The s. 212(3.7) formula can allocate a disproportionate part of a direct loan to Canco as being from a non-resident shareholder of the lender

The formula in s. 212(3.7) can operate as a boon or a bane where shareholder funding of a non-resident intermediary might be tainted by the connectivity test in s. 212(3.6)(a)(ii).

If Canco owes $30 to the intermediary and the intermediary, in turn, owes $40 in debt to a non-resident that is tainted under the connectivity test in s. 212(3.1)(c), then it does not matter that the intermediary has also been funded with tainted equity from another non-resident: the $40 non-resident creditor will be treated under the formula as the sole ultimate funder of the $30 direct loan to Canco.

On the other hand, if there instead is no indirect debt and the $30 direct debt to Canco is funded entirely or at least as to $20 out of surplus funds derived from the intermediary's operations, the shareholder of the intermediary effectively will be considered under the formula to have funded the entire amount of the $30 direct loan even though its share capital account was only $10 – so that Canco will be deemed under the formula to have paid all the interest under the direct loan to that shareholder.

Neal Armstrong. Summaries of Peter Lee, "The Character Substitution Rules", International Tax (Wolters Kluwer CCH), June 2017, No. 94, p. 10 under s. 212(3.7) and s. 212(3.6)(a)(ii).