August 21 2012

No. 2012-31



FA Dumping Proposals Ease Burden of Rules

The Department of Finance has released draft legislation that includes revised foreign affiliate (FA) dumping proposals originally introduced in its 2012 federal budget tax measures. The draft legislation, released on August 14, 2012, seems to be fairly consistent with the description of the rules included in the 2012 budget documents, and also contains a number of new provisions that serve to alleviate some of the harsher results of the rules. The FA dumping rules are intended to curtail the use of Canada’s foreign affiliate system where the relevant Canadian company is controlled by a non-resident corporation.

Background Purpose of the FA Dumping Rules

Canada’s foreign affiliate system allows certain dividends paid by a foreign subsidiary in which Canada has at least a 10% ownership interest (called an FA) to be received tax-free in the hands of the Canadian shareholder. This exemption system generally applies to dividends paid out of the active business earnings of the FA where the FA is resident and carrying on the active business in a treaty jurisdiction or a jurisdiction with which Canada has signed a tax information exchange agreement.

At the same time, Canada’s interest deductibility rules do not limit the ability to claim an interest deduction where debt is used to fund an investment in an FA, even though the underlying income of the FA, when distributed back to Canada, would not result in any Canadian income tax. Canada’s thin capitalization rules, which have also been tightened as a result of the 2012 budget measures, limit the deductibility of interest in Canada, but only where debt originates from a non-resident shareholder of the Canadian company or from certain other related parties.

The combination of our exemption system and interest deductibility rules have made Canada an attractive holding company location in the past, allowing foreign-based multinationals to structure their investments in foreign subsidiaries through Canada.

FA dumping transactions — Examples

In a typical FA dumping transaction, a Canadian corporation (Canco) uses funds it receives as a loan from its non-resident shareholder (NR Parent) to acquire the shares of a foreign subsidiary (FA) of NR Parent. Subject to the thin capitalization limitations, the interest expense that Canco pays to NR Parent should be fully deductible, and any dividends that Canco receives from FA out of its active business earnings should be tax-free. As a result of the new FA dumping rules, however, the amount paid to acquire the shares of FA could now be treated as a dividend paid by Canco to NR Parent, subject to withholding tax.


In another typical transaction, Canco issues its shares to NR Parent as consideration for the acquisition of the FA shares, with the shares of Canco having paid-up capital (PUC) equal to the value of the FA shares. This PUC would then allow Canco to make tax-free returns of capital to NR Parent rather than suffering withholding tax on the payment of dividends. As a result of the new rules, however, this increase in the PUC of Canco’s shares could be deemed not to occur, thereby limiting Canco’s ability to make tax-free returns of capital to NR Parent in the future.


Overview of New FA Dumping Rules

In general, the FA dumping rules will apply where a foreign-controlled corporation resident in Canada (called a CRIC) makes an investment in an FA. An investment in an FA can be any of the following:

·      The acquisition of shares of the FA by the CRIC

·      A contribution of capital to the FA, which includes any transaction whereby the CRIC confers a benefit on the FA

·      A transaction that results in an amount becoming owing by the FA to the CRIC, other than short-term loans that arise in the ordinary course of the CRIC’s business or a “pertinent loan or indebtedness”

·      The CRIC’s acquisition of a debt obligation of the FA, other than one acquired from an arm’s-length person in the ordinary course of the CRIC’s business or a “pertinent loan or indebtedness”

·      The CRIC’s acquisition of an option in respect of the FA’s shares or debt.

The draft legislation broadens the scope of transactions included in the definition of an investment in an FA to encompass the following:

·      The extension of the maturity date of a debt obligation owing by the FA to the CRIC, or of the redemption, acquisition or cancellation date of shares of the FA owned by the CRIC

·      The acquisition of shares of another Canadian-resident corporation by the CRIC if at least 50% of the value of the other Canadian corporation is attributable to FA shares

Foreign multinationals acquiring Canadian companies with significant investments in FAs may be negatively affected by this particular provision.

