• the adjusted cost base to the 

taxpayer of its foreign affiliate shares 
is reduced by the amount of the 
distribution.

The tax payable by a corporation 
resident in Canada in respect of a 
dividend received from a foreign affiliate 
depends on the surplus account of the 
foreign affiliate out of which the dividend 
is paid. There are four surplus accounts: 

• exempt surplus,
• hybrid surplus,
• taxable surplus, and
• pre-acquisition surplus. 

Dividends paid by a foreign affiliate to 
a Canadian resident are deemed to be 
paid out of the surplus accounts in the 
following order:

• exempt surplus, 
• hybrid surplus, 
• taxable surplus, and 
• pre-acquisition surplus. 

A taxpayer may be able to vary the 
application of the dividend ordering 
rules by making an appropriate election. 
Pursuant to such an election, dividends 
may, in certain circumstances, be paid 
out of taxable surplus before exempt 
surplus, taxable surplus before hybrid 
surplus, and pre-acquisition surplus 
before exempt, hybrid, or taxable surplus. 

Dividends can be paid out of a 
particular surplus account only if the 
balance in that account exceeds the 
total of any deficit balances in the 
other surplus accounts. For example, 
dividends may be paid out of exempt 
surplus only to the extent that the 
amount of exempt surplus exceeds 
the total of any hybrid deficit and 
taxable deficit. A similar rule applies 
for dividends paid out of hybrid and 
taxable surplus. Pre-acquisition surplus 
is a residual concept – any dividend 

paid in excess of the net positive 
balance in the other surplus accounts 
is deemed paid from pre-acquisition 
surplus.

The amount of the tax payable by the 
Canadian resident on the dividend 
depends on the type of surplus from 
which the dividend is paid.

Exempt surplus of a foreign affiliate 
includes the active business income 
of the foreign affiliate that is earned in 
a treaty country or in a country with 
which Canada has a TIEA, provided that 
the foreign affiliate is also resident in a 
treaty country or a TIEA country. Exempt 
surplus also includes any capital gain 
from the disposition of property used 
in a qualifying active business, and the 
non-taxable portion of other capital gains 
(with the exception of gains included in 
hybrid surplus – see below). Dividends 
that are received by a Canadian-resident 
corporation out of a foreign affiliate’s 
exempt surplus are exempt from tax in 
Canada. 

Hybrid surplus includes the amount of a 
capital gain realized by a foreign affiliate 
on a disposition of a share of another 
foreign affiliate, a partnership interest, or 
a currency hedging contract that relates 
to certain excluded property. One-half 
of the amount of dividends received 
out of hybrid surplus is exempt, and 
the other half is taxable, subject to a 
deduction for a grossed-up amount of 
the foreign tax paid on the capital gain 
that generated the dividend and for 
any foreign withholding tax paid on the 
dividend itself.

Taxable surplus includes all other income 
earned by the foreign affiliate, including 
FAPI, as well as non-qualifying active 
business income. Taxable surplus 
also includes taxable capital gains that 
are not included in exempt surplus or 
hybrid surplus. Dividends received by 
a Canadian-resident corporation out 

of a foreign affiliate’s taxable surplus 
are taxable in Canada, subject to a 
deduction for the foreign tax paid on the 
income that generated the dividend and 
for any foreign withholding tax paid on 
the dividend itself.

Pre-acquisition surplus is a residual 
concept in that only dividends in excess 
of exempt, hybrid, and taxable surplus 
are deemed to arise from pre-acquisition 
surplus. Dividends from pre-acquisition 
surplus are exempt from tax in Canada, 
but unlike other surplus dividends, they 
reduce the tax cost of the shares of the 
foreign affiliate payer. If the cumulative 
pre-acquisition surplus dividends and 
returns of capital exceed such tax cost, 
a deemed capital gain arises.

The Upstream Loan Rules

It was previously common practice for 
foreign affiliates engaged in mining 
operations to repatriate amounts by way 
of loans to their Canadian parent or, if 
the Canadian parent was a subsidiary 
of a non-resident corporation, to the 
non-resident corporation. This technique 
avoided the Canadian tax that would 
have arisen on a dividend paid out of 
taxable surplus. 

The “upstream loan rules” seek to 
ensure that no Canadian tax benefit 
is obtained through the use of an 
upstream loan rather than a dividend. 
Where a foreign affiliate of a taxpayer 
makes a loan to a “specified debtor,” 
such as the Canadian-resident 
shareholder of the foreign affiliate or 
a person that does not deal at arm’s 
length with such shareholder, the 
taxpayer must include in income the 
“specified amount” of the loan. Where 
the “specified debtor” is the Canadian 
taxpayer, the “specified amount” is 
the product of the principal amount 
of the loan and the Canadian-resident 
shareholder’s direct or indirect equity 

© 2013 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms 
affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

 

Structuring Mining Investments 

|

 39