Offshore Investment Fund Property: How Section 94.1 Taxes Canadians On Offshore Fund Income They Never Received And How To File An Objection

Overview: The Offshore Investment Fund Property Rules in Plain Language

If you hold units or shares of an offshore hedge fund, a foreign investment company or any other non-resident fund that reinvests its income instead of paying it out, the CRA may be able to tax you every year on income you never received. Section 94.1 of the Income Tax Act, the offshore investment fund property rule, imputes a return on the cost of your investment equal to the prescribed interest rate plus 2%, whether or not the fund distributes anything. For 2026, that works out to 5% of cost for the year.

The rule targets Canadians who use non-resident investment vehicles to defer or reduce Canadian tax on portfolio income. It does not apply to every foreign investment, and the leading judicial analysis of it, the Tax Court of Canada’s decision in Gerbro Holdings Company v. The Queen, 2016 TCC 173, affirmed 2018 FCA 197, was a taxpayer win. But section 94.1 applies to investments that fall outside the foreign affiliate and FAPI rules entirely, which is exactly where many investors stop looking. This article explains how offshore investment fund property is taxed, how section 94.1 interacts with Form T1135 and the FAPI regime, and what investors can do to manage the risk.

Background: Why Canada Has an Offshore Investment Fund Property Rule

Canada taxes its residents on their worldwide income. Without anti-deferral rules, a Canadian investor could hold a portfolio through a non-resident corporation or fund in a low-tax jurisdiction, let the income compound offshore, and pay Canadian tax only when the investment was eventually sold, often many years later and often as a capital gain rather than as income.

The Income Tax Act closes that gap in several ways. Where a Canadian controls a foreign corporation, alone or with a small group of other Canadian shareholders, the controlled foreign affiliate rules apply and the corporation’s passive income is taxed every year as foreign accrual property income (FAPI).

Foreign trusts are dealt with separately under sections 94 and 94.2, discussed in our article on how the FAPI regime applies to foreign corporations and foreign trusts. Section 94.1 covers what remains: offshore investments that a Canadian does not control but holds in order to defer or reduce Canadian tax.

Section 94.1 was introduced in 1984 as a targeted anti-avoidance rule. Through the 2000s, the federal government released several versions of much broader foreign investment entity rules intended to replace it, but those proposals were abandoned in 2010 in favour of more limited amendments to section 94.1 that apply to taxation years ending after March 4, 2010. Section 94.1 therefore remains the main rule for non-controlled offshore funds.

Key Issues and Findings: How Section 94.1 Works

What Counts as Offshore Investment Fund Property

Section 94.1 applies to a share of, an interest in, or a debt of a non-resident entity, and to a right to acquire any of those, where two tests are met. The entity must not be a controlled foreign affiliate of the taxpayer or a prescribed non-resident entity.

• The asset test: the interest may reasonably be considered to derive its value, directly or indirectly, primarily from portfolio investments in assets such as shares, debt, commodities, real estate, resource properties, currencies, derivatives, or interests in other entities.
• The motive test: having regard to all the circumstances, it may reasonably be concluded that one of the main reasons the taxpayer acquired, held or had the interest was to benefit from the portfolio investments in a way that results in significantly less tax than the taxpayer would have paid if the underlying income had been earned directly.

The Act directs attention to, among other circumstances, the nature, organization and operation of the entity and the terms of the taxpayer’s interest, the extent to which the entity’s income is taxed at rates significantly lower than Canadian tax, and the extent to which the entity distributes its income. A fund that pays out its income every year and is fully taxed is a much weaker target than a low-tax fund that accumulates everything.

What Is a Portfolio Investment?

The Act does not define “portfolio investment.” The CRA takes a broad view. In technical interpretation 2019-0810391I7, it stated that the term is not limited to passive investments and generally describes an investment in which the investor has no active role in managing the property invested in, regardless of the number, value or length of ownership of the assets. In Gerbro, the Tax Court considered a range of definitions, including those used in international investment practice, and accepted that the hedge funds at issue derived their value primarily from portfolio investments. As a practical matter, most hedge funds and pooled investment vehicles will meet the asset test, so the motive test usually decides the case.

