4 July 2002 External T.I. 2002-0141345 - 95 (2)(a)(ii)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Whether subparagraph 95(2)(a)(ii) would apply where the interest paid or payable by a foreign affiliate to another foreign affiliate is not deductible under the income tax law of country of the first-mentioned affiliate as a result of the thin capitalization rules therein?

Position: Yes.

Reasons: Subsection 5907(2)(j) would apply such that the interest paid or payable would be considered to be deductible in computing the earnings or loss of the payer affiliate from an active business income carried on by it.

XXXXXXXXXX 2002-014134
S. Leung
July 4, 2002

Dear XXXXXXXXXX:

Re: Subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act")

We are writing in response to your letter of May 13, 2002 in which you requested our confirmation that the interest earned by FA1 in the situation outlined below would be included in computing the income from an active business of FA1 pursuant to subsection 95(2)(a)(ii) of the Act.

The situation described in your letter is as follows:

1. A Canadian corporation has two foreign affiliates, FA1 and FA2.

2. FA1 lends money to FA2 which uses the money in its active business.

3. Due to the thin capitalization rules in the country in which FA2 resides and operates, the interest paid by FA2 to FA1 will not be deductible in any year by FA2.

Our Comments

The comments we offer below take into account the assumption that the Canadian corporation has a qualifying interest, within the meaning of paragraph 95(2)(m) of the Act, in FA1 throughout the year the interest is received by FA1.

It is our view that subparagraph 95(2)(a)(ii) of the Act would apply to include in computing the income from an active business of FA1 the interest income received from FA2 in the situation outlined above even though the interest expense incurred by FA2 is not deductible by FA2 in any year for income tax purposes in the country in which FA2 resides.

Subparagraph 95(2)(a)(ii) of the Act operates to include in computing the income of a foreign affiliate from an active business such income from foreign sources that would otherwise be income from property of the foreign affiliate to the extent that the income is derived from amounts that were paid or payable to the affiliate by another foreign affiliate and are for expenditures that were or would be deductible by the other affiliate in computing the amounts prescribed to be earnings or loss from an active business of the other affiliate.

Earnings or loss from an active business is prescribed under subsection 5907(1) of the ITR. While subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the ITR provides that earnings of a foreign affiliate from an active business are to be computed in accordance with the income tax law of the country in which the affiliate is resident, it also provides that such earnings amount is to be computed as adjusted by subsections 5907(2), 5907(2.1), 5907(2.2) and 5907(2.9) of the Income Tax Regulations (the "ITR"). Since it is assumed that the interest expense was incurred by FA2 in the situation outlined above for the purposes of gaining or producing income from an active business carried on by FA2, the disallowed interest expense would be deductible in computing the earnings from an active business of FA2 under subparagraph 5907(2)(j)(i) of the ITR. As a result, it is our view that the requirement in subparagraph 95(2)(a)(ii) of the Act regarding that the expense was or would be deductible by the other affiliate in computing the amount prescribed to be its earnings or loss from an active business is met and that the interest income earned by FA1 from FA2 would be included in computing the income of FA1 from an active business.

As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, the opinions expressed in this letter are not rulings and are consequently not binding on the Canada Customs and Revenue Agency.

Yours truly,

for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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