• The foreign affiliate is resident in a country listed in the income tax regulations as a designate country with a tax treaty in force with Canada.
• Dividends are paid out of the foreign affiliate's "exempt surplus"

The "Exempt surplus" is defined as:

• Earnings from active business activities carried out from the affiliate's permanent establishment. (Thus interest earned from the deposit of funds in a bank account does not come within the definition of exempt surplus.)
• Certain capital gains;
• Dividends received by the foreign affiliate from the exempt surplus of other affiliates.

Thus dividends remitted to a Canadian parent by an Irish affiliate which manufactures goods for export to the UK market and which enjoys a tax holiday under Irish laws will not be taxed in the hands of the Canadian corporate entity. (N.B. A characteristic of double taxation treaties is to define certain categories of income as exempt surplus income which qualifies for tax free repatriation).

Budget 2007 had this to say with regard to the exempt surplus rule:

"Although its mismatch with interest deductibility has been a long-standing problem, the 'exempt surplus' rule in itself is a key competitive advantage of the Canadian tax system. The rule allows a Canadian company to earn business income through a foreign affiliate in any tax-treaty country, and bring that income back to Canada, with no Canadian tax. Since the only tax on this business income will be that paid to the foreign country in which it is earned, the system ensures that Canadian firms are able to operate on a level playing field with their foreign competitors.

With the proposal above to resolve the interest deductibility problem, it is no longer necessary to link the exemption to the presence of a tax treaty. In the current environment, it is more appropriate to link the exemption to the presence of a comprehensive exchange of information agreement.

Budget 2007 therefore proposes to extend the exemption to active business income from non-treaty jurisdictions as well as treaty countries, provided those jurisdictions agree to exchange tax information with Canada. This will give Canadian firms more scope to expand internationally, especially into new and emerging markets, without our tax system imposing additional costs that could reduce their competitiveness, while also maintaining tax fairness. It will also encourage non-treaty jurisdictions to join in the efforts of Canada and our treaty partners to control international tax evasion."

In December 2008, the Advisory Panel on Canada’s System of International Taxation made the following recommendations with regards the taxation of outbound foreign direct investment from Canada:

• Broaden the existing exemption system to cover all foreign active business income earned by foreign affiliates.
• Pursue tax information exchange agreements (TIEAs) on a government-to-government basis without resort to accrual taxation for foreign active business income if a TIEA is not obtained.
• Extend the exemption system to capital gains and losses realized on the disposition of shares of a foreign affiliate where the shares derive all or substantially all of their value from active business assets.
• Review the “foreign affiliate” definition, taking into account the Panel’s other recommendations on outbound taxation, the approaches of other countries, and the impact of any changes on existing investments.
• In light of the Panel’s recommendations on outbound taxation, review and undertake consultation on how to reduce overlap and complexity in the anti-deferral regimes while ensuring all foreign passive income is taxed in Canada on a current basis.
• Review the scope of the base erosion and investment business rules to ensure they are properly targeted and do not impede bona fide business transactions and the competitiveness of Canadian businesses.
• Impose no additional rules to restrict the deductibility of interest expense of Canadian companies where the borrowed funds are used to invest in foreign affiliates and section 18.2 of the Income Tax Act should be repealed.

In response to the panel's report, Finance Minister Jim Flaherty announced the following in the 2009 budget in January:

• Interest Deductibility: Section 18.2 of the Income Tax Act, scheduled to come into force in 2012, constrains the deductibility of interest in certain situations where a Canadian corporation uses borrowed funds to finance a foreign affiliate and a second deduction for that interest is available in the foreign jurisdiction. Early action is being taken in relation to the Panel’s recommendation concerning section 18.2 because of the conclusions of the Panel on the potential effects of the provision on foreign investment by Canadian multinational firms, particularly in the context of the current global financial environment. Accordingly, it is proposed that section 18.2 be repealed.

• Non-Resident Trusts and Foreign Investment Entities: Outstanding proposals for non-resident trusts and foreign investment entities, first introduced in the 1999 Budget, apply in respect of arrangements under which Canadian residents seek to avoid Canadian tax through the use of foreign intermediaries under circumstances designed to circumvent the application of existing anti-avoidance rules. The government has received submissions, including the Panel’s recommendations, on these proposals; the government supports the fundamental policy objective of ensuring that Canadian taxpayers should not be able to avoid paying their fair share of income tax through the use of foreign intermediaries, but will review the existing proposals in light of these submissions before proceeding with measures in this area.

• 2004 Foreign Affiliate Proposals: The government will consider the Panel’s recommendations relating to foreign affiliates before proceeding with the remaining foreign affiliate measures announced in February 2004, as modified to take into account consultations and deliberations since their release.

On 4 March 2010, Finance Minister Jim Flaherty presented the 2010 budget in which it was stated that: "The Government would, in response to submissions by the Panel and others, review its outstanding proposals with respect to tax issues associated with foreign investment entities and non-resident trusts before proceeding with measures in this area. As a result of this review, the Government is initiating a consultation process for revised proposals on which commentary is welcomed and encouraged. The revised proposals would replace the outstanding proposals relating to foreign investment entities with several limited enhancements to the current ITA and substantially modify the outstanding proposals with respect to non-resident trusts in order to better target and simplify them."