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On December 20, 2002, the Canadian Department of Finance ("Finance"), which plays a similar tax policy role to that of the U.S. Department of the Treasury, released a package of proposed amendments to the Canadian federal Income Tax Act (the "ITA") and Income Tax Regulations (the "Regulations"). If enacted, these amendments would include a considerable number of changes to certain aspects of Canada's "CFC" rules, known as the "foreign affiliate" and "FAPI" rules.1 This article is intended to provide an overview of these proposed amendments.2
BACKGROUND
A foreign affiliate is a nonresident corporation in which a taxpayer resident in Canada has, either alone or together with related persons,3 a 10% or greater interest in any class of stock. Foreign affiliate status is generally a good thing in that it gives access to Canada's system of inter-corporate dividends-received deductions, pursuant to section 113 of the ITA, applicable to dividends from foreign corporations.
In effect, Canada actually has two such systems. The first operates as an exemption system, and is applicable to dividends received from foreign affiliates if two general conditions 4 are met:
* The foreign affiliate must be resident in a jurisdiction with which Canada has a comprehensive income tax convention; and
* The dividends must be paid out of earnings from an active business carried on in such a jurisdiction, or certain other specified amounts.
Such dividends, considered to be paid out of "exempt surplus," prescribed in subsection 5907(1) of the Regulations, give rise to deductions equal to the dividends received, regardless of the rate of foreign tax, if any, which may have been imposed on the dividends or on the underlying earnings being distributed, and it is in that sense that they are "exempt."
The second system operates as an effective foreign tax credit, and is applicable to all other dividends from foreign affiliates that are paid out of earnings.5 Such dividends, considered to be paid out of "taxable surplus," give rise to deductions equal to the foreign underlying and withholding taxes carried with the dividends grossed-up by a fraction that reflects the generally applicable corporate tax rate under the ITA. Thus, the dividends are "taxable" to the extent that the foreign taxes applicable to the dividends or to the underlying earnings...