Tax Insights: Finance releases draft legislation to amend the Pillar Two rules and integrate the foreign affiliate regime with Pillar Two

Issue 2025-30

In brief

What happened? 

On August 15, 2025, the Department of Finance released draft legislation to amend the Income Tax Act (ITA) and the Global Minimum Tax Act (GMTA). The draft legislation includes:

• new foreign affiliate rules in the ITA to ensure the appropriate amount of income or profits tax paid by a foreign affiliate (FA) of a taxpayer under a domestic minimum top‑up tax (DMTT) regime is taken into account in determining the deduction available to the taxpayer as foreign accrual tax (FAT) paid in respect of the FA’s foreign accrual property income (FAPI); the FA surplus regulations are also amended to specify how income or profits tax paid under DMTT regimes will be taken into account for purposes of surplus computations
• amended foreign tax credit rules in the ITA to ensure the appropriate amount of income or profits taxes paid by a taxpayer under DMTT regimes is considered in determining the amount of business income tax paid by a taxpayer
• amendments to the GMTA to implement certain concepts set out in administrative guidance published by the Organisation for Economic Co‑operation and Development (OECD), including rules that would restrict the ability to use certain deferred tax assets generated before the multinational enterprise (MNE) group is subject to the Pillar Two rules¹
• a new GMTA rule to implement a de‑consolidation in respect of MNE groups when there is a private Canadian corporation that holds controlling interests in one or more public Canadian corporations

The Department of Finance has requested that interested parties provide feedback on the draft legislation by September 12, 2025.

Why is it relevant?

The proposed changes to the ITA are intended to integrate the foreign affiliate regime and foreign tax credit rules with the GMTA. The proposed amendments to the GMTA relating to private investment entities could have wide‑ranging implications for Canadian private and public companies that are part of the same MNE group.

Actions to consider

MNEs that are subject to the GMTA should review these proposals and determine how they could affect their corporate and global minimum tax compliance obligations. Private investment entities and public companies controlled by private investment entities should consider how the proposed de‑consolidation rule will impact their Pillar Two compliance obligations.

In detail

ITA proposals

The ITA includes several rules that aim to prevent double taxation, by providing recognition for foreign income taxes paid by Canadian taxpayers or their subsidiaries. Specifically, when:

• a Canadian taxpayer has an income inclusion for FAPI of a controlled foreign affiliate, the FAT rules generally provide a deduction for the grossed‑up foreign tax paid on that FAPI
• a Canadian corporation receives a dividend from an FA, which is paid from the taxable surplus or hybrid surplus of that affiliate, the rules for underlying foreign tax (UFT) and hybrid underlying tax (HUT) generally provide a deduction for the grossed‑up foreign tax paid on that surplus
• a Canadian corporation earns foreign source income, the foreign tax credit rules generally provide a tax credit for the foreign tax paid on that income

The proposals amend each of these rules, to address taxes paid under the DMTT regimes of foreign jurisdictions.

DMTT regimes determine top‑up tax liability using a jurisdictional blending approach: the income and taxes of all members of an MNE group located in the jurisdiction are combined, to determine the total top-up tax for that jurisdiction. DMTT regimes may differ in how this total tax liability is allocated to the entities in the jurisdiction. Some regimes (such as the Canadian DMTT) allocate the tax liability on a pro‑rata basis, based on the amount of income or profits earned by each entity (as determined under the DMTT regime). Other DMTT regimes may use different allocation methods (e.g. allocations to entities that are under‑taxed under ordinary income tax regimes). The proposals therefore focus on allocating taxes paid under DMTT regimes to particular entities (and to particular types of income earned by those entities).

The proposed rules are effective as of August 15, 2025.

FAT and surplus amendments

The treatment of tax paid by a particular FA under a DMTT regime will be determined based on a two‑part test:

• Income or profits test: The tax must be in respect of the income or profits earned by the particular FA (as determined under the DMTT regime). This test follows the allocation of taxes to entities under the DMTT regime: if an amount of top‑up tax is allocated to the particular FA under the rules of the DMTT regime, that tax amount is considered to be in respect of the affiliate’s income or profits for purposes of the FAT and surplus rules.
• Activities test: To be considered a tax paid in respect of FAPI (or a particular surplus balance), the tax must be in respect of income or profits that are derived from the activities that generate the FAPI (or the particular surplus balance). For example, if a particular FA carries on both active business activities and FAPI‑generating activities, only top‑up taxes paid on income arising from the FAPI‑generating activities is included in FAT. Likewise, if an FA carries out activities that generate taxable surplus and activities that generate exempt surplus, only top‑up taxes paid on income deriving from the taxable surplus‑generating activities is included in UFT.

