interest in the lending foreign affiliate. 
If the “specified debtor” is another 
foreign affiliate of the Canadian-resident 
taxpayer, the “specified amount” is the 
product of the principal amount of the 
loan and the difference between the 
Canadian-resident shareholder’s direct 
or indirect equity interest in the lending 
and borrowing foreign affiliates. If the 
loan is repaid (other than as part of a 
series of loans or other transactions 
and repayments) within two years, the 
taxpayer is not required to include the 
“specified amount” in income. Where 
the taxpayer does have an income 
inclusion, the taxpayer is entitled to 
a deduction in the year in which the 
loan is ultimately repaid in proportion 
to the amount that was previously 
included in income. The rules provide 
for a five-year grandfathering period for 
loans outstanding on August 19, 2011.

Where a taxpayer has an income 
inclusion pursuant to the upstream 
loan rules, it may deduct all or a portion 
of such income inclusion under a 
special reserve-like mechanism. More 
specifically, the taxpayer may deduct a 
portion of the income inclusion if the 
taxpayer demonstrates that the portion 
would, were it paid to the taxpayer 
directly or indirectly by the foreign 
affiliate as dividends out of exempt, 
hybrid, taxable, or pre-acquisition 
surplus, reasonably be considered to 
have been deductible in computing 
taxable income. The taxpayer is required 
to add back into income its deduction for 
the immediately preceding taxation year, 
and may then claim a fresh deduction 
for the current year if the conditions 
for application continue to be met. The 
reserve mechanism does not reduce the 
surplus accounts of the foreign affiliate, 
but if those surplus accounts diminish 

for a taxation year while the loan 
remains outstanding, the taxpayer may 
realize an income inclusion.

The FAPI Rules

The purpose of the FAPI rules is 
to prevent the deferral of Canadian 
tax on passive property income 
earned offshore.

FAPI includes property income (e.g., 
interest, dividends, rents, and royalties), 
as well as income from an investment 
business and certain taxable capital 
gains. A Canadian resident is taxable on 
a current basis in respect of FAPI earned 
by a controlled foreign affiliate (but 
not a non-controlled foreign affiliate), 
whether or not the income is repatriated 
(distributed to the Canadian resident), 
subject to a tax credit for foreign taxes 
paid on the income. 

An investment business includes a 
business carried on by a foreign affiliate 
whose principal sources of income 
include:

• income from property, 
• income from the insurance or 

reinsurance of risk, 

• income from the factoring of 

receivables, or 

• profits from the disposition of 

investment property (including 
commodities and Canadian and 
foreign resource properties). 

A business (other than a business 
conducted principally with non-arm’s-
length parties) that derives income or 
profit principally from these sources 
may not be an investment business 
if it employs, alone or together with 
certain other related parties, more than 
five full-time employees in the business 

throughout the year. This exception 
does not apply to all types of “passive” 
businesses listed above (only certain 
listed types of activities qualify), 
although it should apply to royalties on 
foreign resource properties.

In some cases, income that would 
otherwise be FAPI is recharacterized as 
active business income for tax purposes, 
with the result that the FAPI rules do 
not apply. This occurs typically where 
the income is connected to an active 
business carried on by another foreign 
affiliate of the Canadian resident. For 
example, the interest income of a foreign 
affiliate derived from an intercompany 
financing arrangement with another 
foreign affiliate is not FAPI to the extent 
that the other foreign affiliate deducts 
the interest payment from its active 
business earnings. The same treatment 
will apply to royalty income where, for 
example, one foreign affiliate earns 
resource royalties paid by another foreign 
affiliate with an active mining operation. 

Canada has rules to prevent taxpayers 
from eroding the Canadian tax base by 
diverting income from Canadian-source 
activity to foreign affiliates. This income 
may relate to income from the sale of 
property, services, interest and leasing, 
and insurance and reinsurance. In such 
cases, the income is considered FAPI. 

The entitlement of a Canadian resident 
to deduct a tax credit for foreign taxes 
paid on FAPI is subject to the “foreign 
tax credit generator” rules. The foreign 
tax credit generator rules can deny a 
foreign tax credit where foreign taxes 
are incurred as a part of a transaction 
that involves a “hybrid instrument” that 
is characterized as equity for Canadian 
tax purposes but as debt under foreign 
tax law. These rules are intended to deny 

© 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.

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 A Guide to Canadian Mining Taxation