December 7, 2012

No. 2012-42



Foreign Affiliate Rules Now Set — Take Action to Manage Their Impact

Canadian multinationals may need to act now that the Department of Finance has released long-awaited legislation that provides the latest, and likely final, version of the proposed tax rules affecting foreign affiliate members of Canadian corporate groups.

The legislation is making its way through Parliament, and although not yet formally enacted into law, it is considered to be substantively enacted for purposes of International Financial Reporting Standards (IFRS) and Canadian Accounting Standards for Private Enterprises (ASPE). (See TaxNewsFlash-Canada 2012-39, “Tax Accounting Update — Finance Clears the Slate”.)

Once the applicable technical bills receive Royal Assent, the clock will start ticking on the time available for making the vast number of elections contained in almost 1,000 pages of pending legislation.

The legislation includes several key provisions that have changed significantly since the last version of the proposals was released. The legislation also brings into law measures that could have a significant impact on foreign affiliate reorganizations and the computation of surplus in foreign affiliate groups. This TaxNewsFlash-Canada highlights these changes and their potential impact on Canadian multinationals with foreign affiliates.

Inside this Issue

This TaxNewsFlash-Canada summarizes the following key foreign affiliate measures:


·      Upstream loans

·      Foreign tax credit generator rules

·      Foreign affiliate dumping rules

·      Foreign affiliate distributions

·      Other foreign affiliate measures

Upstream loans

Background — Application of rules remains unchanged
The upstream loan rules generally apply to require an income inclusion in Canada where a foreign affiliate (or a partnership of which a foreign affiliate is a member) of a Canadian taxpayer (Canco) makes a loan to a person (or partnership) that is a “specified debtor” in respect of Canco, and the loan remains outstanding for more than two years.

The definition of “specified debtor” includes Canco and any non-arm’s length person other than a controlled foreign affiliate. However, to be considered a controlled foreign affiliate in this case, the affiliate must be controlled by Canadian residents. The definition also includes partnerships of which the taxpayer or a non-arm’s length person is a member.

Example 1 — Upstream loan



If a foreign affiliate of Canco (Lender FA) makes a loan to Canco’s non-resident parent (NR Parent), a specified debtor who does not deal at arm’s length with Canco, the amount of the loan must be included in Canco’s income if it is not repaid within two years.

The rules still contain an exception for loans made in the ordinary course of the creditor’s business as long as arrangements are made for repayment of the loan within a reasonable period of time.

New deductions available
If a loan remains unpaid at the end of two years and is required to be included in a Canadian corporation’s income under the upstream loan rules, certain deductions may be claimed to offset this income inclusion.

Any amount of the loan that would have been deductible as an exempt surplus or taxable surplus dividend if it had instead been paid as a dividend to the Canadian corporation (e.g., Canco) by the applicable lending foreign affiliate (e.g., Lender FA) is generally deductible under these rules. A deduction is also available for Lender FA’s hybrid surplus, provided that the foreign tax rate applicable to that surplus is greater than the Canadian capital gains tax rate.

The new measures clarify that the surplus (and deficit) balances in respect of all affiliates in the chain of ownership between the lender FA and the Canadian corporation (i.e., upstream surplus) can be included in this computation, as can surplus balances of other foreign affiliates in which the lender FA has direct or indirect ownership (i.e., downstream surplus).

New measures now also allow deductions for the cost base of the lender FA's shares, or such other relevant foreign affiliate in the chain that is held directly by the Canadian corporation. This cost-base deduction is not available, however, if the specified debtor is a non-resident corporation. Previously taxed foreign accrual property income (FAPI) will also be eligible as a deduction if the cost-base deduction is not otherwise available.

Example 1 — Continued

Continuing with the previous example, if the loan from Lender FA is included in Canco’s income, Canco will be able to claim a deduction for any surplus balances in Lender FA. However, Canco will not be able to claim a deduction for its cost base in the shares of Lender FA, as the specified debtor in this case (NR Parent) is a non-resident corporation.