Consequences of making an investment in an FA

If a foreign-controlled CRIC makes an investment in an FA as outlined above, generally one of two results will take place. First, the CRIC is deemed to have paid a dividend to its non-resident parent equal to the fair market value of any property transferred (excluding shares of the CRIC itself), obligation assumed, or benefit conferred by the CRIC that is considered to be related to the FA investment. Second, if the PUC of the CRIC’s shares is otherwise increased because of the FA investment, that increase is deemed not to have occurred.

Both of these results will create withholding tax implications, either at the time that the investment in the FA is made by the CRIC as a result of the deemed dividend rule, or in the future on the payment of a dividend because there is insufficient PUC in the CRIC to support a return of capital.

There are, however, some options that taxpayers may consider to mitigate the results of such consequences.

Exceptions to the New FA Dumping Rules

The draft legislation includes four provisions that can result in the FA dumping rules not applying to an investment in an FA. The business purpose exception was originally included in the budget proposals, but the test in the draft legislation is significantly different from before. New PUC reduction and “pertinent loan and indebtedness” elections, as well as an exception for certain corporate reorganizations, give taxpayers some flexibility to ensure that the rules will not create a deemed dividend in some situations. These three alleviating measures were not previously included in the budget proposals, but were identified as areas that should be dealt with due to the inadvertent application of the rules in such circumstances.

Business purpose exception

The 2012 budget documents contained a number of guidelines that were to be used in assessing whether there was a bona fide business purpose for having the CRIC make the investment in the FA such that the rules would not apply. According to the budget documents, the guidelines were “intended to assist in determining whether it is reasonable to conclude that the investment in, and ownership of, the foreign affiliate belongs in the Canadian subsidiary more than in any other entity in the foreign parent’s group. If it is reasonable to so conclude, then this measure will not apply.”

The draft legislation now takes a different approach to the business purpose exception, requiring three specific conditions to be met in order for the rules not to apply to an investment in an FA:

·      The business activities of the particular FA and all of its subsidiary FAs must be more closely connected to the Canadian business activities of the CRIC than to the business activities of any related non-resident corporation.

·      The CRIC’s officers must have exercised the principal decision-making authority in respect of the investment in the FA, and the majority of those officers must have been resident and working in Canada at the time that the investment was made.

·      It is reasonably expected that the officers of the CRIC will have on-going principal decision-making authority in respect of the investment in the FA. These officers must be resident and working in Canada, and their compensation and performance evaluation must be based on the results of the FA’s operations to a greater extent than the compensation and performance evaluation of other officers of any related non-resident corporations.

KPMG observation

There may be too much uncertainty in the conditions that must be met under the business purpose exception for them to be relied upon by taxpayers. Determining whether the tests apply will be difficult, especially when their applicability will be verified many years after the fact. While taxpayers may be interested in obtaining a ruling from the Canada Revenue Agency (CRA) before relying on this exception, it is uncertain whether the CRA will consider such a request.

PUC reduction election

The draft legislation includes new rules that allow a CRIC to elect to reduce the PUC of its shares to avoid the consequences of a deemed dividend as a result of an investment in an FA. The conditions for making such an election differ depending on whether the CRIC has more than one class of shares outstanding.

If the CRIC has only issued one class of shares, it may file an election to reduce the PUC of that class by the amount of the deemed dividend that would otherwise arise. Accordingly, a CRIC may invest in shares of an FA and choose to reduce the PUC of its only class of shares by the amount of that investment, rather than incurring the withholding tax cost of triggering a deemed dividend.

KPMG observation

The ability to make such an election reflects the tax policy indifference as to whether funds are used by the CRIC to return PUC to its shareholder or to invest in shares of an FA: in both cases, the CRIC’s cash has left the Canadian tax net.


Electing to reduce a CRIC’s PUC can have other tax implications as well.  If the PUC balance is being used to support the CRIC’s thin capitalization limits to ensure that its debt-to-equity ratio is not exceeded, the reduction in that PUC balance could adversely affect those limits.  Because of the proposed changes to the thin capitalization rules which are also included in the August 14, 2012 draft legislation, denied interest expense resulting from excess debt levels will now be treated as a deemed dividend subject to Canadian withholding tax.