How the Section 94.1 Income Inclusion Is Calculated

Where section 94.1 applies, the taxpayer includes in income, for each month of the year, the designated cost of the interest at the end of the month multiplied by one-twelfth of the total of the prescribed interest rate for the period and 2%. The taxpayer then subtracts his or her actual income from the interest for the year, other than capital gains. Designated cost is generally the taxpayer’s cost of the interest, with certain statutory adjustments. Amounts included under section 94.1 are added to the adjusted cost base of the interest so that they are not taxed a second time on disposition.

The rate used is the CRA’s base prescribed interest rate, which has been 3% in every quarter of 2026, including the fourth quarter. The imputed return for 2026 is therefore 5% of designated cost. Many online summaries of section 94.1 still describe a combined rate of about 3% and a $500,000 example producing $15,000 of income; those figures reflect the 1% prescribed rate that applied from mid-2020 to mid-2022 and understate the current inclusion by two-fifths.

Consider an Ontario resident who invested $500,000 in a Cayman Islands feeder fund that reinvests all of its income. If section 94.1 applies, the imputed income for 2026 is about $25,000 ($500,000 × 5%), less any income actually distributed other than capital gains. At Ontario’s top combined marginal rate of 53.53%, that is roughly $13,400 of tax in a year in which the investor received no cash. The imputed amount is added to the adjusted cost base, which reduces the capital gain when the units are redeemed, but the tax is paid years earlier and at full income rates rather than capital gains rates.

The Gerbro Decision: How the Motive Test Is Applied

Gerbro Holdings Company was a Canadian holding company wholly owned by a spousal trust. Under investment guidelines approved by its board, it placed part of its portfolio in five hedge funds based in the Cayman Islands, the Netherlands Antilles and the British Virgin Islands. The CRA reassessed its 2005 and 2006 taxation years under section 94.1, imputing income of $841,803 and $754,210.

Associate Chief Justice Lamarre allowed the appeal. She accepted that the funds derived their value primarily from portfolio investments, but found that tax deferral was not one of the main reasons for the investments. The evidence showed an overarching, bona fide commercial reason for investing: the company followed documented investment guidelines, selected the funds for the reputation and performance of their managers, and chose the offshore vehicles because they were the best available options for that strategy. The Federal Court of Appeal dismissed the CRA’s appeal from the bench on October 25, 2018, finding no reviewable error in the Tax Court’s reasons.

Three lessons follow.

1. First, the motive test is decided on objective evidence, and contemporaneous documents such as investment policies, manager due diligence and board minutes carry real weight.
2. Second, the question is whether tax was one of the main reasons, not the only reason, so the commercial rationale has to be strong enough to explain the choice of an offshore vehicle over an onshore alternative.
3. Third, commercial reasons are personal to each investor and must be objectively reasonable in the circumstances, so the result in one case does not transfer automatically to another investor who bought the same fund.

How Section 94.1 Interacts with FAPI, Form T1134 and Form T1135

Some investors deliberately hold just under 10% of an offshore fund or company to stay outside the foreign affiliate rules and Form T1134. That structure does nothing to avoid section 94.1, because minority, non-controlled positions are precisely what the rule was designed to reach.

The practical consequence is that section 94.1 and FAPI never apply to the same corporation for the same taxpayer, because a controlled foreign affiliate is excluded from section 94.1. A foreign affiliate that is not controlled, such as a 20% interest in a foreign investment company, can be subject to Form T1134 reporting and to section 94.1 at the same time. A 5% interest in the same company is not a foreign affiliate, so it is reported on Form T1135 instead, and it can still be offshore investment fund property.

