer in respect of whom those calculations are relevant.

However, arguably the correct rationale for these amendments is not that Acquisitionco acquires control of Target, but rather that, following the acquisition of control, Amalco applies the paragraph 88(1)(d) tax cost bump in order to increase Amalco's adjusted cost base of the FA1 shares potentially up to their fair market value as at the time Acquisitionco acquires control of Target. This may well be Finance's unstated reason for recommending the amendments, since the comfort letter does indicate the amendments to paragraphs 95(2)(f) and (f.1) would exclude the FAPI accrued before the acquisition of control, in the circumstances described in the letter, which circumstances of course include the bump designation made by Amalco as a result of the vertical amalgamation.

By way of explanation, consider the results in the case of an amalgamation of Acquisitionco and Target, but in the absence of a bump designation. Existing paragraph 95(2)(f) would require Amalco to take into account the gain or loss on the FA2 shares that accrued during the holding period while FA1 was a foreign affiliate of Target. Moreover, Regulation 5905(5)(b) would require the surplus balances of FA1 and FA2 in respect of Amalco to be computed by adding the surplus balances of FA1 and FA2 in respect of each of Target and Acquisitionco, effectively preserving and carrying over the historical surplus balances generated before the acquisition of control of Target by Acquisitionco. These carryover rules are appropriate because the tax attributes of FA1 and FA2 in respect of Target (surplus balances, adjusted cost base, FAPLs, accrued gains and losses, etc.) are already within the Canadian tax system (since Target is a taxable Canadian corporation) and should be preserved in Amalco following an amalgamation, consistent with the comprehensive carryover rules in subsection 87(2) that provide, for numerous purposes, that the new corporation formed on the amalgamation is deemed to be the same corporation as, and a continuation of, each predecessor.

On the other hand, where an amalgamation is a vertical amalgamation that subsection 87(11) permits to be treated as a winding-up for purposes of the tax cost bump (such as the amalgamation of Target and Acquisitionco), and a paragraph 88(1)(d) bump designation is in fact made in respect of the top-tier foreign affiliate shares of FA1 held by Target, the carryover of tax attributes in FA1 and its underlying chain of foreign affiliates is no longer warranted. As I have argued in a previous article in this journal in relation to the bump as it applies to foreign affiliates,5 the tax cost bump conceptually is intended to place the acquiror in the same position in relation to the bumped foreign affiliate shares as if the acquiror had purchased them directly. If Acquisitionco had purchased the FA1 shares directly, paragraphs 95(2)(f) and (f.1) would have appropriately excluded the gain on the FA2 shares, and the accrued FAPI of FA1, in respect of the period preceding the acquisition of control. Arguably therefore the comfort letter is correct to recommend that those provisions be amended to provide the same results where Acquisitionco acquires control of Target and subsequently amalgamates to bump the tax cost of the FA1 shares.

One might ask whether the proposed amendments in the comfort letter would allow the accrued FAPI of FA1 to escape Canadian taxation where the tax cost bump is employed and the accrued FAPI does not carry over to Amalco following the amalgamation. Is it appropriate that the accrued FAPI should simply disappear? Yet in a sense this is not the correct question, since the accrued FAPI in FA1 does not disappear. The accrued FAPI would be reflected in the value of the FA1 shares that are indirectly acquired by Acquisitionco through its purchase of the Target shares. Thus the accrued FAPI would already be effectively taxed, or at least taken into account within the parameters of the Canadian tax system, when the Target shares (shares of a Canadian corporation) are disposed of to Acquisitionco. The subsequent amalgamation of Target and Acquisitionco and bump of the FA1 shares should then permit Amalco to be treated in a manner consistent with a direct acquisition of the FA1 shares – Amalco should have a "fresh start" and a reset of all relevant tax attributes of FA1 as at the time of the acquisition of control, as is now the case under proposed Regulations 5905(5.1) and (5.2) in relation to FA1's surplus and deficit balances.

