The Taxation of Foreign Affiliates - ctf.ca · THE TAXATION OF FOREIGN AFFILIATES 1605 (1995), Vol. 43, No. 5 / no 5 existing Canadian law. The article does not deal with other areas,

(1995), Vol. 43, No. 5 / no 5 1603

The Taxation of Foreign Affiliates

Allan R. Lanthier, FCA*

PRÉCIS

Les règles visant l’imposition du revenu des sociétés étrangères affiliéesont été présentées, telles qu’elles sont présentement, dans le cadre de laréforme fiscale de 1972. Les dividendes versés à même le revenu d’uneentreprise exploitée activement par une société étrangère affiliée à unesociété canadienne actionnaire, sont généralement soit exonérés, soitadmissibles aux déductions relatives aux impôts étrangers, selon que lerevenu est attribuable à un pays avec lequel une convention fiscale a étéconclue ou non. Le revenu compris dans le revenu étranger accumulé,tiré de biens et gagné par une société affiliée étrangère contrôlée, tellequ’elle est définie, est imposable régulièrement entre les mains desactionnaires canadiens résidents (les particuliers et les sociétés).Jusqu’en 1995, les règles sont demeurées en place sans modificationfondamentale. La publication du rapport annuel du vérificateur général ennovembre 1992 a déclenché un débat sur le régime des sociétésétrangères affiliées qui a abouti à des modifications législatives qui sontgénéralement applicables après 1994 (les modifications de 1995). Il adécoulé des modifications de 1995 un important resserrement des règlesen ce qui a trait au régime d’exemption et au revenu étranger accumulé,tiré de biens. Plusieurs des lacunes réelles et perçues que les règlescomportent y sont aussi abordées. Il en résulte une loi qui chevauche lafine ligne entre la préservation de l’intégrité de l’assiette fiscalecanadienne sans éroder la position concurrentielle des entreprisescanadiennes.

L’auteur conclut que le régime du Canada est compatible avec lesnormes internationales et les approches d’autres pays et que d’autresmodifications fondamentales à la législation seraient inutiles etmalavisées. Toute autre modification doit être autant que possiblespécifique et ciblée de sorte à aborder les changements dans lespratiques commerciales canadiennes et les événements dans d’autrespays au fur et à mesure qu’ils surviennent.

ABSTRACT

The rules governing the taxation of income from foreign affiliates wereintroduced in their present form as part of the 1972 tax reform. Dividendspaid from active business income by a foreign affiliate to a Canadian

* Of Ernst & Young, Montreal.

1604 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE

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corporate shareholder are generally either exempt or eligible fordeductions in respect of foreign taxes, depending on whether the incomeis attributable to a treaty or non-treaty country. Income included inforeign accrual property income (FAPI) and earned by a controlled foreignaffiliate, as defined, is taxable on a current basis in the hands ofCanadian-resident shareholders (individuals as well as corporations). Until1995, the rules stayed in place without fundamental change. A debateover the foreign affiliate regime was sparked when the auditor generalissued his annual report in November 1992, culminating in amendmentsto the legislation that are generally applicable after 1994 (the 1995amendments). The 1995 amendments resulted in a significant tighteningof the rules with respect to the exemption system and to FAPI, andaddressed many of the actual and perceived deficiencies in the rules. Theresult is law that treads the fine line between preserving the integrity ofthe Canadian tax base without undermining the international competitiveposition of Canadian business.

The author concludes that Canada’s regime is consistent withinternational norms and standards and with approaches taken by othercountries, and that any further fundamental changes to the legislationwould be both unnecessary and misguided. Any future amendmentsshould be as specific and targeted as possible, so as to address changesin Canadian business practices and developments in other countries asthey arise.

INTRODUCTIONAmong the most complex set of provisions in the Income Tax Act1 are therules relating to the taxation of foreign affiliates. The basic structuralframework, by contrast, is quite straightforward. Dividends (other thanportfolio dividends) received by a Canadian corporate shareholder out ofactive business income are generally either exempt or eligible for deduc-tions in respect of foreign taxes, depending on whether the income isattributable to a treaty or non-treaty country. Income included in foreignaccrual property income (FAPI) and earned by controlled foreign affili-ates, as defined, is attributable on a current basis and taxed in the handsof Canadian-resident shareholders (individuals as well as corporations),whether or not the income is distributed as dividend payments. While thebasic concepts are relatively simple, the legislation itself is exceedinglycomplex, a feature common to the international tax regimes of manyother countries.

After describing the existing law relating to the taxation of foreignaffiliates and providing a historical review, this article summarizes theapproaches taken by other countries, and concludes with an assessment of

1 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “theAct”). Unless otherwise stated, statutory references in this article are to the Act.

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existing Canadian law. The article does not deal with other areas, such asthe taxation of non-resident trusts and offshore investment funds.2

OVERVIEW OF EXISTING LAWThe following is a summary of the taxation of income from foreign affili-ates under existing law. For this purpose, “existing law” includes the1995 amendments to the Act, including draft amendments to the foreignaffiliate regulations issued by the Department of Finance on January 23,1995, which, at the time of writing, had not yet been promulgated. Thesummary is general, and is not intended to cover every possible situationor exception.

Definition of “Foreign Affiliate” and “ControlledForeign Affiliate”A non-resident corporation is a foreign affiliate of a taxpayer resident ofCanada if the taxpayer owns, directly or indirectly, at least 1 percent ofany class of shares, and the taxpayer, together with related persons (whetherresidents or non-residents of Canada) owns, directly or indirectly, at least10 percent of any class. The threshold for foreign affiliate status is there-fore fairly low, and, subject to a specific anti-avoidance provision,3 canbe satisfied by a foreign affiliate’s issuing a separate class of shares,irrespective of its value. Qualifying as a foreign affiliate can be eithergood or bad. If the affiliate is carrying on an active business, foreignaffiliate status will give a Canadian corporate shareholder access to de-ductions under the exempt/taxable surplus regime. However, if the foreignaffiliate is also a “controlled foreign affiliate,” as defined, any Canadianshareholders (individuals as well as corporations) will be subject to an-nual taxation on their pro rata share of any FAPI.

A controlled foreign affiliate (CFA) of a taxpayer resident in Canadameans a foreign affiliate that is controlled4 by

1) the taxpayer;

2) the taxpayer and not more than four other persons resident in Canada;

3) not more than four persons resident in Canada, other than thetaxpayer;

4) a person or persons with whom the taxpayer does not deal at arm’slength; or

5) the taxpayer and a person or persons with whom the taxpayer doesnot deal at arm’s length.

2 Sections 94 and 94.1 of the Act respectively. For a more general review of the Cana-dian taxation of international income, see Brian J. Arnold, “The Canadian InternationalTax System: Review and Reform,” in this issue of the Canadian Tax Journal.

3 Subsection 95(6).4 “Control” for this purpose is de jure control, not the extended definition in subsection

256(5.1) of the Act.


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Dividends from Active Business IncomeDividends paid from active business income5 by a foreign affiliate to aCanadian corporate shareholder may be out of “exempt surplus,” “taxablesurplus,” or “pre-acquisition surplus.” Exempt surplus generally includesafter-tax, active business income earned in a treaty country, provided thatthe affiliate is also resident in a treaty country, both under the commonlaw principle of management and control and as defined in the applicabletreaty.6 An affiliate is regarded as a treaty resident if it would have beena treaty resident had it been a body corporate7 or, with respect to treatiesthat entered into force before 1995 and that have not been amended after1994, if it would have been a treaty resident but for a provision in thetreaty that provides that the treaty does not apply to the affiliate.8 Activebusiness income earned by a foreign affiliate in a non-treaty country, orby an affiliate that is not resident, as defined, in a treaty country, isincluded in taxable surplus. Dividends paid by a foreign affiliate thatexceed its exempt and taxable surplus accounts are deemed to come outof pre-acquisition surplus, a notional account for which no actual compu-tations are made.