Definition of “specified amount” amended
The balance of the loan that must be included in a Canadian taxpayer’s income is based on the definition of “specified amount”. In general, the taxpayer’s ownership percentage in the lending foreign affiliate is multiplied by the balance of the loan to determine the amount to be included in income. The “specified amount” of a loan now includes an offsetting reduction for the taxpayer’s ownership interest in the recipient of the loan (e.g., another foreign affiliate). As a result, if the taxpayer’s ownership interest in the debtor foreign affiliate is greater than its ownership interest in the lending foreign affiliate, the specified amount will be nil and no income inclusion will arise.

Example 2 — Upstream loan



Assume that a Canadian corporation (Canco) has a wholly owned foreign affiliate (FA-1) and a 40% interest in another foreign affiliate (FA-2) whose remaining 60% interest is owned by Canco’s non-resident parent (NR Parent). FA2 is not considered a controlled foreign affiliate of Canco under the upstream loan rules as it is not controlled by a Canadian resident.


If FA-1 makes a loan to FA-2 that remains outstanding for more than two years, the “specified amount” of the loan that would have to be included in Canco’s income would be equal to 60% of the loan balance, calculated as the difference between Canco’s ownership percentage in FA-1 (100%) and its ownership percentage in FA-2 (40%).

New repayment period and foreign exchange relief for loans outstanding on August 19, 2011
One of the most controversial aspects of the upstream loan rules when they were first introduced in draft legislation released on August 19, 2011 was the transitional measure requiring all such outstanding loans to be repaid by August 19, 2013 to avoid an automatic income inclusion. This deadline gave taxpayers only a short time to unwind such loans, especially given the significant balances that existed in many foreign affiliate groups. If such loans were repaid, significant foreign exchange gains could often be triggered in Canada if the loans were denominated in a currency other than the Canadian dollar.

The revised coming-into-force measures now provide grandfathered loans with a five-year repayment period. If a loan that was entered into prior to August 19, 2011 remains outstanding on August 19, 2014, it will be deemed to be a new loan issued on that date. The loan then becomes subject to the regular two-year repayment period, and must be repaid by August 19, 2016 to avoid being subject to the rules described above.

New transitional measures have also been introduced to deal with foreign exchange exposure when such grandfathered loans are repaid. These measures only apply to grandfathered upstream loans that are repaid before August 19, 2016, and only in certain situations where a Canadian borrower realizes a foreign exchange capital gain or loss equal to the lender foreign affiliate’s related capital loss or gain arising from the repayment. 

GAAR warning in Explanatory Notes
The upstream loan commentary in the Explanatory Notes includes a paragraph headed “GAAR Warning”, which states that any attempts at circumventing these rules will be subject to the general anti-avoidance rule (GAAR). The commentary also says that the use of debt-like equity interests such as preferred shares, or synthetic lending arrangements such as the factoring of receivables or the sale of securities at a discount, would be considered a misuse of these provisions.

KPMG observation
The use of GAAR language and policy discussions in the Explanatory Notes seems to be a new approach by Finance, presumably to assist in the future settlement of GAAR court challenges where the decision hinges on the policy intent of the rules in question.

Upstream loan action plan

Canadian taxpayers need to review all foreign affiliate loans to ensure that they will not run afoul of the upstream loan rules if such loans remain outstanding for more than two years (or more than five years for grandfathered loans).


This review includes analyzing the relationship of all entities involved, as well as determining surplus and cost base numbers of such entities. If any such loans have been repaid since August 19, 2011, foreign exchange relief could now be available, potentially requiring the amendment of tax returns.

Foreign Tax Credit Generator Rules

The foreign tax credit generator rules were introduced in the 2010 federal budget and focused on the ownership of hybrid instruments — that is, an investment that is treated as equity in one jurisdiction, and as debt in the other jurisdiction. A partnership interest would also be considered a hybrid instrument if the income allocation thereon is different in the two relevant jurisdictions. If the rules apply to such an instrument, any foreign tax applicable to the foreign accrual property income (FAPI) earnings of a relevant foreign affiliate will be denied.