The rules are very different where there is more than one class of shares issued by the CRIC. To benefit from the PUC reduction election in this situation, the CRIC will have to trace and link the creation of the PUC to property it received and used to make the investment that is giving rise to the deemed dividend. For example, the election will be possible if the PUC that the CRIC wishes to reduce arose because a non-resident parent transferred funds to the CRIC which it then used to make an investment in an FA. It appears that the election may not be available if the CRIC has two classes of shares, and PUC was created by the contribution of funds used by the CRIC to purchase Canadian assets, while borrowed funds were used to make an investment in an FA that has given rise to a deemed dividend.

If the CRIC has other shareholders in addition to its controlling non-resident parent, the PUC reduction election is only available if the other shareholders all deal at arm’s length with the CRIC. As a result, if the CRIC is owned directly by another Canadian corporation, and indirectly by the controlling non-resident, the PUC reduction election cannot be made.

Election reversal — PUC reinstatements

 Where a CRIC has elected to reduce PUC under the rules outlined above, in certain cases the PUC can then be reinstated prior to a return of capital. One of the purposes of this rule is to facilitate the use of a Canadian corporate acquisition vehicle by a non-resident investor.


Assume a non-resident investor capitalizes a CRIC with $1 million to allow it to purchase the shares of a foreign corporation. Assuming the investment in the foreign corporation would otherwise give rise to a deemed dividend of $1 million, the CRIC can elect to reduce the PUC of its shares by $1 million. If the foreign corporation is subsequently sold for $1.2 million, the PUC reinstatement rule allows the CRIC to reinstate its PUC just before returning the original $1 million to the non-resident investor (provided that the proceeds are returned to the non-resident investor within 30 days of the sale). This $1 million distribution would not attract any Canadian withholding tax, but any additional distribution over and above the original $1 million investment would remain subject to dividend withholding tax. 

Pertinent loans and indebtedness

The broad categories of investment transactions now include an exception for a loan made by a CRIC to an FA that meets the definition of a “pertinent loan or indebtedness”. To qualify for this exception, the CRIC and non-resident parent must jointly elect in respect of a debt owing by the FA to the CRIC that arose after March 28, 2012. This loan, and any other loan made to that FA, then become subject to new interest imputation rules requiring the CRIC to calculate a deemed interest inclusion each year that the loans are outstanding.

The current interest imputation rules in the Income Tax Act (the Act) that apply to loans made by a Canadian corporation to a non-resident require the deemed interest inclusion to be calculated using the CRA’s lowest prescribed interest rate – for the past three years, this rate has been 1%.

The new interest imputation rules that apply to such pertinent loans and indebtedness will require the deemed interest inclusion to be calculated at a rate that is 4 percentage points higher than the lowest prescribed rate – this would currently result in a deemed interest inclusion on such loans at a rate of 5%. 

This new concept of a pertinent loan or indebtedness will also apply to certain loans that would have otherwise given rise to a deemed dividend under the shareholder benefit rules in the Act.  As with the rule outlined above, the election to treat such a shareholder loan as a “pertinent loan or indebtedness” applies to loans that arose after March 28, 2012 and must be made in respect of all amounts owing to a particular a non-resident debtor. 

Corporate reorganizations

The Canadian tax rules that apply to corporate wind-ups, amalgamations, and other forms of reorganizations generally result in some form of acquisition of property. As such, if the property in question includes shares of an FA, the FA dumping rules as proposed in the budget would have automatically applied because of that acquisition, even where it could not truly be said to be an investment in an FA.

Because of this inadvertent application, the draft legislation now excludes the following acquisitions of FA shares from the FA dumping rules:

·      Where the CRIC acquires the shares of the FA from a related Canadian corporation, as long as that corporation was not previously dealing at arm’s length with the CRIC

·      Where the CRIC results from the amalgamation of two or more predecessor corporations that were related to each other, as long as these corporations were not previously dealing at arm’s length with each other

·      Where the FA shares are acquired by the CRIC as a result of one of a number of tax-deferred transactions under the Act, such as a reorganization of capital, a foreign merger, or a liquidation.

