Canada: Department Of Finance Releases Draft Foreign Affiliate Amendments Affecting Acquisitions And Reorganizations

Copyright 2010, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, January 2010

On December 18, 2009, the Department of Finance (Finance) released a package of technical amendments to the foreign affiliate rules (the December 18th Proposals). Although many of the proposals are consistent with those contained in previously released draft legislation, many of the provisions have been restructured and reorganized and certain proposed changes take a completely different approach from that taken in earlier proposals. The December 18th Proposals only deal with certain aspects of the foreign affiliate rules and there are many issues still to be addressed, including proposed amendments to the rules governing mergers, liquidations and other reorganizations involving foreign affiliates that continue to be under review by Finance. Nonetheless, Canadian multinationals with foreign affiliates should carefully review this latest legislative initiative.

Changes to Regulations Governing Calculation of Surplus and Deficit Accounts of Foreign Affiliates

The regulations to the Income Tax Act (Canada) (the Act) contain detailed rules governing the calculation of surplus and deficit accounts of foreign affiliates of Canadian taxpayers. These surplus and deficit accounts are necessary for determining the tax treatment to a Canadian corporation of dividends received or deemed to be received from a foreign affiliate.

(a) Acquisition of Control

Although the Act contains a number of rules that affect the tax attributes of a corporation when control has been acquired, there have been no such rules applicable to foreign affiliates of Canadian taxpayers. The December 18th Proposals introduce a new rule which will adjust the surplus accounts of a foreign affiliate directly owned by a Canadian corporation when control of such Canadian corporation has been acquired. In such circumstances, the surplus and related underlying foreign tax accounts of such affiliate owned by the Canadian corporation will be reduced when the aggregate of the "tax-free surplus balance" of such foreign affiliate and the adjusted cost base of the shares of such foreign affiliate owned by the Canadian corporation exceeds the fair market value of the shares of the foreign affiliate owned by the Canadian corporation. The purpose of this rule is to "grind" amounts that may be repatriated to the Canadian corporation by way of dividend free of Canadian tax.

The term "tax-free surplus balance" is a newly defined term that would generally be comprised of the exempt surplus balance of the foreign affiliate and any other foreign affiliates in which it had a direct or indirect interest, as well as a grossed-up amount of foreign taxes paid by such foreign affiliates in respect of their taxable surplus balances.

This rule generally applies to acquisitions of control that occur after December 18, 2009 and will also apply where the relevant Canadian corporation owns the shares of a foreign affiliate through a partnership.

(b) "88(1)(d) Bump" and Surplus Accounts

New rules have been proposed to apply to limit the ability of a Canadian taxpayer to increase the adjusted cost base of shares of a foreign affiliate where such shares were owned by a Canadian corporation that has been wound-up into or amalgamated with its Canadian parent. There had been previously announced changes that would limit the "bump" in these situations and these, as modified by the December 18th Proposals, will generally apply for wind-ups or amalgamations occurring after February 27, 2004. The modified version of the relevant rule will limit the amount of the available "bump" to the extent that the Canadian subsidiary involved has received dividends after its acquisition of control by its Canadian parent out of taxable or exempt surplus earned before the acquisition of control, which dividends are deductible under paragraph 113(1)(a) or (b) of the Act. This provision addresses some of the shortcomings that were contained in previously proposed paragraph 88(1)(d.4) of the Act which presumably will now be abandoned.

For wind-ups or amalgamations that are preceded by an acquisition of control that occurred after December 18, 2009, a new rule will be applicable which takes a different approach from that described above. This new rule will limit the availability of the "bump" to the adjusted cost base of shares of a foreign affiliate owned by the Canadian subsidiary to the extent that the fair market value of the foreign affiliate's shares at the time of the acquisition of control of the Canadian parent exceeded the aggregate of the "tax-free surplus balance" of such affiliate (described above) and the adjusted cost base of such foreign affiliate's shares.

(c) Section 93 Election and Surplus Accounts

Where shares of a foreign affiliate are disposed of by a Canadian taxpayer or another foreign affiliate for non-share consideration, the Canadian taxpayer or the other foreign affiliate will generally realize a gain or loss, subject to the special rules in section 93 of the Act and the related regulations that allow a Canadian corporate shareholder to elect to treat all or a portion of the proceeds of disposition as a dividend. The section 93 election essentially allows the Canadian corporate shareholder to access the surplus accounts of its foreign affiliates without receiving an actual dividend which may be subject to foreign withholding tax.

Previous proposed rules require the surplus of the foreign affiliate and its subsidiaries to be computed on a consolidated basis for purposes of a section 93 election. The December 18th Proposals introduce a new "fill-the-hole" rule which will replace the previous draft consolidated surplus rules and will reduce the number of surplus account adjustments.

The new "fill-the-hole" rule will apply where a foreign affiliate has an exempt deficit (FA1) and any shares of a lower-tier foreign affiliate (FA2) are acquired by the Canadian corporate shareholder or another foreign affiliate (including upon the winding-up of FA1, as well as dispositions or issuance of shares of FA2) in circumstances where FA1's interest in FA2 is diluted. Where it applies, the effect of the rule is to reduce the exempt deficit balance of FA1 and the exempt surplus balance of FA2 in a manner comparable to the result that would have occurred had a dividend equal to the "tax-free surplus balance" (described above) of FA2 been paid, immediately before the transaction, to the extent necessary to "fill the hole" in the FA1. The new rule also provides for increases to the adjusted cost base of the shares of FA2 and the shares of any other affiliate in between FA1 and FA2.