The original version of these rules, released in August 2010, was broadly worded and did not require any tracing between the jurisdiction where the FAPI was earned and the jurisdiction governing the issuer of the hybrid instrument. As such, the rules could have applied to any foreign affiliate in any jurisdiction if there was a hybrid instrument in place somewhere in the corporate group.

Rules narrowed
The rules now focus on the particular chain of foreign affiliates where the hybrid instrument is in place, and generally require the FAPI-earning affiliate to be in that same ownership chain (unless the proposed "funding" rules described below apply). Specifically, if the answer to all of the following questions is yes, then the foreign tax credit generator rules will apply to deny a foreign tax deduction in respect of FAPI earned by a Canadian corporation.

·      Has the Canadian company (Canco) included FAPI in its income in respect of a particular foreign affiliate (FAPI-FA) which has been offset by some level of foreign tax paid by FAPI-FA?

·      Is there a hybrid instrument in place somewhere in the foreign affiliate group?

·      Is the “specified owner” of the hybrid instrument either Canco (or a partnership of which Canco is a member) or any foreign affiliate of Canco?

·      Is the issuer of the hybrid instrument either FAPI-FA or another foreign affiliate of Canco that either owns shares in FAPI-FA or is owned by FAPI-FA?

·      Is the owner of the hybrid instrument considered to own fewer shares of the issuer foreign affiliate (or to have a different allocation of partnership income) under its relevant foreign tax law than it is considered to own (or be allocated) under Canadian tax law?

Essentially, in order for these rules to apply, the issuer of the hybrid instrument must be in the same chain of ownership as the foreign affiliate that is earning FAPI.

REPO example

Consider the following example.



A Canadian corporation (Canco) has a wholly owned U.S. subsidiary (US Holdco). US Holdco in turn has a wholly owned U.S. subsidiary (US Subco). US Subco is the sole shareholder of a U.S. financing company (US Finco). US Finco earns FAPI, which is included in Canco’s income each year, and is offset by any U.S. tax paid by US Finco on its FAPI.


Under a repurchase (REPO) agreement that Canco has entered with the U.S. companies, Canco owns preferred shares of US Subco. The preferred shares are a hybrid instrument because they are viewed as a share investment for Canadian tax purposes, but as debt for U.S. tax purposes.

To determine whether the foreign tax credit generator rules apply to this REPO example, you must answer the following questions:

·      Has Canco included FAPI in its income in respect of a particular foreign affiliate which has been offset by some level of foreign tax?

Yes — US Finco.

·      Is there a hybrid instrument in place somewhere in the foreign affiliate group?

Yes — Between Canco and US Subco.

·      Is the “specified owner” of the hybrid instrument Canco or one of its foreign affiliates?

Yes — Canco.

·      Is the issuer of the hybrid another foreign affiliate of Canco that is in the same ownership chain as US Finco?

Yes — US Subco.

·      Is the owner of the hybrid instrument (Canco) considered to own fewer shares of US Subco under U.S. tax law than under Canadian tax law?

Yes — Under U.S. tax law, Canco owns no US Subco preferred shares but under Canadian tax law, Canco owns 100% of US Subco preferred shares.

Because the answer to all of these questions is yes, the foreign tax credit generator rules will deny the deduction of any U.S. tax paid by US Finco in respect of its FAPI to Canco.

Foreign affiliate “funding” rules
Additional rules will come into play if, as part of the transaction under which Canco’s FAPI arose, another foreign affiliate of Canco or of a related Canadian company provided funding to the foreign affiliate that is earning FAPI (FAPI-FA). According to the Explanatory Notes, funding in this case includes loans, advances, asset purchases, dividends and share redemptions. This rule has two exceptions — if the funding is in the form of a loan with arm’s-length terms and conditions, or is in the form of acquisition of shares, the rules will not apply.

