Envision a situation where a foreign corporation (“Forco”) buys all of the shares of a private Canadian corporation (“Canco”) for $10 million.
What happens if Canco generates profits, and Forco would like to use those profits to recover the $10 million cost of its investment in Canco?
Can Forco just take funds from Canco up to the amount of that cost without paying any Canadian withholding tax? It should be able to, since it is just trying to recover its cost, right?
Unfortunately, that is not the case. Any dividends that Canco pays to Forco will be subject to non-resident withholding tax under Part XIII of the Income Tax Act (“the Act”). The fact that Forco is just recovering its cost does not change that . The only amount that can be withdrawn tax-free is the “paid-up capital” of such shares, which, typically in Canadian private corporations, is only a nominal amount.
However, there is a way that Forco can recover its $10 million cost of acquiring the shares of Canco from the earnings generated by Canco without such recovery being treated as a dividend for the purposes of the Act. That way involves the creation of a Canadian subsidiary (“Canholdco”) of Forco to be the buyer of the shares.
Forco would contribute the funds that are needed to buy the Canco shares to Canholdco as either a loan or share capital (or a combination of both).
After the acquisition of Canco by Canholdco, earnings generated by Canco may be paid as dividends to Canholdco tax free . Those amounts received could then be paid by Canholdco to Forco tax free, as debt repayments and/or distributions of paid-up capital.
If desired, Canholdco and Canco could be merged on a tax-free basis  via a “statutory amalgamation”, which would allow tax-free payments to flow directly from the merged entity to Forco until the point where the $10 million cost was fully repatriated. This amalgamation could also allow deductible interest to be paid by the merged corporation to Forco on the outstanding debt payable to it .
What if Forco has already acquired the shares of Canco directly-can it now form Canholdco, and transfer the Canco shares for it in return for debt and/or high paid-up capital shares? Unfortunately, not-this strategy only works if implemented from inception .
 In certain cases, however, Forco can borrow funds from Canco with the loan remaining outstanding indefinitely. The rules regarding such “upstream loans” from a Canadian corporation to a foreign parent will be explored in a future article.
 Subsection 112(1) of the Act.
 Section 87 of the Act
 Subject to the application of Canada’s “thin capitalization” restrictions, which generally will require at least 40% of the original capital to be contributed as share capital, as opposed to debt.
 A transfer of the Canco shares by Forco to Canholdco will run afoul of section 212.1 of the Act, which will effectively prevent tax-free withdrawal of the cost of the Canco shares, except to the extent of the “paid-up capital” of those shares
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