Taxes paid under a particular DMTT regime will not be considered FAT, UFT or HUT, if that DMTT regime takes into account taxes paid under the ITA (other than withholding tax under Part XIII of the ITA). This means that the effective tax rate (ETR) and top-up tax computations under the DMTT regime cannot take into account Canadian income tax payable under the ITA. Essentially, the DMTT regime must take precedence over the Canadian income tax regime.

The proposals include several supporting rules, such as the following:

• In some DMTT regimes, one member of the MNE group (the primary affiliate) pays top‑up tax on behalf of other group members (the secondary affiliates). If a secondary affiliate makes a compensation payment to the primary affiliate, for tax paid on the secondary affiliate’s income or profits that are derived from FAPI‑generating activities, the compensation payment will generally be treated as FAT of the secondary affiliate. This rule is based on the surplus rules for tax consolidation regimes, which are discussed below.
• Special rules apply for surplus purposes when a primary affiliate pays taxes under a DMTT regime on behalf of secondary affiliates. These rules are similar to the existing surplus rules for tax consolidation regimes in Regulations 5907(1.1) to (1.13). The primary affiliate is deemed to only pay the tax relating to its own activities. The remaining tax reduces the surplus balances of the primary affiliate based on the surplus account of the secondary affiliates to which that tax relates. If a secondary affiliate makes a payment to the primary affiliate in respect of its tax liability, this payment is deemed to be tax paid by the secondary affiliate, and increases the surplus balances of the primary affiliate. Therefore, if top‑up tax is paid in respect of the taxable surplus or hybrid surplus of a secondary affiliate, a UFT or HUT deduction will be available only if the secondary affiliate makes a compensation payment to the primary affiliate.
• Other rules apply when income or profits earned by one member of an MNE group (the transparent affiliate) are allocated to an upper‑tier group member (the shareholder affiliate) under the DMTT regime. These rules are similar to the existing surplus rules for tax transparent entities in Regulations 5907(1.091) and (1.092). The shareholder affiliate is deemed to only pay the tax relating to its own activities. The remaining tax is considered tax paid by the transparent affiliate, which is allocated to its surplus balances based on the activities to which the tax relates. In contrast to the rules for tax consolidation regimes, the transparent affiliate does not need to make compensation payments to the primary affiliate to get UFT or HUT treatment for taxes paid by the shareholder affiliate in respect of amounts included in its taxable surplus or hybrid surplus.
• The top‑up tax computation under a DMTT regime includes all group entities located in that jurisdiction, which may include entities that are not FAs (e.g. entities that are part of the MNE group, but are not directly or indirectly owned by a Canadian group member). These entities are deemed to be FAs for purposes of the allocation rules discussed above. All activities of the deemed FAs are deemed to be activities that would generate exempt surplus, so any top-up tax arising from these activities is considered tax in respect of exempt surplus.

Foreign tax credit amendments

A foreign DMTT regime may impose tax on income of a Canadian taxpayer (e.g. if the taxpayer earns income through a foreign permanent establishment). The foreign tax credit proposals set out rules for claiming foreign tax credits for these taxes. These rules are on a two‑part allocation test, similar to the tests in the FAT and surplus proposals discussed above.

• Income or profits test: The tax must be payable in respect of the Canadian taxpayer’s income or profits (as determined under the DMTT regime). If the DMTT regime actually determines the amount of tax that is payable by the Canadian taxpayer in respect of its income, that allocation is followed for this test. If the DMTT regime does not make an allocation, the taxpayer is allocated a portion of the total tax paid by the MNE group under the DMTT regime, based on the taxpayer’s share of the group’s total income (as determined under that regime).
• Activities test: The tax payable under a DMTT regime will be allocated to a business carried on in the particular country (and therefore eligible for the business income tax credit in subsection 126(2) of the ITA) if that tax is in respect of income or profits derived from activities, the income from which would be included in computing the taxpayer’s income from carrying on a business in the country. Taxes in respect of other foreign income or profits may be eligible for the non‑business income tax credit in subsection 126(1) of the ITA.

