Mr. X, a Canadian resident, owns 100% of Canco which owns 100% of the shares (having a low ACB) of Foreignco, which is required by the income tax law in its country of residence to compute its income from its active business carried on therein. The proceeds of a life insurance policy (previously acquired by Foreignco) received by it upon the death of Mr. X are exempt under the local tax law and also would be exempt if received in Canada. Into which surplus account will they go? After stating that it is "conceivable" that "in very rare cases" the proceeds might be viewed as income pertaining or incident to the active business, CRA went on to state:
[T]here are no facts provided as to why a life insurance policy was acquired by Foreignco on the life of Mr. X and therefore no basis to conclude the policy was related to Foreignco's active business. If that is the case, the life insurance proceeds would not be added to "earnings" from an active business of Foreignco under paragraph 5907(2)(f) of the Regulations. … As no amount is included in the computation of income under the provisions of the Act, no amount could be included as FAPI. Therefore, the life insurance proceeds received by Foreignco would not be included in its taxable surplus pool. Accordingly, the life insurance proceeds … would form part of Foreignco's pre-acquisition surplus pool.
If no exempt, hybrid, or taxable surplus is available any dividend paid by Foreignco will be determined to be paid out of Foreignco's pre-acquisition surplus and a capital gain will be triggered by virtue of subsection 40(3)… .