CRA finds that the connection test in XXIX-A(3) of U.S. Treaty can be satisfied by funding interest to a non-qualifying U.S. parent, on a loan whose use had nothing to do with a connected Canadian business, out of the cash flows generated by that business

Para. XXIX-A(3) of the Canada-U.S. Treaty lets a U.S. resident which is not a qualifying person access Treaty benefits (e.g., no withholding on non-arm’s length interest) if it satisfies a three-prong active trade or business test.  One of these tests (the "Connected Test") is that the item of income, for which the Treaty benefit is sought, is derived from the source state (Canada) in connection with or incidental to the (U.S.) actively-conducted trade or business of the U.S.  person - including any such income derived directly or indirectly by that U.S. person through a person that is resident in Canada.

A U.S. person who was not a qualifying person (US-Holdco1) lent money to a direct or indirect Canadian subsidiary (Canco, carrying on a connected business) to help fund the purchase by Canco (through an intermediate structure) of a non-North American target.  CRA considered that the Connected Test could be satisfied so as to permit the interest on the loan to enjoy the Treaty exemption, even though the lent money was not used in Canco's business, if the interest payments were funded out of the cash flow from that business.  Conversely, if the interest payments to US-Holdco1 were partially funded from foreign affiliate dividends, no relief would be available under para. XXIX-A(3).

Neal Armstrong.  Summary of 5 November 2015 Memo 2013-0496401I7 under Treaties - Art. 29A.