On August 19th, 2011, the Department of Finance released for public consultation a package of amendments to the foreign affiliate rules in the Income Tax Act (Canada) (the "ITA") and related regulations.1 Included among these proposals are a series of new provisions (the "upstream loan rules") designed to restrict the use of loans as a mechanism to distribute funds from certain types of foreign affiliates to their Canadian shareholders to avoid the tax that would otherwise be paid on dividend distributions by such affiliates.2 Under the current rules, such loans can be used to distribute profits to a Canadian taxpayer, thereby enabling the taxpayer to avoid receiving a dividend from a foreign affiliate that would be, at least partially, subject to Canadian income tax.

Conceptually, these proposed amendments will operate in a manner similar to the existing rules in subsection 15(2) that apply to shareholder loans, in that they will require, subject to certain exceptions, all or a portion of an upstream loan that is received by a Canadian taxpayer (or certain other persons) to be included in the taxpayer's income.

Main Rule

Subject to certain exceptions, where a specified debtor in respect of a Canadian resident taxpayer receives a loan from (or otherwise becomes indebted to) a foreign affiliate of the taxpayer, the specified amount in respect of the loan/indebtedness (the "Loan") will be required to be included in the taxpayer's income for the year in which the Loan was made. For these purposes, a specified debtor is defined to include the Canadian resident taxpayer and persons (other than certain controlled foreign affiliates of the taxpayer) that do not deal at arm's length with the taxpayer.3 A specified amount in respect of a Loan is essentially the proportion of the principal amount of the Loan that is equal to the Canadian resident taxpayer's equity interest in the foreign affiliate making the Loan. These measures will apply to all Loans that are outstanding on or after August 20th, 2011.


The general rule described above will not apply if: (a) the shareholder loan rules in subsection 15(2) apply; (b) the Loan was made in the ordinary course of business of the lending affiliate and bona fide arrangements were made to repay the Loan within a reasonable period of time, or (c) the Loan is repaid within two years of the day on which the Loan was made (provided that the repayment was not part of a series of loans and repayments). As a transitional measure, any Loan that was outstanding on August 19th, 2011 will be deemed to have been made on that date, thereby starting the two-year "run time" on the date that these proposed amendments were publicly announced.


There are two rules that potentially enable a taxpayer to claim a deduction to fully or partially offset an income inclusion required in a particular taxation year in respect of a Loan. First, a Canadian resident taxpayer will generally be able to deduct an amount equal to its pro rata share of the portion of the Loan that was repaid by the debtor. Second, the proposed amendments enable the taxpayer to claim a deduction to the extent that the following three conditions are satisfied:

  1. The taxpayer is able to establish that all or a portion of the Loan, if paid directly or indirectly as a dividend, would have been received by it on a tax-free basis through the application of the deductions in paragraphs 113(1)(a), (a.1) and (b).4 In other words, there would be no tax avoidance motive for undertaking the upstream loan transactions since the taxpayer would have been able to repatriate the funds without incurring Canadian income tax.
  2. While the Loan is outstanding, no dividends are paid to the taxpayer (or other Canadian residents with which the taxpayer does not deal at arm's length) by foreign affiliates of the taxpayer that are relevant for the determination of an amount under the first condition (i.e., paragraph (a), above).
  3. While the Loan is outstanding, no other loan or indebtedness is made or incurred that relies on the same surplus amounts as the Loan for satisfying the first condition (i.e., paragraph (a), above). In other words, for the purposes of applying the first condition, any particular amount of surplus balance can only "support" one loan or amount of indebtedness - double counting is not permitted.

Since each of these three conditions must be satisfied for each taxation year of the taxpayer during which the Loan is outstanding, any amount deducted by the taxpayer under this provision will be included in the taxpayer's income for the subsequent taxation year. The same deduction (or the repayment deduction) would then be potentially available for each subsequent taxation year to the extent that its conditions of application are satisfied.

Certain Issues

There appear to be several issues with the proposed upstream loan rules including the following:

  • The rules do not provide for an offsetting tax deduction to the extent that the amount of a Loan is "supported" (see paragraph (a) in the previous section) by either a taxpayer's pre-acquisition surplus (i.e., outside basis) or foreign-accrual property income (i.e., FAPI) that has previously been subject to Canadian income tax, in each case, in respect of a foreign affiliate.
  • It is not clear why the rules provide for the absolute prohibition against foreign affiliates (whose surplus balances are supporting a deduction in respect of a particular Loan) paying dividends while a particular Loan is outstanding (i.e., the second condition in paragraph (b) in the previous section). Presumably, there would be no mischief in paying a dividend if the paying foreign affiliate had sufficient surplus balances in excess of those supporting the particular Loan.
  • The proposed rules appear to have the potential to apply more broadly than to achieve their stated policy objective. For example, under a scenario where one foreign affiliate borrows money from an upper-tier affiliate and then on-lends the money to a lower-tier affiliate (i.e., a back-to-back loan scenario), it is possible for both such loans to be included in the income of the Canadian shareholder even if they, in economic terms, represent the same funding. In addition, these rules seem to apply to loans that couldn't reasonably be characterized as a synthetic surplus distribution (i.e., where an upper-tier affiliate of a Canadian shareholder makes a loan to a lower-tier affiliate with funds obtained from the non-Canadian parent company).