CRA applies a pro-rating approach to money borrowed from an affiliate to return capital used to fund both exempt and non-exempt activities

Where FA1 borrows from a sister (FA3) to make a capital distribution on its Class A common shares, which had previously been issued solely to finance FA1’s active business, CRA would accept that the interest on this loan would be received as deemed active business income by FA3 under s. 95(2)(a)(ii)(B), on the basis that it was deductible in computing FA1’s earnings from an active business under Reg. 5907. This would be so even if FA1 had issued shares of another class (its Class B common shares), to finance the acquisition of shares which were not excluded property, at the same time as it issued the Class A common shares – so that even though CRA did not articulate it this way, a tracing approach evidently is accepted.

In the situation where FA1 was required to compute its income (pursuant to Reg. 5907(1) – earnings – (a)(iii)) under Part I of the Act, CRA indicated that the interest was deductible under s. 20(1)(c) “because the borrowed funds replaced capital that…had been used by FA1 for the purpose of earning income from an active business,” whereas in the situation where the earnings were computed pursuant to (a)(i) or (iii) of the earnings definition under local tax law and the interest was non-deductible under such law, CRA laconically stated that the interest would be deductible under Reg. 5907(2)(j) without explicitly indicating that it was applying the fill-the-hole approach here as well.

If instead, shares of only one class had been issued to fund the two (good and bad) uses of funds, as to 80% and 20%, respectively, CRA would consider that “the portion to which clause 95(2)(a)(ii)(B) applies should be determined on a pro-rata basis based on the current use of the capital (i.e., prior to its replacement with the borrowed funds)…[so that] 20% of the interest income of FA3 would not be recharacterize.” as active business income.

Neal Armstrong. Summary of 26 May 2016 IFA Roundtable Q. 8, 2016-0642041C6 under s. 95(2)(a)(ii)(B).