Dividends received by a corporation resident in Canada from foreignaffiliates are initially included in income, but deductions are then allowedfor all or a portion of the dividends in computing taxable income, de-pending on the surplus account from which the dividend is prescribed tohave been paid.9 Dividends out of exempt surplus are deductible in com-puting taxable income, irrespective of the foreign tax burden that hasbeen incurred. Where a dividend is out of taxable surplus, deductionsrelated to the underlying foreign tax applicable to the earnings beingdistributed, as well as to any foreign withholding taxes applicable to thedividends, are available. The general policy rationale is that Canadian taxwill be payable on dividends out of taxable surplus only to the extent thatthe total foreign tax burden is less than the basic Canadian corporate taxrate. While the underlying foreign tax applicable to a dividend received

5 Other than active business income defined to be FAPI. The taxation of FAPI is dis-cussed below.

6 See, inter alia, draft regulation 5907(11.2), in Canada, Department of Finance, For-eign Affiliates: Revised Draft Amendments to the Income Tax Regulations, January 23,1995.

7 Thereby accommodating entities such as US limited liability companies, which aregenerally regarded as corporations for Canadian tax purposes, but which may, dependingon the circumstances, be treated as partnerships under US tax law.

8 Entities such as Barbados international business corporations, to which theCanada-Barbados tax treaty does not apply, will therefore continue to be eligible forexempt surplus treatment in respect of active business income, unless the treaty is amendedin future.

9 In certain limited situations, deductions in respect of dividends out of exempt, tax-able, or pre-acquisition surplus may be subject to refundable tax under part IV of the Act.In addition, dividends otherwise eligible for deductions under section 113 may be deemedto be interest under subsections 258(3) and (5) of the Act.


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out of taxable surplus is generally determined on a pro rata basis accord-ing to the proportionate amount of the taxable surplus being distributed, ataxpayer can claim more than a pro rata amount if prescribed tests are met.

Dividends received out of pre-acquisition surplus are deductible incomputing taxable income, but the amount of such dividends, net of anyforeign withholding tax, reduces the tax basis of the shares on which thedividends were paid.

Dividends paid by a foreign affiliate are deemed to come first out ofthe affiliate’s exempt surplus to the extent available, and next out oftaxable surplus. However, a taxpayer may elect to have all or part of adividend received from a foreign affiliate treated as having been paid outof taxable surplus rather than exempt surplus. This election may be desir-able where, for example, the dividend is out of low-taxed taxable surplus,and the Canadian corporation has a non-capital loss carryforward expir-ing in the year. Any dividend payments that exceed an affiliate’s exemptand taxable surplus balances are generally deemed to be paid out of pre-acquisition surplus.

Taxation of FAPITaxpayers resident in Canada must include their proportionate amount ofany FAPI earned by a CFA in income on a current basis (subject to deduc-tions in respect of underlying foreign tax), whether or not the income isdistributed by the affiliate as dividend payments. These rules apply toCanadian-resident individuals as well as to corporations, and to affiliatesin treaty as well as non-treaty countries. The allocable amount is basedon the taxpayer’s participating percentage,10 determined at the end ofeach taxation year of the affiliate. If a Canadian taxpayer has an interestin a CFA at the end of a particular taxation year, there is an attribution ofFAPI earned by the affiliate during the entire year; conversely, there is noattribution if the Canadian shareholder does not have an interest in a CFAat the end of a year. Generally, no further Canadian tax is imposed whenFAPI is repatriated to Canada as dividend payments, although deductionsmay be available at that time for foreign withholding tax imposed on thedividends.11

Income characterized as FAPI is included in taxable surplus and, to theextent that FAPI is earned by a foreign affiliate that is not a CFA of aCanadian taxpayer, the income is subject to potential Canadian tax whenit is ultimately paid to Canada as dividends.

10 As defined in subsection 95(1) and regulation 5904.11 While foreign affiliate surplus accounts are generally not relevant in respect of

Canadian-resident shareholders who are individuals, amounts paid as dividends to an indi-vidual resident in Canada out of previously taxed FAPI are deemed by regulation 5900(3)to be out of taxable surplus, with deductions then being available under subsection 91(5)of the Act.


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Determination of FAPIFAPI, as defined, includes an affiliate’s income from property and busi-nesses other than active businesses, and taxable capital gains fromdispositions of property other than “excluded property,”12 less the affili-ate’s losses from property and businesses other than active businesses andallowable capital losses from dispositions of property other than excludedproperty. There is a five-year carryforward of any net FAPI losses in-curred by an affiliate in a particular year.13 Interaffiliate dividends arespecifically excluded from the definition of “FAPI.”

The definition of “FAPI” is, however, somewhat misleading. There arestatutory definitions of “active business,” “income from an active busi-ness,” and “income from property” for the purposes of the FAPI rules, aswell as provisions that deem various sources of income to be incomefrom property or from businesses other than active businesses. As a re-sult, various sources of active business income are in fact characterizedas FAPI. In addition to property income that is purely of a passive nature,FAPI includes income from an adventure or concern in the nature of trade,as well as

• income from an “investment business,” as defined;

• income from trading or dealing or indebtedness; and

• various types of income earned by a foreign affiliate, where thecorresponding deduction erodes the Canadian tax base.

Income from an Investment BusinessIncome from an investment business is included in the definition of “in-come from property.” Under the investment business rules, where theprincipal purpose of a business is to earn interest, dividends, rents, royal-ties, or similar returns or substitutes therefor, insurance income, incomefrom factoring accounts receivable, or profits from the disposition ofinvestment property, the income is FAPI unless specifically exempted.Exemption generally applies if the affiliate employs more than five em-ployees (or the equivalent thereof ) full-time in the active conduct of thebusiness, the business is conducted principally with arm’s-length per-sons,14 and the business is either regulated in the country in which it is

12 Defined in subsection 95(1) to include any property used or held by an affiliate prin-cipally for the purpose of gaining or producing income from an active business, an amountreceivable the interest on which is (or would if interest were payable thereon) be deemedto be income from an active business under certain of the interaffiliate exemptions describedbelow, or shares of the capital stock of another foreign affiliate of the taxpayer, where allor substantially all of the property of the other foreign affiliate is excluded property.

13 Draft regulation 5903, in the January 23, 1995 draft amendments, supra footnote 6.Prior to the 1995 amendments, FAPI was also reduced by active business losses of the yearor five immediately preceding years.

14 For this purpose, a foreign affiliate of a Canadian financial institution is deemed todeal at arm’s length with the Canadian financial institution with respect to the sale orexchange of currency under certain conditions (subsection 95(2.1) of the Act).


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principally carried on, or is a qualifying business (the development ofreal estate for sale, the lending of money, the leasing or licensing ofproperty, or the insurance or reinsurance of risks).

Income from Trading or Dealing in IndebtednessActive business income that is not otherwise income from an investmentbusiness is nonetheless included in FAPI if the principal purpose of thebusiness is to derive income from trading or dealing in indebtedness(including the earning of interest on indebtedness). The exceptions are(1) indebtedness owing by arm’s-length residents of the country in whichthe affiliate is governed and in which its business is principally carriedon; (2) accounts receivable owing by persons with whom the affiliatedeals at arm’s length; and (3) a business carried on by an affiliate that isregulated in the country in which it is governed and in which its businessis principally carried on, provided that the affiliate is owned by a regu-lated Canadian financial institution. Beyond these somewhat narrowexceptions, there is no relief from the FAPI provisions for such income,even if the affiliate employs more than five full-time employees in theactive conduct of the business. Revenue Canada takes the view that, un-less one of the narrow exceptions is met, interest income may be includedin FAPI under this provision, whether or not the interest is derived from abusiness of trading or dealing in indebtedness. It remains to be seenwhether the courts will ultimately agree with this view.

Income That Erodes the Canadian Tax BaseFive categories of income are specifically deemed to be income from abusiness other than an active business and therefore are characterized asFAPI. All generally involve transactions where the corresponding deduc-tion erodes the Canadian tax base. In certain cases, the rules apply onlywhen the transactions are between a foreign affiliate and the ultimateCanadian shareholder (or persons related to the Canadian shareholder); inothers, the FAPI characterization applies irrespective of the relationshipbetween the parties. The five categories of income are as follows:

1) Purchase of goods from foreign affiliates: FAPI of a foreign affiliateof a Canadian taxpayer includes the income of the affiliate in respect ofthe sale of property (either as a principal or as a commission agent)where the cost of the property is relevant in computing the income from abusiness carried on by the Canadian taxpayer or by related persons resi-dent in Canada (or where it is relevant in computing the income from abusiness carried on in Canada by a related non-resident person), unlessthe property was manufactured, processed, grown, or extracted by theaffiliate in the country in which the affiliate is governed and in which itsbusiness is principally carried on.15 Such income is generally not FAPI ifmore than 90 percent of the affiliate’s gross income for the year is derived

15 Paragraph 95(2)(a.1). The provision is an obvious legislative response to The Queenv. Irving Oil Limited, 91 DTC 5106 (FCA) (leave to appeal to SCC refused).