In light of the new "fill-the-hole" rule, the following previously proposed amendments to the regulations are being abandoned:

  • Amendments that require the deficits of a foreign affiliate that is dissolved into another foreign affiliate to move up to the shareholder foreign affiliate on the dissolution; and
  • Amendments that require interest on inter-foreign affiliate debt incurred to acquire shares of another foreign affiliate in certain circumstances be applied to reduce the exempt surplus of the borrowing affiliate, the acquired affiliate and/or any lower‑tier affiliates.

The new "fill-the-hole" rule will apply to an acquisition of shares of a foreign affiliate that occurs after December 18, 2009 and will also apply where the shares of lower-tier foreign affiliates are held through partnerships. Taxpayers that had applied the previous proposed rules with respect to dispositions of shares of a foreign affiliate prior to December 19, 2009 and have filed or will file section 93 elections may want to revisit the calculations relating to such election.

(d) Rules Governing Surplus Adjustments on Reorganizations

The structure of the regulations governing the adjustments to be made to foreign affiliate surplus and deficit accounts where there have been corporate reorganizations or certain share transactions is being significantly overhauled. With the exception of the new "fill-the-hole" rule described above, such changes are generally not intended to result in consequences different from those that would occur under existing rules, but are being made to streamline the rules while bringing them into line with the other proposed changes that have been discussed above.

(e) Partnerships

A number of provisions governing the calculation and treatment of surplus and deficit accounts of foreign affiliates held by partnerships are included in the December 18th Proposals. Generally, these rules adopt the same approach as that taken in subsection 93.1(1) of the Act in the context of foreign affiliate surplus and deficit account determinations where shares of a foreign affiliate are owned by a partnership. The newly proposed rules relating to surplus and deficit accounts are not intended to represent any substantive change to existing proposed rules; however, they are significantly more extensive than the existing proposed rules which they will replace.

(f) Other Changes

The December 18th Proposals also (i) introduce a definition of "permanent establishment" for purposes of various foreign affiliate provisions; (ii) deal with the treatment of eligible capital property held by a foreign affiliate; (iii) modify the foreign tax consolidation provisions in the regulations; and (iv) deem a portion of certain foreign oil and gas levies to be income taxes paid by a foreign affiliate for purposes of the regulations.

Foreign Affiliate Elections

A number of amendments to the foreign affiliate rules were enacted in 2007 as part of the Budget and Economic Statement Implementation Act, 2007 (the Bill C-28 Amendments). The Bill C‑28 Amendments permit taxpayers to make various elections to have certain of the amended provisions come into force at a date that is earlier than would otherwise be the case. The first of the two types of election available under the Bill C-28 Amendments is the so-called "Global Election", which permits taxpayers to elect to have a package of over 20 amendments apply to all of their foreign affiliates in most cases retroactively back to 1995. The second type of election permits taxpayers to elect to have a specific amendment apply to all of their foreign affiliates retroactively back to 1995 (the Individual Elections). The Individual Elections relate to the following amendments:

  • Relieving amendments to the recharacterization rule for interest on inter-foreign affiliate debt incurred to acquire shares of another foreign affiliate.
  • The amendment to broaden the scope of the definition of foreign affiliate in respect of which a taxpayer has a "qualifying interest".
  • The new look-through rule for tiered partnerships and corporations.
  • Minor amendments to the rules that deem a foreign affiliate to be a "qualifying interest" foreign affiliate of a taxpayer or related to the taxpayer and another affiliate under certain circumstances.
  • The amendment to exclude certain services from the definition of "services".
  • Relieving amendments to the rule that deems certain income from the sale of property to be income from a business other than an active business.

Under the Bill C-28 Amendments, only the Global Election, once made, may be revoked; no Individual Election is revocable. In June 2008, Finance announced an 18-month extension of the deadline for making the Global Election and the Individual Elections so that the new deadline for corporate taxpayers with calendar taxation year-ends is December 31, 2009. The December 18th Proposals retain this new deadline, but extend revocability to the Individual Elections. Thus, in addition to the Global Election, the Individual Elections made by a taxpayer can be revoked until the filing due-date for the taxpayer's taxation year that includes December 14, 2010 (in the case of a corporate taxpayer with a calendar taxation year-end, until June 30, 2011). Given that some taxpayers may have decided not to make one or more Individual Elections because of the lack of an ability to revoke such elections, it is hoped that Finance considers extending the December 31, 2009 election deadline in order to give taxpayers a chance to re-evaluate any earlier decision not to file an Individual Election.

Foreign Accrual Property Losses (FAPLs)

The carry-forward period for being able to utilize FAPLs is being extended to 20 years. This change, which had been previously announced, is being made to align these rules with the domestic loss carry-forward periods which have been repeatedly extended in recent years. Although generally effective for taxation years of foreign affiliates beginning after November 1999, the extension is phased in to mirror the extensions of domestic loss carryforward rules from five to seven years, then to 10 years and finally to 20 years. A foreign affiliate's FAPLs will continue to be able to be carried back for three years.

Certain other changes have been made to the computation of and the mechanics of claiming FAPLs.


Finance indicated that the government will be accepting comments on the December 18th Proposals until February 15, 2010. The December 18th Proposals do not include most of the previous proposals dealing with mergers, liquidations and other reorganizations of foreign affiliates. Finance indicated that those proposals will be included in a separate package of proposals to be issued in the near future which will be anxiously awaited.

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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