On May 7, 2009, Bermuda's Ministry of Finance announced that it will be signing a bilateral tax information exchange agreement ("TIEA") with Canada. This first TIEA for Canada is significant, as Canada will be extending an important benefit to Bermuda (i.e., active business income earned by a foreign affiliate residing in and carrying on business in a TIEA jurisdiction will now be included in "exempt surplus"); a benefit which was generally provided only to countries with which Canada has a comprehensive tax treaty. By entering into a TIEA, the contracting parties will provide mutual assistance through the exchange of tax-related information that is relevant to the administration and enforcement of the domestic laws of the contracting parties.


Canada has become increasingly concerned with Canadians using international tax-avoidance structures. In order to uncover these structures, OECD countries such as Canada have sought access to tax-related information from countries which do not have tax treaties ("non-treaty countries") as well as from countries with tax treaties, where the particular treaty has inadequate information exchange provisions.

On March 19, 2007, the Federal Budget (the "Budget") introduced a number of significant changes to Canada's foreign affiliate rules (i.e., modifying how Canada taxes foreign-source income). The most significant change is the added role that TIEAs play in Canada's foreign affiliate system.

The new TIEA rules provide for a significant departure from linking exempt surplus to the presence of a tax treaty (a system which has been in place since 1976). Under Canada's foreign affiliate rules, if a foreign affiliate earns active business income in a "designated treaty country" (i.e., a country with which Canada has a comprehensive income tax treaty), and pays a dividend to its Canadian corporate shareholder, the foreign affiliate's business earnings are deemed to be paid out of the foreign affiliate's exempt surplus, and the Canadian corporate recipient will not be required to pay Canadian tax, provided the foreign affiliate is resident in the jurisdiction that has a tax treaty with Canada. As an incentive for non-treaty countries to enter into TIEAs with Canada, the Canadian government has now extended the exempt surplus treatment to a foreign affiliate that is resident and carrying on business in a non-treaty country if that country enters into a comprehensive TIEA with Canada. Specifically, the definition of "designated treaty country" has been expanded to include a country with which Canada has entered into a comprehensive TIEA.

The Budget also expanded the scope of foreign accrual property income ("FAPI") to include active business income earned in a non-TIEA country when that country fails to conclude a TIEA with Canada within five years of being invited to do so. Generally speaking, if a non-treaty country does not agree to a TIEA within five years of being formally approached by Canada to do so, active business income earned in that jurisdiction by a controlled foreign affiliate will be treated as FAPI to the Canadian shareholder and taxed in Canada on an accrual basis. Again, this new regime marks a significant change in the policy underlying the foreign affiliate system from one based on the presence of tax treaties to one based on the presence of comprehensive exchange of information agreements.

Going Forward

For purposes of determining whether a foreign affiliate is generating exempt surplus, the foreign affiliate must be resident in a designated treaty country under the common law mind, management and control test (i.e., "common law test"), and it must also be resident in that country under the applicable tax treaty (generally speaking, this means the foreign affiliate is liable to tax in that country by reason of that person's domicile, residence, place of management, place of incorporation or any other criterion of a similar nature). If the foreign affiliate fails to satisfy both tests, it will not be a resident in the treaty country for purposes of calculating the foreign affiliate's surplus accounts. There appears to be a more stringent requirement placed on foreign affiliates in a treaty jurisdiction as compared to a TIEA jurisdiction, where only the common law test must be met.

This new regime creates a strange result in that it would be easier and more tax efficient for a foreign affiliate in a TIEA jurisdiction to receive exempt surplus treatment as compared to a foreign affiliate in an established treaty jurisdiction. For instance, an international business corporation which carries on an active business in Barbados will generally be taxed at the rate of 2.5%, while the same corporation carrying on the same business in Bermuda will pay no income tax.

It is not clear how these new changes will impact Canada's relationship with its existing treaty partners. Bermuda does not tax profits, dividends or income and it does not have capital gains tax, withholding tax or sales tax. It will not be surprising to see a number of Canadian-based multinationals shifting their existing foreign affiliates or establishing new ones in countries with zero or little tax, such as Bermuda based on the country's execution of a TIEA with Canada. This tax policy initiative seems to be at odds with other Canadian international tax policy objectives to discourage taxpayers from deferring Canadian tax by the use of tax havens.

It will be interesting to see what will happen in the coming months as Canada enters into more TIEAs, and how Canada's existing treaty partners will be affected and how they will react to this significant change in Canada's international tax policy.