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from sales to arm’s-length persons. Where the provision does apply, iteffectively overrides the reasonable arm’s-length transfer-pricing provi-sions in section 69 of the Act, and includes as FAPI income earned by anoffshore purchasing affiliate from the sale of property to the Canadiantaxpayer or related persons. The provision does not generally apply tooffshore marketing affiliates.16

2) Insurance of Canadian risks: FAPI includes the income of a foreignaffiliate from the insurance or reinsurance of Canadian risks, unless morethan 90 percent of the gross premium revenue of the affiliate for the yearis from the insurance of foreign risks of persons with whom the affiliatedeals at arm’s length.17 While the provision has technical application inrespect of the insurance of Canadian risks of both related and unrelatedparties, the rule is targeted at the insurance of third-party risks, such ascreditor insurance programs sponsored by Canadian financial institutionsand certain warranty programs structured to provide insurance to resi-dents of Canada who are not related to the Canadian sponsor/shareholder.

3) Indebtedness and lease obligations of Canadian residents: FAPI in-cludes the income of a foreign affiliate from indebtedness and leaseobligations of persons resident in Canada, or in respect of businessescarried on in Canada, unless more than 90 percent of the affiliate’s grossrevenue is derived from indebtedness and lease obligations of arm’s-lengthnon-resident persons.18 Income from lease obligations includes an obliga-tion that authorizes the use of or the production or reproduction of property;as a result, income from activities such as exploitation of software throughthird-party licences into Canada will often be deemed to be FAPI.

4) Income received from a partnership with Canadian partners: In-come from indebtedness and lease obligations earned by a foreign affiliateof a Canadian taxpayer in respect of a business carried on outside Canadaby a partnership is FAPI if the Canadian taxpayer or persons with whomthe taxpayer does not deal at arm’s length are members of the partner-ship.19 The rule effectively treats as FAPI the proportion of the incomeearned by the affiliate that is deducted by the Canadian taxpayer in com-puting its share of the income or loss from the partnership.

5) Income from Canadian services: FAPI includes income from serv-ices provided by a CFA of a Canadian taxpayer where (a) an amount paidor payable therefor is deductible in computing the income from a busi-ness carried on in Canada by the Canadian taxpayer or a person related to

16 The provision also does not apply to income earned by foreign affiliates of Canadianfinancial institutions from the sale or exchange of currency or a right to sell or exchangecurrency under certain conditions (subsection 95(2.3) of the Act).

17 Paragraph 95(2)(a.2).18 Paragraph 95(2)(a.3), a provision that was added as an obvious legislative response

to specific jurisprudence—Canada Trustco Mortgage Company v. MNR, 91 DTC 1312(TCC) (under appeal). Certain exceptions again apply to financial institutions.

19 Paragraph 95(2)(a.4).


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the taxpayer, or can reasonably be considered to relate to a deductibleamount, or (b) the services are performed by the Canadian taxpayer or aperson related to the taxpayer who is an individual resident in Canada.20

Of the five categories of income related to the erosion of the Canadiantax base, this is the only one that has been in place since the 1972 taxreform; the other four were added by the 1995 amendments.

Interaffiliate ExemptionsAs can be seen, the FAPI net is broad indeed. However, specific relief isprovided in the legislation in respect of income that would otherwise becharacterized as FAPI, that involves interaffiliate transactions, and thatdoes not erode the Canadian tax base. In order to make use of any ofthese exempting provisions, a taxpayer must have a “qualifying interest”in respect of the particular foreign affiliate that is being tested. A “quali-fying interest” is defined for this purpose as the ownership of 10 percentor more of the outstanding shares of the affiliate (both votes and value).The concept of qualifying interest is maintained down a chain of foreignaffiliates: attribution of the proportionate amount of votes and values atlower tiers is based on the relative fair market value of shares held byintermediate companies.

The exemptions fall into two general categories: income of an affiliatethat is directly related to the active business of another, and interaffiliatepayments and other transactions.

Directly Related IncomeForeign source income derived by a particular foreign affiliate in which ataxpayer has a qualifying interest, which would otherwise be income fromproperty, is deemed to be active business income to the extent that theincome is derived by the affiliate from activities that can reasonably beconsidered to be directly related to the active business activities carriedon outside Canada by another non-resident corporation to which the af-filiate and the taxpayer are related, and which would have been includedin computing the active business earnings of the other non-resident cor-poration had the income been earned by it.21 In some circumstances theapplicability of this provision will be relatively clear—for example, wherea foreign affiliate acting as a global treasury centre earns interest incomeby investing temporary surplus funds (lent to it by another related affiliate)

20 Paragraph 95(2)(b). The term “services” is defined for this purpose to include theinsurance of Canadian risks, but excludes the transportation of persons or goods as well asservices performed in connection with the purchase or sale of goods.

21 Subparagraph 95(2)(a)(i). Provided that various tests are met, the subparagraph alsoexempts income directly related to the Canadian taxpayer itself, where the taxpayer is alife insurance corporation resident in Canada, to the extent that the amounts relate to abusiness carried on outside Canada (subclause 95(2)(a)(i)(A)(II)). This recognizes the factthat life insurance corporations are taxable only on Canadian source income, and equatesthe treatment accorded to foreign branches of Canadian life insurance companies with thatapplibable to foreign affiliates.


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that are required by and at risk in an active foreign business of the otheraffiliate. In many cases, however, the applicability of the provision willbe uncertain. For example, it is understood that in the case of a verticallyintegrated business of developing, manufacturing, and marketing prod-ucts, carried out partly inside Canada by a Canadian taxpayer and partlyoutside Canada by foreign affiliates of the taxpayer, Revenue Canadaadopts a facts-and-circumstances approach, and evaluates the nature andextent of the activities carried on inside and outside Canada in determin-ing whether the provision should apply. This could be relevant, forexample, in respect of interest income earned by another related affiliateby providing customer financing to the ultimate third-party consumer.

Interaffiliate Payments and Other TransactionsThe second set of exemptions relates to various situations involving pay-ments and other transactions between affiliates, and again provides thatincome that might otherwise be income from property is deemed to beactive business income. For example, interest, rents, and royalties paid bya particular foreign affiliate of a Canadian taxpayer out of active businessincome will generally be deemed to be active business income if receivedby another foreign affiliate of the taxpayer. The policy rationale is straight-forward: income should not be transformed from active business incomeinto FAPI simply because it is paid from one foreign affiliate to another.

The provisions that may apply are summarized below.22 In all cases,the Canadian taxpayer must have a qualifying interest in the particularaffiliate that is being tested.

The first set of provisions applies to income derived from amounts thatwere paid or payable, directly or indirectly, to the particular affiliate (orto a partnership of which the particular affiliate was a member)

1) by a non-resident corporation to which the particular affiliate andthe taxpayer are related;23

2) by another foreign affiliate of the taxpayer in respect of which thetaxpayer has a qualifying interest;24 or

3) by a partnership of which the particular affiliate is a member (otherthan a specified member as defined).25

22 In addition to these provisions, clause 95(2)(a)(ii)(E) provides that, where a life insur-ance corporation resident in Canada has a qualifying interest in a particular foreign affiliate,income earned by the affiliate from sources outside Canada shall be deemed to be activebusiness income to the extent that the income is derived from amounts paid or payable by theCanadian taxpayer that are deductible in computing its income or loss from carrying on a lifeinsurance business outside Canada. This is a sister provision to subclause 95(2)(a)(i)(A)(II).

23 Clause 95(2)(a)(ii)(A). This provision also applies to payments by a partnership ofwhich a related non-resident corporation is a member (other than a specified member).