Resources:

• Form T1134 for foreign affiliates
• Foreign property reporting requirements
• Form T1135 guidance

Practical Implications for Canadian Investors

Section 94.1 is a self-assessment rule. Nothing on a fund statement will tell you that it applies, and investors who hold offshore funds through a broker or private bank often never hear of it until the CRA raises it during a tax audit. The investors with the most exposure are:

• Canadians holding offshore hedge funds, feeder funds or private investment companies in low-tax jurisdictions that accumulate rather than distribute income.
• Holding companies and family trusts that invested in foreign funds without a written investment policy explaining why those funds were chosen.
• New residents of Canada who kept foreign funds bought before they moved here, since the motive test looks at why the interest is held and not only why it was acquired.
• Canadians invested in offshore cryptocurrency or digital asset funds, which commentators have flagged as potential offshore investment fund property where the fund is based in a low-tax jurisdiction and accumulates its returns.
• Investors whose foreign fund units cost more than $100,000 and who have not filed Form T1135, since the reporting failure and the income inclusion often surface together.

Ordinary foreign mutual funds and exchange-traded funds that distribute their income each year and are taxed in their home jurisdictions are generally weaker candidates for section 94.1, because the distribution and tax-rate factors point away from a tax-deferral motive. They are not automatically exempt, however, and the analysis turns on the facts of each holding.

Where the CRA applies section 94.1, it normally reassesses the years still open for reassessment. Unreported income from specified foreign property, combined with a late or incomplete Form T1135, can extend the normal reassessment period by three years under paragraph 152(4)(b.2) of the Income Tax Act. A taxpayer who disagrees can file a notice of objection within 90 days and, if the objection fails, appeal to the Tax Court of Canada, where a Canadian tax litigation lawyer will have to prove the commercial reasons for the investment with evidence, as the taxpayer did in Gerbro.

David J. Rotfleisch, founding Toronto tax lawyer and CPA at Rotfleisch & Samulovitch, and a Law Society of Ontario Certified Specialist in Taxation, stresses how much turns on records created at the time of the investment:

“Section 94.1 is one of the rare provisions where the investor’s own records can decide the tax bill. The taxpayer in Gerbro won because it could show, with documents created at the time, that it chose its offshore funds for commercial reasons. An investor who cannot do that is left arguing about motive after the CRA has already reassessed.” — David J. Rotfleisch, Certified Specialist in Taxation Law (Law Society of Ontario)

Investors who have omitted section 94.1 income or T1135 filings can consider a voluntary disclosure. Under Information Circular IC00-1R7, an unprompted application made before the CRA contacts the taxpayer about the specific issue receives the broadest relief, and voluntariness is assessed issue by issue rather than across the whole file. We do not recommend the CRA’s pre-disclosure discussion service under any circumstances, because it creates a record of contact with the CRA without securing binding protection or an effective date of disclosure.

Takeaway: Offshore Investment Fund Property and Section 94.1

Section 94.1 reaches offshore investments that Canadians do not control, which is exactly the territory the foreign affiliate and FAPI rules leave open. If an offshore entity derives its value mainly from portfolio investments and tax deferral or reduction was one of the main reasons for holding it, the investor must include a notional 5% return on cost in income for 2026, whether or not anything was distributed. Gerbro shows that the motive test can be won, but only with contemporaneous evidence of genuine commercial reasons. Investors should test each offshore holding against section 94.1, FAPI, Form T1134 and Form T1135 separately, since clearing one regime does not clear the others.

Pro Tax Tips: Managing Offshore Investment Fund Property Risk

Document the reasons for an offshore investment when you make it, not when the CRA asks. A written investment policy, notes on why particular managers and funds were chosen, and a record of the onshore alternatives that were considered are the kind of evidence that carried the day in Gerbro, and they are far more persuasive than explanations prepared years later during a tax audit.

Where an offshore fund offers a choice, a distributing share class or an onshore parallel fund can materially reduce section 94.1 exposure, because distribution and taxation are both factors in the motive test. Where section 94.1 clearly applies, calculating and reporting the imputed amount each year is usually less costly than defending an unreported position later, and the adjusted cost base addition means the tax is not lost when the units are eventually sold.

New residents and investors who have held offshore funds for years without considering section 94.1 or Form T1135 should have their holdings reviewed by a seasoned Canadian tax lawyer. If income or filings were missed, an unprompted voluntary disclosure made before the CRA makes contact remains the most effective way to limit penalties and interest.