If the funding provisions apply, the application of the rules is expanded and FAPI-FA can be outside the chain of ownership where the hybrid instrument resides.

Coming-into-force measures
The proposed foreign tax credit generator rules will generally apply to taxation years that end after March 4, 2010. However, the funding rules outlined above only apply to taxation years ending after October 24, 2012.

Foreign tax credit generator action plan

If your foreign affiliate group has a hybrid instrument in place, you should test the questions outlined above in respect of that instrument. At the same time, amounts contributed direct or indirectly to the applicable FAPI-FA will need to be traced to determine whether such contributions will bring the expanded funding rules into the picture.

Foreign affiliate dumping rules

The foreign affiliate (FA) dumping rules were introduced to curtail the use of Canada’s foreign affiliate system where the relevant Canadian company is controlled by a non-resident corporation. In general, the rules will apply where a foreign-controlled corporation resident in Canada (called a CRIC) makes an investment in a foreign affiliate.

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.

An investment in a foreign affiliate includes:

·      The acquisition of shares of, or a capital contribution to, the foreign affiliate by the CRIC.

·      A loan made to the foreign affiliate by the CRIC, or the acquisition by the CRIC of an amount owing by the foreign affiliate. In this case, short-term loans that arise in the ordinary course of the CRIC’s business, or “pertinent loans or indebtedness”, are not included as investments.

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

·      The acquisition of shares of another Canadian-resident corporation by the CRIC if at least 75% of the value of the other Canadian corporation is attributable to foreign affiliate shares (the indirect acquisition rule). The previous version of the rules contained a 50% test.

Consequences of the proposed rules
A foreign-controlled CRIC’s investment in a foreign affiliate as outlined above will generally have one of two results. 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 foreign affiliate investment. Second, if the paid-up capital (PUC) of the CRIC’s shares is otherwise increased because of the foreign affiliate investment, that increase is deemed not to have occurred.

Both of these results will create withholding tax implications, either at the time the CRIC makes the investment in the foreign affiliate as a result of the deemed dividend rule, or in the future on the payment of a dividend because the CRIC has insufficient PUC to support a return of capital.

“Qualifying substitute corporation” election
A new election (the qualifying substitute corporation (QSC) election) allows the deemed dividend created under the FA dumping rules to be deemed to be paid by a “qualifying substitute corporation” rather than by the CRIC. A qualifying substitute corporation is defined to be a Canadian resident corporation that is controlled by the same non-resident corporation as the CRIC, or that has a direct or indirect interest in the CRIC. 

If the QSC election is made, the PUC of the qualifying substitute corporation’s shares is automatically reduced by the amount of the deemed dividend. If no QSC election is made, this reduction is applied to the cross-border PUC, if any, of the CRIC. Effectively, cross-border PUC is reduced to the extent possible before a deemed dividend will arise. If a deemed dividend still arises, the QSC election deems the dividend to have been paid by the QSC, and received by either the QSC’s non-resident parent corporation or another related non-resident corporation, such that reduced tax treaty withholding tax rates can be accessed.

Other amendments to rules
The election to treat a foreign affiliate loan as a “pertinent loan or indebtedness” provides an exception to the rules. However, the result of making this election is an imputed interest charge applying to the Canadian lender if the actual interest rate on the loan is less than the prescribed rate plus 4 percentage points. This election must now be made
on a loan-by-loan basis and is now also available if the loan was outstanding prior to March 29, 2012 and its term is extended beyond that date.

New exceptions also allow certain Canadian reorganizations, such as amalgamations, reorganizations of share capital, and exchanges of convertible property, that would otherwise have triggered the indirect acquisition rule referred to above, to be excluded from its application.

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.

For further details of the FA dumping rules, see TaxNewsFlash-Canada 2012-31, “FA Dumping Proposals Ease Burden of Rules”.