24 Clause 95(2)(a)(ii)(B). The provision also applies to payments by a partnership ofwhich another foreign affiliate of the taxpayer, in respect of which the taxpayer has aqualifying interest, is a member (other than a specified member).

25 Clause 95(2)(a)(ii)(C). The term “specified member” is defined in subsection 248(1)of the Act.


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The provisions listed above all refer to amounts that were paid orpayable for expenditures that were or would be, if the payer were aforeign affiliate of the taxpayer, deductible in the year or in a subsequentyear in computing earnings or loss from an active business carried onoutside Canada. The reference to deductions in subsequent years elimi-nates the risk that interaffiliate payments might be transformed into FAPIin the hands of the recipient where foreign tax law denies immediatedeductibility.26 In addition, the reference to “expenditures” appears tocapture amounts of either a current or a capital nature and could, forexample, accommodate situations in which a sale-purchase is character-ized as a capital lease in the jurisdiction of the payer.

A fourth provision applies when a finance affiliate lends funds to aforeign affiliate holding company, and the holding company uses the bor-rowed funds to acquire shares of a third affiliate that is resident andsubject to tax in the same country as the holding company. Provided thatvarious tests are met, income received by the finance affiliate from theholding company is deemed to be active business income. For example,the interest paid or payable by the foreign affiliate holding company mustbe relevant in computing the liability for taxes of the members of a groupthat includes the holding company and one or more other foreign affili-ates of the taxpayer, the shares of which are excluded property and inrespect of which the taxpayer has a qualifying interest. While the rulesare complex, the policy rationale is simple: if interest expense is de-ducted in a country against active business income under a combined orconsolidated tax system (including an imputation system), the fact thatthe interest is paid by a holding company (rather than an operating com-pany) should not in and of itself result in a conversion of the interest intoFAPI in the hands of the recipient.

The final exempting provisions in respect of interaffiliate transactionsrelate to income derived by a particular affiliate from factoring of ac-counts receivable, or from loans or lending assets, provided that theaccounts receivable, loans, or lending assets were acquired by the par-ticular affiliate (or a partnership of which the particular affiliate was amember) from a related non-resident corporation, and that the assets arosein the course of an active business carried on in a country other thanCanada by the related non-resident corporation. In these circumstances,the income received by the particular affiliate is again deemed to beactive business income.

Dispositions of Foreign Affiliate SharesWhere a resident of Canada sells shares of a foreign affiliate, 75 percentof any capital gain is included in income. Similarly, where a foreignaffiliate of a Canadian taxpayer sells shares of another foreign affiliate,

26 For example, it is understood that interest expense that is disallowed and deferredunder the earnings-stripping provisions in section 163(j) of the US Internal Revenue Codeof 1986, as amended, will qualify as eligible payments.


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75 percent of any capital gain is included in FAPI (and therefore in tax-able surplus), and attributed as income on a current basis to the Canadianshareholder if the disposing affiliate is a CFA. The remaining 25 percentincreases the exempt surplus of the disposing affiliate vis-à-vis a Cana-dian corporate shareholder.

There are two important exceptions to these general rules. The first isthat a Canadian corporate taxpayer can elect to convert what would other-wise be a capital gain on the disposition of a foreign affiliate into a deemeddividend, whether the shares are held directly by the Canadian corpora-tion or by another foreign affiliate. The filing of an election will oftenreduce, but not necessarily eliminate, the capital gain for Canadian taxpurposes. Where one foreign affiliate disposes of the shares of another, aCanadian corporate shareholder will normally elect with respect to bothexempt and taxable surplus balances attributable to the shares being dis-posed of. Interaffiliate dividends are excluded from FAPI, and the effectof the election is to move the surplus balances to the disposing affiliate,thereby deferring Canadian taxation until dividends are eventually paid toCanada. In the case of a disposition of a foreign affiliate held directly bythe Canadian corporate shareholder, an election will generally be madeonly in respect of exempt surplus.27 In either situation, filing of the elec-tion eliminates the requirement to pay actual dividends prior to a sale(which might otherwise result in the imposition of foreign taxes).

The second important exception involves situations where the sharesbeing disposed of constitute excluded property,28 and where the shares areheld by another foreign affiliate (rather than directly by the Canadiantaxpayer). A capital gain realized by a foreign affiliate on the dispositionof shares of another affiliate that qualify as excluded property is auto-matically exempt from FAPI, without the requirement for filing an election,and irrespective of the balances in the surplus accounts of the foreignaffiliate being disposed of. Where the Canadian shareholder is a corpora-tion, however, a deemed election is considered to have been made, therebymoving exempt or taxable surplus balances of the affiliate being disposedof to the disposing affiliate.29

Interest DeductibilityInterest is deductible on funds borrowed to acquire or invest in foreignaffiliates, whether the investor is a corporation or an individual, andwhether the affiliate is in a treaty or non-treaty country. The general testsin the Act must of course be satisfied. For example, the interest must be

27 It may, however, also be appropriate to elect in respect of taxable surplus in certainsituations, provided that there is sufficient underlying foreign tax.

28 Supra footnote 12.29 The deemed election is limited to the capital gain as otherwise computed (regulation

5902(6)), although Revenue Canada’s position is that in these circumstances an actualelection can be filed which will override the deemed election, and can serve to move agreater amount of surplus balances to the disposing affiliate.


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reasonable in amount, and must be incurred for the purpose of gaining orproducing income.30

LEGISLATIVE HISTORYOriginsThe exemption system has been a longstanding part of the Canadian taxmosaic and has been in place, in one form or another, since 1938.31 Theexemption first introduced in that year was a narrow one, under which divi-dends received by public Canadian companies from wholly owned foreignsubsidiaries were not taxable if 75 percent of the combined assets of theCanadian corporation and all of its foreign subsidiaries was employed inforeign business operations, and the relevant foreign jurisdiction providedsubstantially similar relief to companies incorporated therein in respect ofdividends received from Canadian subsidiary corporations. The exemptionwas extended in 1948 to apply to any corporation resident in Canada, pro-vided again that at least 75 percent of the combined property of the groupwas outside Canada, and the relevant foreign country provided substantiallysimilar relief. In 1949, the requirement that 75 percent of the combinedproperty of the corporate group be employed outside Canada was elimi-nated, as was the requirement that the foreign jurisdiction providesubstantially similar relief. Most important, the ownership threshold wasreduced to one of control. In 1951, the ownership threshold was reducedagain, to 25 percent of shares having voting rights in all circumstances.

From 1951 until tax reform in 1972, the exemption for dividends from25 percent-owned subsidiaries remained unchanged. There was no dis-tinction between active business income and passive income for thepurposes of this exemption, nor was there any attribution of income toCanadian-resident shareholders on a current basis. Finally, prior to 1972tax reform, dividends that were deductible in computing taxable incomewere defined to be exempt income; as a result, interest deductibility wasdenied for investment in both Canadian and foreign subsidiaries.

1972 Tax ReformThe taxation of international income was fundamentally changed as ofJanuary 1, 1972. The tax reform process began with the appointment ofthe Royal Commission on Taxation in 1962, which tabled its report in theHouse of Commons in 1967.32 The Department of Finance released a

30 For examples of situations in which deductions for interest expense have been de-nied in the international context, see Ludmer et al. v. MNR, 93 DTC 1351 (TCC) (underappeal), and Mark Resources Inc. v. The Queen, 93 DTC 1004 (TCC) (also under appeal).

31 For a detailed analysis of the taxation of international income since the introductionof the Income War Tax Act in 1917 (as well as an excellent overall review of the design,in principle, of the foreign affiliate system), see J. Scott Wilkie, Robert Raizenne, HeatherI. Kerr, and Angelo Nikolakakis, “The Foreign Affiliate System in View and Review,” inTax Planning for Canada-US and International Transactions, 1993 Corporate Manage-ment Tax Conference (Toronto: Canadian Tax Foundation, 1994), 2:1-72, at 2:27-55.

32 Canada, Report of the Royal Commission on Taxation (Ottawa: Queen’s Printer, 1966).


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white paper in November 1969,33 and revised tax reform measures werefinally tabled for first reading in the House of Commons on June 30,1971 as Bill C-259,34 which was passed by the House of Commons onDecember 17, 1971. A number of substantive amendments were subse-quently enacted, particularly after the budget proposals tabled on May 6,1974, and reintroduced with some refinements in a subsequent budgettabled on November 18, 1974, all retroactive to January 1, 1972. Theregime as ultimately enacted is summarized below.