Taxes paid under a particular DMTT regime will not be eligible for foreign tax credits, if that DMTT regime takes into account taxes paid under the ITA (other than withholding tax under Part XIII of the ITA).

GMTA proposals

Private group de-consolidation

The proposals introduce a de‑consolidation rule for certain MNE groups in which a Canadian private entity controls a Canadian public company.

This rule applies to an MNE group that includes a “private investment entity.” A private investment entity is a Canadian entity that is not publicly listed and has a controlling interest in a Canadian public company. The private investment entity prepares financial statements under Canadian Accounting Standards for Private Enterprises (ASPE), and chooses to prepare non‑consolidated financial statements (a choice permitted under ASPE). Therefore, the private investment entity does not prepare consolidated financial statements that include the public company.

For GMTA purposes, an MNE group generally consists of an ultimate parent entity (UPE) and the entities that are included in the UPE’s consolidated financial statements. The GMTA rules include a “deemed consolidation test,” which applies to entities that do not prepare actual consolidated financial statements. This test essentially asks whether the particular entity would consolidate with other entities, if it did prepare consolidated financial statements. Because of this test, the composition of an MNE group for GMTA purposes can differ from the consolidated group that is recognized for financial reporting purposes. Under the existing rules, the private investment entity in the scenario described above would generally be the UPE of an MNE group that includes the public company, even though it does not prepare actual consolidated financial statements that include the public company.

The proposals change this result, by effectively deconsolidating the private investment entity and the public company for GMTA purposes. The proposed rule applies to a qualifying MNE group (i.e. a group that is subject to the GMTA rules) that includes a private investment entity. The private investment entity, together with any privately held subsidiaries, are deemed to be a separate MNE group (the private group); the public company and its subsidiaries form a second MNE group (the public group). Each group is deemed to be a qualifying MNE group. For example, the private group will be in‑scope for the GMTA rules, even if its annual revenue falls below the EUR 750 million threshold. An anti‑avoidance rule prevents the deeming rule from applying if any transaction is undertaken with the main purpose of causing the deeming rule to apply.

The private group and the public group will therefore prepare separate top‑up tax calculations. It appears that the private group and the public group will also be treated as separate MNE groups for other purposes of the GMTA (e.g. for purposes of the transitional country-by-country reporting (CbCR) safe harbour and the Global Anti-Base Erosion (GloBE) Information Return). It is not clear whether other jurisdictions will introduce similar de‑consolidation rules in their Pillar Two legislation. If other jurisdictions do not adopt similar rules, this could produce conflicts between the GMTA and foreign Pillar Two regimes.

Other measures

The proposals include other amendments to the GMTA, which largely implement recent changes to the Commentary and Administrative Guidance on the GloBE Model Rules published by the OECD. These include:

• rules for the cross‑border allocation of deferred tax amounts
• changes to the rules for:
  • allocating profits and taxes in structures involving flow‑through entities or hybrid entities
  • allocating taxes payable under blended CFC regimes
  • recapture relating to deferred tax liabilities
• rules addressing:
  • divergences between the carrying value of balance sheet items for GloBE and accounting purposes
  • certain “excluded deferred tax assets,” which are ignored for purposes of the GloBE transition rules and the transitional CbCR safe harbour (with a grace period allowing recognition for 20% of certain deferred tax assets)

For more information on these changes, see our Tax Policy Alerts discussing the Pillar Two Administrative Guidance released by the OECD in December 2023, June 2024 and January 2025.

All of the GMTA proposals apply retroactively to the original effective date of the GMTA (i.e. to taxation years of qualifying MNE groups that begin after December 30, 2023).

The takeaway

The GMTA proposals for private investment entities could significantly affect Canadian public companies that are controlled by Canadian private entities. Affected taxpayers should review how these proposals may impact their top‑up tax liabilities and tax compliance obligations. The ITA proposals dealing with foreign tax credits and deductions for taxes paid under DMTT regimes are broadly similar to the existing rules for recognizing foreign income taxes. However, taxpayers that are subject to foreign DMTTs should review the rules in detail to assess the impact on their groups.

1. For more information, see our Tax Policy Alert “OECD publishes Pillar Two GloBE administrative guidance package.”