The policy underlying the amendments to paragraphs 95(2)(f) and (f.1) proposed in the comfort letter can be tested by changing the facts somewhat. Suppose instead that the FA2 shares were excluded property, so that FA1 had a substantial accrued capital gain that, if realized, would create substantial exempt surplus and taxable surplus. Under existing paragraph 95(2)(f), FA1's unrealized exempt surplus in respect of the excluded property FA2 shares would carry over to Amalco following the amalgamation of Acquisitionco and Target. This would allow Amalco after the bump of the tax cost of the FA1 shares and the sale of the FA2 shares to benefit both from the creation of the exempt surplus (which accrued before the acquisition of control of Target), and from the bumped tax cost of the FA1 shares. Potentially this would give rise to a "double dip" of tax attributes. The amendments recommended by Finance would prevent this result by requiring FA1's capital gain on the excluded property FA2 shares to be computed without regard to the gain that accrued before Acquisitionco acquired control of Target, which would have the effect of eliminating the unrealized exempt surplus. This is arguably appropriate where Amalco has bumped the tax cost of the FA1 shares, since Amalco should be treated in a manner consistent with a direct acquisition of the FA1 shares, and in a direct acquisition of the FA1 shares Amalco would effectively be required to reset all relevant tax attributes of its new foreign affiliate, FA1, as at the time of the acquisition of control.

Implications of the Recommended Amendments

Seen in the context of the paragraph 88(1)(d) tax cost bump, the amendments to paragraphs 95(2)(f) and (f.1) recommended in the comfort letter are consistent with the tax policy underlying the bump and with other proposed amendments to the Act including Regulations 5905(5.1) and (5.2) and paragraph 88(1)(d.4) (as proposed by Finance to be further modified). The theme of all of these amendments is that a Canadian acquiror of a Canadian target corporation that owns foreign affiliates should, if the acquiror utilizes the bump to increase the tax cost of the target's top-tier foreign affiliates, be treated under the foreign affiliate rules as though the acquiror purchased directly the shares of those bumped top-tier foreign affiliates. This implies a reset of all tax attributes of those foreign affiliates in relation to the acquiror, including surplus and deficit balances, adjusted cost base amounts, and FAPI and FAPL accruals in those foreign affiliates.

Yet the comfort letter also suggests or anticipates a further possible amendment that could be considered by Finance. In particular, why does the current FAPI accrual and carryover apply only on a subsection 87(1) amalgamation and not on a subsection 88(1) winding-up? There does not appear to be a compelling justification to apply the tax attribute carryover under paragraphs 95(2)(f) and (f.1) to an amalgamation but not to a winding-up. In each case the successor corporation should in principle inherit the foreign affiliate tax attributes of the predecessor, just as Regulation 5905(5) now accomplishes with respect to surplus and deficit balances on both an amalgamation and a winding-up. Perhaps the appropriate rules would apply the same accrual carryover to an amalgamation or winding-up, but not, as contemplated in the comfort letter, where the amalgamation or winding-up is accompanied by a bump designation under paragraph 88(1)(d) in respect of a top-tier foreign affiliate of the subsidiary predecessor.


1 See Department of Finance comfort letter of Brian Ernewein dated September 1, 2006, headed "Foreign Affiliates – Exclusions in Computing Foreign Accrual Property Income".

2 The comfort letter does not refer to the possibility of an automatic election under subsection 93(1.1) reducing FA1's proceeds of disposition on the sale of the FA2 shares. The current version of subsection 93(1.1) would not apply because the FA2 shares disposed of are not excluded property, but the February 27, 2004 version of subsection 93(1.1) is broadened to apply to a disposition of foreign affiliate shares, regardless of their excluded property status. The discussion in this article will follow the implicit assumption in the comfort letter that FA2 has no surplus balances that could reduce FA1's capital gain by virtue of a deemed subsection 93(1) election pursuant to subsection 93(1.1).

3 The comfort letter states in the facts that it is FA2 that has accrued FAPI, but the remaining discussion in the comfort letter establishes that it is accrued FAPI in FA1, not FA2, that is relevant.

4 The comfort letter refers to control of Acquisitionco being acquired in an arm's length transaction but this is understood to be an inadvertent typographical error.

5 See Geoffrey S. Turner, "Bumping Foreign Affiliate Shares under the February 27, 2004 Proposals", International Tax, Report # 28 (CCH: June 2006).

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

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

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

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

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

Use of

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


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

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


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

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

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

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

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

Information Collection and Use

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

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

Mondaq News Alerts

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


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

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

Log Files

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


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

Surveys & Contests

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


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


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

Correcting/Updating Personal Information

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

Notification of Changes

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

How to contact Mondaq

You can contact us with comments or queries at

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