A non-resident corporation qualified as a “foreign affiliate” of a Cana-dian shareholder if the Canadian shareholder held at least 10 percent ofany class of shares either directly or indirectly. Active business incomeearned by a foreign affiliate of a Canadian corporate taxpayer formed partof either exempt or taxable surplus, depending on whether the incomewas attributable to a “listed country” as defined (however, as a specialtransitional measure, exempt surplus included all active business incomefor the years 1972 to 1975 inclusive, without regard to the concept oflisted countries). Listed countries were set out in regulation 5907(11) tothe Act. In a press release, then Finance Minister Donald Macdonaldannounced the list of countries that would be initially prescribed for thepurposes of regulation 5907(11).35 The minister prescribed 35 countries atthat time, and the press release stated that the list included those coun-tries with which Canada had a tax convention in force or had “reachedgeneral agreement on the contents of a tax treaty.” It appears that thepolicy established in 1975 was to provide countries with listed status iftax treaties were in force or if negotiations were substantially advanced.36

The 1972 tax reform introduced interest deductibility on funds bor-rowed to invest in both Canadian and foreign companies by changing thedefinition of “exempt income” to exclude dividend income.37

Finally, with respect to a foreign affiliate that was also a controlledforeign affiliate, as defined, the FAPI system was introduced: it requiredattribution on an annual basis of a proportionate amount of FAPI to Cana-dian shareholders, and was applicable to the 1976 and subsequent taxationyears. There was, however, no definition of “income from property” or“income from a business other than an active business,” and only one pro-vision that deemed income to be FAPI.38 The concept of FAPI as initially

33 E.J. Benson, Proposals for Tax Reform (Ottawa: Queen’s Printer, 1969).34 Bill C-259, An Act To Amend the Income Tax Act and To Make Certain Provisions

and Alterations in the Statute Law Related to or Consequential upon the Amendments tothat Act; SC 1970-71-72, c. 63.

35 Canada, Department of Finance, Release, no. 75-87, December 30, 1975.36 It is understood that during the 1980s the policy changed so that countries would be

listed only if tax treaties were ratified.37 Except for the purposes, at the time, of the surplus-stripping provisions in subsection

247(1) of the Act.38 Paragraph 95(2)(b), related to income from Canadian services. See supra footnote 20

and accompanying text.


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introduced was extremely narrow, and was essentially limited to purelypassive income and the taxable portion of capital gains accruing after anaffiliate’s 1975 year (net of allowable capital losses accruing after the samedate). Capital gains relevant for the purposes of FAPI included gains real-ized by a foreign affiliate on the disposition of shares of other affiliates,but excluded gains on assets used directly in an active business.

The 1980sWhile the fundamental elements of the foreign affiliate system remainedunchanged throughout the 1980s, some changes were made to the Act andthe regulations. In particular, the November 1981 federal budget intro-duced a number of substantive changes.39 Most important, the concept of“excluded property” was introduced,40 thereby narrowing the scope of FAPIsomewhat, so that exemption from FAPI would apply not only where aforeign affiliate sold active business assets (as introduced in 1972), butalso where the affiliate sold shares of another foreign affiliate that wascarrying on an active business. Rules were introduced to eliminate taxbenefits that were previously available when foreign affiliates immigratedto Canada, and a number of complex changes were made to the regula-tions dealing, inter alia, with the computation of surplus accounts in casesof acquisitions or dispositions of shares and of certain corporate reorganiza-tions, and in countries having combined or consolidated tax regimes.41

Other amendments were made from time to time. For example, a numberof technical issues were addressed in the amendments to the foreign af-filiate regulations issued on December 23, 1985. These included changesto various technical provisions and, in certain cases, additions or dele-tions to the countries listed under regulation 5907(11). However, they didnot fundamentally change the foreign affiliate system introduced as partof 1972 tax reform.

The 1995 AmendmentsOn January 23, 1995, Finance Minister Paul Martin released draft amend-ments to the Act and regulations relating to foreign affiliates.42 The releasefollowed earlier drafts issued with the February 22, 1994 budget and on

39 The amendments to the Act were contained in Bill C-139, An Act To Amend theStatute Law Relating to Income Tax (no. 2); SC 1980-81-82-83, c. 140; given royal assenton March 30, 1983. The bill contained the tax measures originally proposed in the federalbudgets of November 12, 1981 and June 28, 1982, and in the economic statement ofOctober 27, 1982.

40 Supra footnote 12.41 For a detailed review of these changes to the Act and regulations, see Robert J. Dart,

John H. Meek, Victor Peters, and Ronald S. Wilson, “The 1982 Draft Amendments: Impli-cations for International Taxation,” in Report of Proceedings of the Thirty-Fourth TaxConference, 1982 Conference Report (Toronto: Canadian Tax Foundation, 1983), 199-246;and Nathan Boidman, The Foreign Affiliate System: Canadian Taxation After 1982—AStructured Overview (Toronto: CCH Canadian, 1983).

42 See supra footnote 6.


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June 23, 1994. Certain further modifications were made to the proposedamendments to the Act as part of Bill C-70, which received royal assenton June 22, 1995.43 In this section, the amendments to the Act enacted aspart of Bill C-70 and the draft amendments to the regulations issued onJanuary 23, 1995 are referred to as “the 1995 amendments.”

The Auditor General’s ReportThe debate over the foreign affiliate rules that culminated with the 1995amendments was sparked when the auditor general issued his annual re-port on November 24, 1992. The report included a severe criticism of theDepartment of Finance (“Finance”) for not having completed reviews ofthe tax rules related to interest deductibility, foreign source income, andforeign affiliates. In a statement widely reported by the media, the auditorgeneral concluded that “hundreds of millions of dollars in tax revenuehave already been lost and will continue to be at risk.”44

Finance included an aggressive rebuttal in the report, noting that theforeign affiliate regime accurately reflected the policy intent of Parlia-ment and provided for the taxation of all income that was intended to besubject to Canadian tax. Finance also noted that the system promoted theinternational competitiveness of Canadian business and that, in formulat-ing its policy with respect to the taxation of foreign source income, it hadhad to recognize that there are substantial costs inherent in implementinga system that deviates substantially from international norms.

The Public Accounts CommitteeThe Standing Committee on Public Accounts of the House of Commons(PAC) met in December 1992 and early 1993 to consider the auditorgeneral’s report; officials of the auditor general’s office, Finance, andRevenue Canada and four experts from the private sector were asked toattend.45 Most of the questions from committee members during the meet-ings in December were directed at Finance, and certain PAC memberswere clearly antagonistic toward Finance officials. The following excerptgives an indication of the combative tone of the questioning:

I knew you were going to give that answer. That’s a recording, Mr. Chair-man. I want to move on. You are not going to waste the committee’s timerepeating that crap.46

43 Bill C-70, An Act To Amend the Income Tax Act, the Income Tax Application Rulesand Related Acts; SC 1995, c. 21.

44 Canada, Report of the Auditor General of Canada to the House of Commons 1992(Ottawa: Supply and Services, 1992), 50.

45 In addition to myself, the outside witnesses included Robert Brown of Price Water-house, Alan Schwartz of Fasken Campbell Godfrey, and Brian Arnold of the University ofWestern Ontario (Professor Arnold had assisted the auditor general in drafting the report).

46 Intervention by Mr. John Rodriguez (Nickel Belt), while Mr. David Dodge, the deputyminister of finance, was in the process of answering a question: Canada, Minutes ofProceedings and Evidence of the Standing Committee on Public Accounts, 34th Parlia-ment, 3d session, 1991-92, issue no. 37, December 8, 1992, 37:26.


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Many of the technical questions raised during the meetings related tothe exempt surplus system, the method of listing countries, and whetherthe use of offshore finance vehicles was appropriate. There was littlediscussion of interest deductibility.

PAC tabled its conclusions and recommendations on April 23, 1993 inthe House of Commons, and its report was highly critical of Finance. Theconclusions and recommendations set out in the report included thefollowing:

• Finance should immediately, and regularly thereafter, review the coun-tries listed in regulation 5907(11) and remove all countries with whichCanada has not signed a tax treaty or with which negotiations are notlikely to be concluded.

