Foreign Affiliate Surplus and Dividend Calculator
A dividend from a foreign subsidiary can reach a Canadian corporation completely tax-free, partly taxed, or with a cost base reduction that later becomes a gain. Which one depends on surplus accounts that most corporations have never computed. Estimate the position before the dividend is declared.
Canadian tax on the dividend
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The Surplus Accounts
| Account | Built From | Balance |
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How the Dividend Is Treated
| Portion | Deduction | Paid Out | Canadian Tax |
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The Full Cost of Bringing the Money Home
| Item | Basis | Amount |
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Points That Decide This
What to Do Next
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Disclaimer: A dividend received by a corporation resident in Canada from a foreign affiliate is included in income under section 90 of the Income Tax Act and a deduction is then available under section 113 according to the surplus account from which the dividend is prescribed to have been paid. Under the Income Tax Regulations, exempt surplus generally includes the active business earnings of an affiliate resident in, and carrying on business in, a country with which Canada has a tax treaty or a tax information exchange agreement; taxable surplus generally includes other earnings, including passive income and active income earned elsewhere; hybrid surplus arises from certain capital gains; and dividends paid in excess of those balances are generally deemed paid out of pre-acquisition surplus. Paragraph 113(1)(a) permits a full deduction for exempt surplus dividends; paragraphs 113(1)(b) and (c) permit deductions for taxable surplus dividends by reference to underlying foreign tax and withholding tax respectively, grossed up by the relevant tax factor; and paragraph 113(1)(d) permits a deduction for pre-acquisition surplus dividends, which reduce the adjusted cost base of the shares under subsection 92(2) and give rise to a gain under subsection 40(3) where that cost base would otherwise become negative. The ordering of surplus accounts, the elections available under the Regulations, the calculation of the relevant tax factor, the treatment of hybrid surplus and the computation of each balance are considerably more detailed than this estimator models, which uses simplified single-period balances and ignores hybrid surplus, foreign exchange, deficits and elections. Surplus accounts must be computed from the affiliate’s actual history in accordance with the Regulations. The rates, the relevant tax factor and the inclusion rate used here are defaults that should be confirmed. This page is general information, not tax advice.
The Same Dividend, Three Different Outcomes
A Canadian corporation receiving a dividend from a foreign subsidiary includes it in income and then claims a deduction. How large that deduction is depends entirely on which surplus account the dividend is treated as coming from, and that is decided by the affiliate’s history rather than by anything written on the dividend resolution.
Most owner-managed corporations with a foreign subsidiary have never computed those accounts. They find out the answer when a dividend has already been paid.
| Paid Out Of | Built From | Canadian Result |
|---|---|---|
| Exempt surplus | Active business income in a treaty or information exchange country | Fully deductible, no Canadian tax |
| Taxable surplus | Passive income, and active income earned elsewhere | Deduction limited by foreign tax paid |
| Pre-acquisition surplus | Anything beyond the other balances | Deductible, but reduces the cost base |
Exempt Surplus Is Where the Value Is
Active business income earned by an affiliate resident in a country with which Canada has a tax treaty or information exchange agreement builds exempt surplus. A dividend out of exempt surplus is fully deductible, so it arrives in Canada free of Canadian corporate tax.
That is the outcome most structures are built around. It reflects the view that income already taxed in a country with a proper tax system should not be taxed again when it comes home.
Both conditions matter. The affiliate has to be resident in a qualifying country and the income has to be active business income earned there. A subsidiary in a treaty country earning passive income, or earning active income through a branch somewhere else, does not build exempt surplus with it.
Taxable Surplus Is Taxed Unless Foreign Tax Covers It
Taxable surplus comes from income that did not qualify as exempt. A dividend out of it is still deductible, but only to the extent that foreign tax has already been paid, grossed up by the relevant tax factor to reflect what the Canadian rate would have been.
The practical effect is that where the foreign tax already paid is at or above the Canadian rate, little or no Canadian tax remains. Where the income was lightly taxed abroad, Canada collects the difference when it comes home.
This is the same passive income that FAPI reaches. Passive income of a controlled foreign affiliate is generally taxed in Canada as it is earned, under the foreign accrual property income rules, and the surplus rules then prevent it being taxed a second time on distribution. The two regimes work together rather than overlapping.
Pre-Acquisition Surplus Is a Deferral, Not a Gift
Where a dividend exceeds the exempt and taxable balances, the excess is generally treated as coming out of pre-acquisition surplus. It is fully deductible, which looks like the best outcome of the three.
It is not free. A pre-acquisition dividend reduces the adjusted cost base of the shares instead of being taxed. Where the reductions take the cost base below zero, the negative amount is treated as a capital gain at that point, and even where they do not, the lower cost base means a larger gain whenever the shares are eventually sold.
A large dividend from a newly acquired or undercapitalised affiliate is where this bites. With little surplus accumulated since acquisition, most of the dividend comes out of pre-acquisition surplus, and a modest cost base can be exhausted in a single payment. The resulting gain arrives in the year of the dividend.
The Order Matters
Dividends are generally treated as paid out of exempt surplus first, then hybrid, then taxable, and then pre-acquisition. That ordering usually works in the corporation’s favour, and elections are available in some circumstances to change it.
But it means the size of the dividend matters as much as the balances. A dividend sized to the exempt surplus balance arrives tax-free. The same affiliate paying a larger dividend can push the excess into taxable or pre-acquisition treatment and produce a very different result.
Withholding Tax Is Charged on the Way Out
The source country usually withholds tax on the dividend itself, at a treaty-reduced rate where one applies. On an exempt surplus dividend that withholding is simply a cost, since there is no Canadian tax against which it could be credited.
On a taxable surplus dividend the withholding is grossed up and deducted, which offsets Canadian tax on that portion. So the same withholding rate has a different effective cost depending on which account the dividend came from.
What This Estimator Does Not Cover
- Hybrid surplus, which arises from certain capital gains and has its own deduction
- Surplus deficits, which reduce balances and have their own ordering consequences
- Foreign exchange on balances maintained in the affiliate’s calculating currency
- Elections under the Regulations to alter the order in which surplus is paid out
- Multi-tier structures, where surplus passes up through several affiliates
- The actual computation, which requires the affiliate’s history from acquisition
Surplus accounts are much cheaper to maintain annually than to reconstruct. Our international tax planning service covers computing the balances from the affiliate’s history, sizing dividends to the exempt surplus available, and managing the cost base where pre-acquisition treatment cannot be avoided.
Frequently Asked Questions
Common questions on dividends from foreign subsidiaries.
Related Calculators and Guides
More tools for Canadian corporations with foreign subsidiaries.
Compute the Surplus Before the Dividend, Not After
Send us the affiliate’s financial statements and tax returns since acquisition, and the dividend you are planning. We will compute the surplus balances, size the dividend to the exempt surplus available, and tell you whether any of it will grind the cost base.