FA dumping rules action plan

Canadian corporations that are foreign-controlled must keep these rules in mind when contemplating transactions with a foreign affiliate group because the rules are very broad and may apply in situations where no tax “mischief” is intended. Routine transactions such as cash movements in cash pooling arrangements and other inter-company funding transactions between Canada and foreign affiliate groups can cause these rules to apply. 

Foreign affiliate distributions

All pro-rata distributions made by a foreign affiliate are now treated as dividends from a Canadian tax perspective, regardless of their treatment under foreign law. However, certain elections may be made to instead treat a distribution as a reduction to the cost base of the shares in the foreign affiliate or a return of paid-up capital.

Election to reduce cost base
An election may be filed to treat
what would otherwise be considered a dividend paid out of the exempt, taxable, or hybrid surplus of a foreign affiliate to instead be treated as a pre-acquisition surplus dividend and a reduction of the cost base of the shares of the foreign affiliate. While the previous version of the rules only allowed this election to be made in respect of dividends paid by a foreign affiliate directly to Canada, the current rules now allow such an election to be made on dividends paid between foreign affiliates.

This election can now be filed up to 10 years after its original due date, as long as the taxpayer can demonstrate that the original determination not to file was made using reasonable efforts, and that it is “just and equitable” to allow for late-filing.

Election to return paid-up capital
The revised rules also allow taxpayers to make an election to treat a foreign affiliate distribution as a “qualifying return of capital” to the extent of the affiliate’s paid-up capital. This new election allows all taxpayers, including non-corporate shareholders, to treat a distribution from a foreign affiliate as a return of capital, and a reduction of cost base, rather than as a dividend.

KPMG observation
In the past, we have generally regarded paid-up capital as a domestic concept applicable to shares of a Canadian corporation, and have not often been concerned with, or even calculated, a foreign corporation’s PUC. It is often difficult to determine the components of legal-stated capital in a foreign jurisdiction, especially when dealing with par value shares, share premium accounts, legal reserves and other non-Canadian equity attributes.

If this election is to be made, it will be imperative that the foreign affiliate’s paid-up capital be calculated to ensure that it is sufficient to allow for a reduction equal to the amount of the distribution.

Foreign affiliate distributions action plan

In assessing whether these elections should be filed, it will be critical to know the surplus account balances, as well as the cost base amounts, of all foreign affiliates in your group. Now that the cost base election applies to all foreign affiliate distributions, the treatment of such distributions through all entities in a chain will need to be analyzed.

Other foreign affiliate measures

As a reminder, the technical bills that are currently making their way through Parliament contain a host of other foreign affiliate amendments that:

·      Apply an anti-avoidance rule to deem exempt earnings to instead be classified as taxable earnings where there is a disposition of property between non-arm’s length persons and the disposition would be an “avoidance transaction” under GAAR

·      Introduce the concept of hybrid surplus, which is created where a foreign affiliate realizes a capital gain (or loss) on the disposition of shares of another foreign affiliate (or a partnership interest) that would not otherwise be included in FAPI

·      Affect foreign affiliate liquidations and mergers, including absorptive mergers, that in certain cases can apply on a tax-deferred basis

·      Change some of the stop-loss provisions in the Income Tax Act to ensure that losses realized on the disposition of excluded property of a foreign affiliate are not stopped for surplus and other purposes

·      Ensure that foreign accrual capital losses (FACL) are only deductible against foreign accrual capital gains

·      Extend the carryforward period for foreign accrual property losses (FAPL) to 20 years (from five years), and introduce a three-year carryback

·      Limit “bump” room in respect of the shares of a foreign affiliate on an acquisition of control where their fair market value does not exceed the total of their cost base and the “good” surplus of the affiliate (i.e., exempt surplus and grossed-up foreign tax, both of which can be returned to Canada tax-free)

·      Apply “fill-the-hole” surplus rules, which require deficits in upper-tier foreign affiliates to be “filled in” with surpluses from lower-tier affiliates before tax deductible dividends can be paid to Canada.

We can help

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 Finance’s attention.


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Information is current to December 6, 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.

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