• Finance should assess the merits of according exempt surplus statusto foreign affiliates that operate in “tax havens.”

• Finance should immediate clarify the definition of “active businessincome” for the purposes of the FAPI provisions and make appropriateamendments to the Act.47

• The Act should be amended to prevent the offset of active businesslosses in a foreign affiliate against passive income.

• Finance and Revenue Canada should submit a report to PAC on anannual basis concerning the effectiveness of the general anti-avoidancerule (GAAR) in thwarting tax-avoidance schemes used in connection withforeign affiliates.

• Finance should, in addition to addressing the specific recommenda-tions contained in the committee’s report, undertake to complete its studiesof foreign source income and foreign affiliates, and develop specificamendments to the Act to protect the integrity of the tax base in the longterm.

• Thereafter, Finance should continue to revise the legislation and regu-lations on an ongoing basis to account for changing circumstances,interpretations by the courts, and the evolution of tax laws in othercountries.

The report was more guarded with respect to interest deductibility,noting that Finance should “move cautiously” in this area, and recom-mending that Finance study the question in depth before making changesto the Act.

47 The courts had clearly established a relatively low threshold on the question ofactive business income in the domestic context. See, for example, Canadian Marconi v.The Queen, 86 DTC 6526 (SCC); The Queen v. Rockmore Investments Ltd., 76 DTC 6156(FCA); The Queen v. MRT Investments Ltd., 76 DTC 6158 (FCA); and ESG HoldingsLimited v. The Queen, 76 DTC 6158 (FCA). PAC’s concern was that analogous reasoningmight ultimately be applied in jurisprudence related to the characterization of active busi-ness income for the purposes of the FAPI provisions.


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Summary of the 1995 AmendmentsFinance’s response came in the form of the 1995 amendments, whichaddress many of the recommendations put forward in the PAC report (andwhich, in certain instances, go further than either the auditor general orPAC had recommended). While the 1995 amendments did not make anyfundamental changes to the existing regime (such as the concept of anexempt and taxable surplus system, interest deductibility, and the restric-tion of attributable income to certain defined categories of income), theydid address many of the actual and perceived deficiencies in the technicalrules, and they had a major impact on many taxpayers. The 1995 amend-ments, most of which were effective for taxation years of foreign affiliatescommencing after 1994,48 included the following changes:49

• The definition of “foreign affiliate” was expanded by aggregatingshareholdings of related persons for the purposes of determining whethera taxpayer has a direct or indirect interest of at least 10 percent of anyclass of shares.

• The foreign affiliate regulations were revised to end the ability toshelter FAPI by using active business losses.

• The definition of “FAPI” was significantly expanded by the introduc-tion of definitions of “active business,” “income from an active business,”and “income from property,” as well as by the introduction of the con-cepts of an investment business and deemed FAPI for a business of tradingor dealing in indebtedness.

• The definition of “FAPI” was further broadened with respect to in-come earned from transactions that erode the Canadian tax base.

• The exemptions from FAPI for interaffiliate transactions were in somerespects tightened, and in others relaxed. On the one hand, a Canadiantaxpayer must now have a “qualifying interest” (not less than 10 percentof votes and value) in a particular affiliate in order to access the exempt-ing provisions. On the other hand, the interaffiliate exemptions wereexpanded to apply, for example, to amounts paid by foreign affiliate hold-ing companies and by certain partnerships.

• With respect to the exemption system, the list of countries in regula-tion 5907(11) was repealed, and replaced by a definition of “designated

48 However, where there was a change in the taxation year of a foreign affiliate in 1994and after February 22, 1994, the amendments generally apply to taxation years that end(rather than begin) after 1994, thereby accelerating the application of the new rules. Thechanges to the foreign affiliate regulations are generally effective for taxation years begin-ning after 1995.

49 For a detailed analysis of the changes, see, inter alia, Brian J. Arnold, “An Analysisof the 1994 Amendments to the FAPI and Foreign Affiliate Rules” (1994), vol. 42, no. 4Canadian Tax Journal 993-1036; Sandra E. Jack, “The Foreign Affiliate Rules: The 1995Amendments” (1995), vol. 43, no. 2 Canadian Tax Journal 347-400; Larry F. Chapman,“Foreign Affiliate Amendments: Three Strikes and You’re Done,” International Tax Plan-ning feature (1995), vol. 43, no. 2 Canadian Tax Journal 433-46; and Nathan Boidman,“Final Foreign Affiliate Amendments: Bill C-70” (April 14, 1995), 24 Tax ManagementInternational Journal 191-204.


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treaty country,” thereby ensuring that exempt surplus treatment will applyonly in situations where tax treaties are ultimately ratified. In addition,the regulations were amended to require that, in addition to being residentin a treaty country under the common law principle of management andcontrol, a foreign affiliate must generally be “resident” as defined in theapplicable treaty.50

• Finally, a number of changes were made to the specific anti-avoidancerule dealing with circumstances in which shares or rights to acquire sharesare issued, acquired, or disposed of, with a view to strengthening theapplication of the provision.

In summary, the 1995 amendments were significant indeed: they sub-stantially expanded the definition of “FAPI” and introduced proposals toprotect the Canadian tax base.

OTHER COUNTRIES’ APPROACHESBefore addressing the current state of Canadian tax law relating to thetaxation of foreign affiliates, it is instructive to consider the approachesof Canada’s major trading and treaty partners. The following is an over-view of the international tax regimes in place in Australia, France,Germany, Japan, the Netherlands, Switzerland, the United Kingdom, andthe United States.51

Taxation of Dividend IncomeWith respect to dividends received by a home-country corporate investorfrom foreign corporations in which the investor has a significant interest(referred to in this section as “foreign participations”), all of the coun-tries named above use either the credit or the exemption method. Japan,the United Kingdom, and the United States have opted for the creditmethod, under which credit is generally given both for foreign withhold-ing taxes imposed on dividend payments and for a proportionate amountof foreign income taxes applicable to the earnings out of which the divi-dends are paid. The credit method tends to be exceedingly complex, andmay result in a tax system that is less competitive than one that uses theexemption method. France, the Netherlands, and Switzerland all use theexemption method, under which dividends received from foreign

50 Draft regulation 5907(11.2)(a), in the January 23, 1995 draft amendments, suprafootnote 6, subject to the exceptions noted above in footnotes 7 and 8 and accompanyingtext. Note that in view of the rationale adopted by the Supreme Court in The Queen v.Crown Forest Industries Limited et al., 95 DTC 5389 (SCC), it is arguable that an affiliatemay be “liable to tax” under the terms of a tax treaty, and therefore a resident of acontracting state under certain of Canada’s tax treaties, even if its income is exempt fromtax in the other contracting state as a result of domestic tax incentives.

51 For a more detailed comparison of various international tax regimes as they existedat the time, see Brian J. Arnold, The Taxation of Controlled Foreign Corporations: AnInternational Comparison, Canadian Tax Paper no. 78 (Toronto: Canadian Tax Founda-tion, 1986).


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participations are exempt from any further tax in the home country.52

Australia and Germany operate both systems (as does Canada, with itsexempt and taxable surplus regimes). Australia generally provides ex-emption for dividends received from foreign participations in listedcountries,53 while dividends out of profits not previously taxed on anattribution basis and received from foreign participations in unlisted coun-tries are eligible for foreign tax credit (including indirect credit for taxeson underlying profits out of which the dividends were paid). In Germany,the method used will generally depend on whether the foreign participa-tion is in a treaty or non-treaty country. Dividends received in Germanyfrom foreign participations in treaty countries are generally eligible forexemption, subject to restrictions contained in certain tax treaties (forexample, several treaties subject the exemption method to an activityproviso); dividends received from foreign participations in non-treaty coun-tries are generally eligible for credit, including indirect credit for taxeson underlying profits.

