The March 2012 federal budget introduced a new rule that significantly restricts a Canadian subsidiary owned by a foreign corporation from investing in a foreign affiliate (FA). The new rule applies to a debt, equity, and similar investment in an FA, including one that is wholly owned by a Canco, and it applies irrespective of the source of funding for the investment. The only exception to the rule is for a bona fide business investment; the budget outlines factors to be considered in applying the business purpose test.
The rule applies to an investment made in an FA or in a corporation (whether or not related) that becomes an FA as a result of the investment. The investment may be in the form of an acquisition of an FA’s shares or debt (or an option to acquire shares or debt) or of a capital contribution to an FA. The rule also applies to indirect acquisitions undertaken through the continuance of a corporation into Canada.
If the business purpose test is not met, the FMV of the consideration paid by the Canco, other than shares issued by it, is deemed to be a dividend paid by it to its foreign parent, and withholding tax applies. If shares are issued by the Canco, there is no resulting PUC increase, which suppresses both the thin capitalization limit and room for future repatriation.