FAQs: Offshore Investment Fund Property and Section 94.1

What is offshore investment fund property?

It is a share of, interest in, or debt of a non-resident entity, other than a controlled foreign affiliate or a prescribed non-resident entity, that derives its value primarily from portfolio investments and that a Canadian holds with a main purpose of reducing or deferring Canadian tax on the underlying income.

What does section 94.1 of the Income Tax Act do?

It requires a Canadian holder of offshore investment fund property to include an imputed amount in income every year, calculated as a prescribed rate of return on the cost of the investment, whether or not the fund distributes anything.

How is section 94.1 income calculated for 2026?

For each month, the designated cost of the interest is multiplied by one-twelfth of the prescribed interest rate plus 2%. With the prescribed rate at 3% throughout 2026, the imputed return is 5% of designated cost for the year, reduced by any actual income from the interest other than capital gains.

Does section 94.1 apply if the fund pays no distributions?

Yes. Section 94.1 is a deemed income rule, and it is aimed squarely at funds that accumulate their income offshore. A fund that pays nothing out is a stronger target than one that distributes its income every year.

Does section 94.1 apply to a controlled foreign affiliate?

No. Controlled foreign affiliates are excluded because their passive income is already taxed each year under the FAPI rules.

Can a foreign affiliate be offshore investment fund property?

Yes, if it is not controlled. A 20% interest in a foreign investment company is generally a foreign affiliate that must be reported on Form T1134, and it can also be offshore investment fund property if the asset and motive tests are met.

What is the motive test in section 94.1?

It asks whether, having regard to all the circumstances, one of the main reasons for acquiring or holding the interest was to benefit from the entity’s portfolio investments in a way that results in significantly less tax than if the income had been earned directly. The Act points to the entity’s structure, the tax rate on its income and how much it distributes.

What did the court decide in Gerbro?

The Tax Court of Canada held in 2016 that section 94.1 did not apply to a Canadian holding company’s investments in five offshore hedge funds because tax deferral was not one of the main reasons for the investments. The Federal Court of Appeal affirmed the decision in 2018.

Do U.S. ETFs or foreign mutual funds fall under section 94.1?

Foreign funds that distribute their income annually and are taxed in their home jurisdictions are generally weaker candidates, because the distribution and tax-rate factors point away from a tax-deferral motive. They are not automatically exempt, and accumulating or low-tax foreign funds need a closer look.

Do I have to report an offshore fund on Form T1135?

Generally, yes. Units or shares of an offshore fund are specified foreign property, so they must be reported on Form T1135 if the total cost of all of your specified foreign property exceeds $100,000 at any time in the year.

Is section 94.1 income taxed again when I sell the investment?

No. Amounts included under section 94.1 are added to the adjusted cost base of the interest, which reduces the capital gain on redemption. The disadvantage is timing and character: the tax is paid earlier and at full income rates.

Can a new immigrant be caught by section 94.1?

Yes. The motive test looks at why the interest is held, not only why it was acquired, so a foreign fund bought before moving to Canada can become a problem if it continues to be held after the move.

Can an offshore crypto fund be offshore investment fund property?

It can. A non-resident fund that invests in digital assets on behalf of passive investors, is located in a low-tax jurisdiction and accumulates its returns raises the same asset and motive test questions as a traditional offshore hedge fund. Whether a particular crypto fund is caught depends on its structure and the investor’s reasons for holding it.

How is section 94.1 different from FAPI?

FAPI taxes a controlled foreign affiliate’s actual passive income. Section 94.1 applies to interests the Canadian does not control and imputes a notional return on cost instead of measuring the fund’s actual income.

What if I never reported section 94.1 income?

A voluntary disclosure may eliminate penalties and reduce interest if it is made before the CRA contacts you about the issue. Missing T1135 filings for the same holdings are usually disclosed at the same time.

How do I challenge a section 94.1 reassessment?

File a notice of objection within 90 days of the reassessment. If the objection is not resolved, the taxpayer can appeal to the Tax Court of Canada, where the commercial reasons for the investment must be proved with evidence.

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.