Deductibility of InterestThe treatment of interest on funds borrowed to invest in foreignparticipations is another important aspect of any international tax regime.Six of the eight countries named above provide for interest deductibility(as does Canada), whether they are on an exemption or credit system.Australia (in the case of foreign participations in listed countries) and theNetherlands are the only countries that deny interest deductions on fundsthat have been borrowed to invest in foreign participations. In France,Japan, the United Kingdom, and the United States, there are generally norestrictions that apply with respect to the deductibility of interest on fundsborrowed to invest in foreign participations (except with respect to anythin capitalization or analogous provisions that may apply).54 In Germanyand Switzerland, some restrictions may apply, depending on the circum-stances. In general terms, interest that would otherwise be deductible in aparticular year is reduced by the amount of exempt dividends received inthat year—in Germany to the extent that the interest expense can bespecifically traced to funds borrowed to acquire the foreign participation,

52 Certain conditions must be met for the participation exemption to apply in the Neth-erlands—the share in the non-resident corporation may not be a portfolio investment, theshareholding must consist of at least 5 percent of the nominal paid-up capital of thenon-resident corporation, and the non-resident corporation must be subject to a local prof-its tax (the rate of tax is unimportant). In cases where exemption is not available underdomestic rules in France, the Netherlands, or Switzerland, credit is generally available forforeign withholding taxes applicable to the dividends (but not for indirect taxes).

53 Over 60 countries have been listed for the purposes of these rules, and are generallycountries (including most of Australia’s tax treaty partners) which the Australian authori-ties regard as having tax regimes comparable to that of Australia.

54 However, in the cases of Japan and the United States, interest expense must beallocated between domestic gross income and foreign source income for the purposes ofdetermining the entitlement to foreign tax credits, and to the extent that interest expense isallocable against foreign source income, available foreign tax credits may be reduced.


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and in Switzerland to the extent that the interest expense is allocable toforeign participations according to balance sheet values. The state of thelaw in Germany is somewhat unsettled, however, and the result of anappeal pending before the German Federal Tax Court is expected to clarifythe issue.55 In both Germany and Switzerland, planning alternatives, in-cluding the appropriate timing of dividend payments, may significantlyreduce the amount of any non-deductible interest.

Annual Attribution of IncomeThe third significant component of any international tax regime is the rulesrelated to the attribution and current taxation of tainted income, analo-gous to the Canadian FAPI rules. Six of the eight named countries—theNetherlands and Switzerland being exceptions56—have enacted legislationwhereby a proportionate amount of tainted income earned by a foreignparticipation is attributable to the home-country investor, and taxable ona current basis, if the income is not subject to a sufficient amount of for-eign tax and/or is earned in unlisted countries,57 and in addition is definedas tainted income under the particular home-country regime. In generalterms, attribution applies in France if the foreign tax system is privileged(generally, if the effective foreign tax rate is lower than two-thirds of theFrench corporate tax rate that would have applied on the income). Attri-bution applies in Germany on income that is taxed at a rate of less than30 percent, in Japan when the effective foreign tax rate is equal to or lessthan 25 percent, and in the United Kingdom if the foreign tax rate is lessthan 75 percent of the UK tax rate.58 The United States has a “high-tax”exception, which allows a US taxpayer to elect to exclude from subpart Fincome most foreign base company income, if the effective rate of for-eign tax exceeds 90 percent of the US corporate tax rate. Finally, attributionapplies in Australia to passive income earned in unlisted (generallylow-taxed) countries, and on specified income earned in listed countries,where the income is subject to zero or other concessional tax treatment.

55 On September 8, 1994, the Tax Court of Baden-Wurttemburg, in upholding earlierdecisions of the German Federal Tax Court, held that interest expense on debt incurred forthe acquisition of foreign participations is deductible for years in which the taxpayer didnot receive exempt dividends (3K294/91). However, the decision is based on income taxlaw that was subsequently amended, and an appeal of the decision is pending before theFederal Tax Court (1R167/94).

56 Although a Netherlands corporation that has an interest of 25 percent or more in a“passive foreign investment company” is required to revalue its interest to fair marketvalue on an annual basis.

57 The Canadian FAPI rules, by contrast, apply irrespective of the country in which theincome is earned or the rate of tax that has been imposed by the foreign country (although,as previously discussed, deduction is given for foreign accrual tax applicable to amountsincluded in FAPI).

58 In addition, the UK Board of Inland Revenue has published a “white list” of coun-tries (with certain carve-outs for tax-favoured entities) where attribution will generally notapply, provided that 90 percent or more of the foreign income is derived from sources inthe country in which the foreign participation is resident and carrying on business.


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The nature of income subject to attribution varies from country tocountry. The rules in certain countries, such as France, Germany, Japanand the United Kingdom, generally provide that any income earned by aforeign participation that is taxed at less than the stipulated rate is subjectto attribution, but then provide detailed rules related to exempt activitiesor other relief.59 Australia and the United States essentially use the re-verse approach, first providing detailed definitions of tainted income thatis subject to attribution, and then creating various exceptions and reliefprovisions. In Australia, the rules are further complicated by the fact thatthe definition of “attributable income” varies according to whether theincome is earned in a listed or unlisted country. While the approaches andthe rules may vary, two underlying themes are common to all countries,and are consistent with Canada’s approach. First, the rules are often ex-ceedingly complex. Second, all of the attribution regimes tend to targetincome from financial and other services, as well as income where thecorresponding cost reduces the tax base in the home country.

ASSESSMENT OF CURRENT LAWWhile the detailed Canadian tax rules governing the taxation of foreignaffiliates may at times seem almost baffling, an assessment of current lawinvolves some fairly basic questions: What is the underlying policy ra-tionale? Is the policy rationale appropriate in the Canadian context, andconsistent with international norms and standards? Is the current legisla-tion consistent with the underlying policy intent?

What Is the Underlying Policy Rationale?As summarized in the response of Finance to the auditor general’s report,Canada has sought to balance the divergent goals of “capital export neu-trality” and “capital import neutrality.” Finance states that it is impossibleto reconcile these competing goals with respect to the same sources ofincome, and that Canada has implemented a system that ensures thatcertain income (FAPI) is taxed at Canadian domestic rates (capital exportneutrality). To preserve the international competitiveness of Canadianbusiness, however, it has opted for an exempt surplus system with respectto active business income that is not FAPI, thereby limiting the tax burdenon that income to the same effective rate as that which applies to aresident of the foreign country (capital import neutrality). Finance statedthat the ability of Canadian corporate taxpayers to receive dividends fromexempt surplus of foreign affiliates on a tax-free basis is intended, atleast in part, as a proxy for the foreign tax credits that would have beenavailable if the Canadian company had carried on the business through a

59 In the United Kingdom, for example, income is exempt from attribution where theforeign participation is engaged in “exempt activities” as defined, and is not mainly engagedin prescribed, prohibited businesses. Exemption from UK attribution may also be availablewhere (1) the foreign participation pursues an acceptable distribution policy, (2) the foreignparticipation is publicly listed, or (3) the foreign participation passes a motive test (in prac-tice, this test is a difficult and uncertain exception, and one that is rarely satisfied).


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foreign branch rather than a subsidiary. In concluding this portion of itsresponse, Finance stated that, in formulating a policy with respect to thetaxation of foreign source income, it has had to recognize that there aresubstantial costs inherent in implementing a system that deviates substan-tially from international norms, and that, ultimately, Canada finds itselfin the position of having to balance tax theory with the economic realitiesof the international marketplace.

On the question of interest deductibility, Finance stated that the princi-pal concern raised in the auditor general’s report relates to interestdeductibility in Canada combined with an exempt surplus system. Fi-nance noted that, although the combination clearly does give rise to amismatching of income and expense, it also historically represents theinternational norm, and that departing from this norm would have a sig-nificant adverse impact on Canada’s international competitiveness.

Is the Policy Appropriate, and Is the Legislation Consistentwith Policy Intent?The Exemption SystemAs noted above, the exemption system has been in place, in one form oranother, for over 55 years under successive governments, and has surviveda long period of study and scrutiny as part of the 1972 tax reform process.It clearly accords with international norms; nonetheless, one must askwhether tax treaty countries that offer special incentives should be deniedexempt surplus treatment or, alternatively, whether there should be acarve-out for low-taxed entities or enterprise zones within those countries.There would be obvious practical difficulties with such a change, given thatfew countries fail to offer such incentives. Indeed, Canada is no exception:we provide special exemptions for international financial institutions lo-cated in Vancouver and Montreal and for international shipping corpora-tions, and incentives for investments in manufacturing and research anddevelopment. Special-status corporations such as non-resident-owned in-vestment corporations are yet another Canadian incentive. This having beensaid, the 1995 amendments ensure that, as treaties or protocols are nego-tiated in future, consideration will be given as to whether it is appropriateto accord exempt surplus status to tax-favoured entities in those countries.60

The 1995 amendments also ensure that this process will take place on adeliberate basis, and that each case will be considered on its merits.

