CRA finds that CFA1’s lending activity that depends on services provided by CFA2 is not directly related to that servicing activity under s. 95(2)(a)(i)(A)

The business of two US CFAs of Canco (FA4 and FA5 Subco) and of a US LP essentially wholly-owned by FA4 consisted mainly of acquiring, owning and collecting portfolios of debt receivables. FA4 had more than 100 employees who managed and operated the activities of FA4, FA5 Subco and LP, and other US group entities, and with the exception of one employee of FA4, these constituted the only employees in that group. LP used the equivalent of more than five full-time FA4 employees.

The Directorate indicated that FA4 appeared to have two separate businesses - a debt portfolio business, and a business of providing services to other foreign affiliates in the group – given inter alia that its services were mostly rendered to other foreign affiliates and thus not principally services rendered to FA4’s own debt portfolio business.

Focusing on the income of FA5 Subco from its debt portfolio for its 2014 taxation year, did s. 95(2)(a)(i) deem that income to be active business income rather than FAPI?

CRA surprisingly stated that the servicing activities of FA4 did not satisfy the directly-related test in s. 95(2)(a)(i)(A)(I) – notwithstanding that FA5 Subco relied on those services to carry on its business - since "[g]enerally, the activities of a customer [i.e., FA5 Subco as the customer of FA4’s servicing business] are detached from the activities of a service provider and one would not necessarily view them as directly related with the active business activities of the service provider … and [furthermore] the assets of FA5 Subco are not at risk or employed in support of the service business of FA4.”

However, the activities of FA5 Subco were directly related to FA4’s debt portfolio business since their respective debt portfolio activities were integrated activities that required the services of employees that had similar expertise, and they carried on the same type of debt portfolio business.

Furthermore, the prescribed active business earnings requirement in s. 95(2)(a)(i)(B) also appeared to be met, “since the income of FA5 Subco would be included in computing the amount prescribed to be the earnings or loss of FA4, from an active business carried on in a country other than Canada, if the income were earned by FA4.”

Similarly, the directly related test in s. 95(2)(a)(i)(A)(IV) appeared to be satisfied by FA5 Subco in relation to the debt portfolio business of LP for essentially the same reasons – and the prescribed active business earnings requirement in s. 95(2)(a)(i)(B) also appeared to be met, also for similar reasons.

If s. 95(2)(a)(i) applied as described above, so that the services fees paid by FA5 Subco to FA4 were deductible from deemed active business income of FA5 Subco rather than foreign accrual property income, s. 95(2)(b)(i)(B) would not apply to deem such services fees to be FAPI to FA4.

Neal Armstrong. Summaries of 18 April 2023 Internal T.I. 2020-0864031I7 under s. 95(2)(a)(i) and s. 4(1)(a).