Coming-Into-Force Measures

The FA dumping rules apply to transactions that occur after March 28, 2012, other than transactions that occur before 2013 between parties that deal at arm’s length and that are obligated to complete the transaction pursuant to a written agreement entered into before March 29, 2012.

Taxpayers can file an election to have certain transitional rules apply for transactions that occur between March 29, 2012 and August 14, 2012.

Joint Committee Recommendations

In June 2012, the Joint Committee issued recommendations to the Department of Finance on the FA dumping proposals. In general, the recommendations were made to ensure that the balance between protecting Canada’s tax base and supporting cross-border investment was not eroded as a result of the new rules.

Although some recommendations were incorporated into the draft legislation, including the corporate reorganization measures and the ability to elect to suppress PUC rather than incur withholding tax on a deemed dividend, other recommendations that have not been addressed in the draft legislation include:

·      An exception to the rules for certain categories of investments, essentially those that yield an acceptable amount of taxable income in Canada. This would include those investments that result in either foreign accrual property income or the receipt of FA dividends being taxable in Canada.

·      An exception to the rules for CRIC’s whose shares are listed on a prescribed stock exchange. In this case, the controlling non-resident shareholder of the CRIC does not always have the ability to dictate what the CRIC can or cannot do without minority shareholder approval.

·      Apportionment of the deemed dividend in cases where the CRIC is not wholly owned by the controlling non-resident shareholder. Even if the non-resident shareholder owns only 51% of the shares of the CRIC, 100% of the dividend will be deemed to be paid to that shareholder.

KPMG observations — Mostly good news for taxpayers

Overall, the draft FA dumping rules seem to be an improvement over the proposals that were outlined in the budget documents, with the exception of the revised business purpose test. As indicated above, taxpayers may have a difficult time relying on this exception in most cases, unless the CRA is willing to rule in a particular fact situation.


The addition of the PUC reduction and reinstatement measures will allow taxpayers in certain situations to avoid a resulting deemed dividend and its immediate withholding tax cost. These rules may provide relief for existing FA groups which could require funding from Canada, as long as the Canadian owner of the group has sufficient existing PUC. In this case, PUC may be reduced, and reinstated, by the amount of an investment in an FA, with no withholding tax implications.  But taxpayers will have to be aware of other potential tax implications that could arise from a reduction of PUC.


The corporate reorganization measures, as well as the new “pertinent loan and indebtedness” election, also provide taxpayers with more flexibility than the previous version of the proposals.


Because the rules apply to transactions entered into after March 28, 2012, it is imperative that any such transactions be reviewed in light of the revisions included in the draft legislation. A transaction that may have triggered a deemed dividend under the budget proposals may now be exempted from the application of the rules. Conversely, a transaction that may have been exempted from the budget proposals, for example because of the application of the business purpose “guidelines” included therein, may now be subject to the rules, creating a deemed dividend and related withholding tax obligations. In this case, the transitional provisions may provide relief, but a joint election to obtain this relief will have to be filed once the rules are enacted into law.


We Can Help

Finance is accepting comments on these rules until September 13, 2012. KPMG will assist the Joint Committee in making further recommendations on the draft legislation.


Your KPMG adviser can help you assess the effect of these tax changes, and point out ways to ease their impact. We can also keep you abreast of the progress of these proposals as they make their way into law and help you bring any concerns you may have to the attention of Finance.


Download KPMG’s new Tax Hub Canada app
KPMG’s free Tax Hub Canada App for iPads and Blackberrys provides timely, convenient tax news and tax rates to help you respond to changes in tax rules and regulations. Download the app today



Information is current to August 21, 2012. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.

KPMG LLP, the audit, tax and advisory firm (, a Canadian limited liability partnership established under the laws of Ontario, is the Canadian member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000 professionals, including more than 7,900 partners, in 146 countries.

The independent member firms of the KPMG network are affiliated with KPMG International, a Swiss entity. Each KPMG firm is a legally distinct and separate entity, and describes itself as such.

KPMG's Canadian Web site is located at

© 2012 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.


The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.