Interest DeductibilityAs noted above, interest deductibility in respect of investment in bothCanadian and foreign subsidiaries was a specific policy initiative intro-duced as part of the 1972 tax reform. Before 1972, Canadian corporationshad been at a significant disadvantage with respect to their competitors inother countries, particularly the United States, as a result of the denial ofinterest expense. First, US companies and other foreign investors were

60 Supra footnote 8 and accompanying text.


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given a considerable advantage over Canadian investors when shares ofCanadian companies were put on the market. Second, Canadian corpora-tions were not able to compete effectively in the international marketplaceor expand in foreign markets. These impediments forced many Canadiancorporations to resort to “cash-damming” techniques to mitigate the ad-verse impact of the denial of interest deductibility.

Interest deductibility was added as a specific initiative as part of the1972 tax reform, and the dramatic decrease in the cost of capital thatresulted meant that Canadian corporations could now compete on a morelevel playing field. Many Canadian multinational groups are now majorplayers in the global market, and there seems to be little doubt that thishas strengthened the Canadian economy and created not only manufactur-ing jobs in this country, but also spinoff jobs in research and developmentand similar activities. Interest deductibility does, of course, result in asignificant cost to the Canadian treasury; this was recognized when thechange was introduced in 1972. However, as discussed above, most ofour major trading partners, whether they are on an exemption or a creditsystem, also allow for interest deductibility, and the economic conse-quences of any substantive change in this area would be both uncertainand hazardous. Accordingly, it was no surprise when the report issued byPAC recommended that Finance “move cautiously” in this area.61

The FAPI SystemThe concept of FAPI was significantly expanded by the 1995 amend-ments. As noted above, most (but not all) of Canada’s major trading andtreaty partners have enacted analogous provisions.

The auditor general’s report expressed concern that the limited caselaw indicated that, in the absence of a statutory definition, investmentincome might in many circumstances not be considered FAPI. This con-cern was echoed by the PAC report. However, these matters have nowbeen addressed by the introduction, in the 1995 amendments, of the defi-nitions of “active business,” “income from an active business” and “incomefrom property,” and the introduction of the concepts of investment busi-ness and attribution of income from trading or dealing in indebtedness(including the earning of interest). In addition to the foregoing, the 1995amendments went further than the auditor general or PAC had recom-mended by introducing additional statutory provisions that deemed activebusiness income to be FAPI where there was an erosion of the Canadiantax base. In summary, while Canada has, as a result of the 1995 amend-ments, an extremely extensive FAPI regime, one issue that some mightview as contentious relates to the provisions that operate to retain activebusiness characterization in situations involving interaffiliate paymentsor other transactions. To put these transactions in context, however, oneshould consider the following structure:

61 Readers will recall the proposed introduction of the concept of “restricted interestexpense” in the November 12, 1981 federal budget, a proposal that was abandoned afterattracting opposition, and amid much controversy.


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In this example, a Canadian corporation (Canco) owns 100 percent of aforeign operating company (Forco) that requires additional equity to ex-pand its active business operations. Rather than investing directly in Forco,Canco establishes a finance vehicle (Finco) in an appropriate jurisdiction,and invests in equity of Finco. Finco then lends at interest to Forco.Forco’s foreign taxes are reduced as a result of deductible interest ex-pense, and the interest income is taxable in Finco, but at substantiallyreduced rates as compared with those that apply in Forco’s home country.If the transaction is properly structured, clause 95(2)(a)(ii)(B) of the Actensures that Forco’s active business income is not transformed into FAPIas a result of the interaffiliate interest payments. Also, if Finco is residentin a treaty country (both under the common law principle of managementand control and as defined in the applicable treaty), and the interest ex-pense reduces Forco’s exempt surplus, the interest income will increaseFinco’s exempt surplus balance, and can now be paid to Canco as divi-dends without incurring Canadian tax. The result is a substantial reductionin foreign taxes.

If the rules were changed so that this type of financing structure wasno longer feasible, Canco could invest directly in Forco. Additional taxwould be levied in Forco’s home country, but exempt dividends wouldstill flow back to Canada. We would therefore have the same transaction,but, appropriately, no additional tax in Canada. Another possibility, ofcourse, is that Canco, now facing a significant reduction in its after-taxreturn, could be forced out of the foreign market altogether. A third pos-sibility is that any indebtedness required to finance the overseas activitiesmight be incurred directly in Forco, perhaps by third-party borrowings. Inmany cases, however, and having regard to Canada’s high corporate taxrates, the indebtedness will almost certainly be incurred in Canada, sothat no additional revenue would accrue to the Canadian tax treasuryfrom a change in the system.62

Canco

Finco ForcoLoan

62 It should be noted that the same type of planning is often available under the attribu-tion regimes in other countries. For example, section 954(c)(3)(A)(i) of the US InternalRevenue Code of 1986, as amended, provides, in general terms, exception from attributionfor interest received from a related corporation, where the payer and recipient are created

(The footnote is continued on the next page.)


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CONCLUDING COMMENTSThat’s the day that I’m going to roll all the dice.63

The 1995 amendments represented a significant tightening of the rulesgoverning the taxation of foreign affiliates, with respect both to the ex-emption system for dividends out of active business income and to FAPI.The result is current law that treads the fine line between preserving theintegrity of the Canadian tax base and the international competitivenessof Canadian business. As is the case with every other major industrializedcountry, Canada’s system for the taxation of foreign affiliates will alwayscontain elements that are more stringent and others that are more lenientthan those of its trading and treaty partners. Canada’s regime is consistentwith international norms and standards, and with the approaches of othercountries. Further, with an economic and capital base inferior to those ofmany of its trading partners, Canada requires a foreign taxation systemthat is at least as generous as those of its major competitors. While Fi-nance must be vigilant and must react to changes in Canadian businesspractices and to legislative and administrative developments in other coun-tries—and while there are certain transactions at the frontier that maymerit further study64—any changes should be as specific and targeted aspossible, and should not simply be imported from other countries.

Some would argue that the Canadian system still requires a completeoverhaul.65 In my view, this would be folly. The result would almostcertainly be a tax regime that rated as one of the most inhospitable tointernational expansion of any industrialized country, with no assurancethat the economic costs would not outweigh any revenue gains that mightensue. Those who trivialize the ability of Canadian corporations to emi-grate from Canada ignore those corporations that have already done so.More important, they ignore restructuring transactions whereby futuregrowth in foreign affiliates that are held by a Canadian entity can befrozen, with any future investment or any future growth from existinginvestment taking place outside Canada. Finally, they ignore the mobilityof young Canadian entrepreneurs with energy, creativity, and the abilityto accumulate or obtain capital, who may simply decide that it is moreappropriate to develop international operations from a more hospitablejurisdiction. This is not the time to roll the dice.

or organized under the laws of the same foreign country. These rules do not require,however, that the recipient be resident or subject to tax in the country in which it iscreated or organized, thus presenting obvious interaffiliate planning possibilities similar tothose used in the example in this paper (and which reduce foreign taxes, rather than thedomestic tax base in the United States).

63 Former Prime Minister Brian Mulroney, in an interview with The Globe and Mail,June 10, 1990, discussing the proposed Meech Lake accord. Meech Lake failed severaldays later, leaving Canada’s constitutional future in a state of disarray.

64 See, for example, Allan R. Lanthier, “Policy or Abuse? The Auditor General’s Re-port” (1993), vol. 41, no. 4 Canadian Tax Journal 613-38, at 629-31.

65 See Arnold, supra footnote 49, at 1036.

62 Continued . . .

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The Taxation of Foreign Affiliates - ctf.ca · THE TAXATION OF FOREIGN AFFILIATES 1605 (1995), Vol. 43, No. 5 / no 5 existing Canadian law. The article does not deal with other areas,