1 November 2001 External T.I. 2001-0110945 - Deemed active business income

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: Application of clause 95(2)(a)(ii)(A) to a specific fact pattern

Position: see detailed response

Reasons: see detailed response

2001 TEI Round Table

Question 11

Foreign Affiliate Rules

Please consider the following hypothetical situations:

Part 1

Canco has two foreign affiliates, FA1 and FA2. Canco has a "qualifying interest" in FA1 but does not have a qualifying interest in FA2. Both FA1 and Canco are related to FA2. FA1 makes a loan to FA2, the interest on which is deductible in computing FA2's earnings from an active business. Will CCRA accept that clause 95(2)(a)(ii)(A) applies to recharacterize the interest income earned by FA1 as income from an active business notwithstanding that FA2 is a foreign affiliate of Canco?

Part 2

Canco owns 100 percent of FA1. FA1 is an operating company that has excess cash that it invests with NR1, a related company that is not a foreign affiliate of Canco and in which Canco does not have a qualifying interest. NR1 performs a group treasury function whereby it obtains money from related cash-rich companies and either deposits the cash with arm's-length financial institutions or lends it to related cash-poor companies for use in their active business. The volume of NR1's borrowing and lending activity makes it impossible to track which portion of FA1's cash has been deposited with arm's-length financial institutions and which portion has been lent to related companies. Will CCRA permit taxpayers to use a "fungibility" approach to determine the amount recharacterized under clauses 95(2)(a)(ii)(A) and (B) as having been paid indirectly by the cash-poor related companies? For example, assume on average that 30% of NR1's cash is on deposit with arm's-length financial institutions and 70% is lent to related companies. Will CCRA consider that 70% of FA1's interest income is deemed to be income from an active business?

CCRA Response

Part 1

The fact that FA2 is a foreign affiliate of Canco and that Canco does not have qualifying interest is FA2, would not preclude the application of clause 95(2)(a)(ii)(A) to recharacterize the interest income earned by FA1 as income from an active business.

Part 2

In this case, the analysis leads us through two potential ways in which clause 95(2)(a)(ii)(A) might apply. That is, one must consider whether interest income derived by FA1 would qualify under clause 95(2)(a)(ii)(A) if it were considered to be derived from amounts paid directly to it by NR1 and if not, whether the income would qualify if it were considered to be derived from amounts paid indirectly to it by the other related non-resident corporations which borrow money from NR1.

If the interest income derived by FA1 was considered to have been derived from payments made directly by NR1, it would not satisfy the tests in clause 95(2)(a)(ii)(A). The conditions in the postamble to clause 95(2)(a)(ii)(A) require that the payment made by NR1 to FA1 be deductible by it in computing its earnings from an active business if NR1 were a foreign affiliate of Canco. If NR1 were a foreign affiliate of Canco, its business would be an investment business because it appears to be conducted principally with persons with whom it does not deal at arm's length. Income derived from an investment business is income from property. In addition, none of such income from property of NR1 would be recharacterized as income from an active business under clause 95(2)(a)(ii)(A), even under the notion that NR1 was a foreign affiliate of Canco, because the preamble to paragraph 95(2)(a) requires that the taxpayer has a "qualifying interest" in the foreign affiliate. The postamble to clause 95(2)(a)(ii)(A) asks us to consider the result only under the assumption that NR1 was a foreign affiliate. It does not ask us to assume that Canco has a "qualifying interest" in NR1. As a result, none of the income of NR1 would be income from an active business if it were a foreign affiliate of Canco and therefore the income of FA1 would not qualify under clause 95(2)(a)(ii)(A) if it were considered to have been derived directly from payments made by NR1.

If the interest income of FA1 can be traced to amounts that were paid indirectly by other non-resident corporations to which both FA1 and Canco are related and which, under the assumptions in the postamble of clause 95(2)(a)(ii)(A), would be deductible in computing such corporations' earnings from an active business, the provisions of clause 95(2)(a)(ii)(A) would nevertheless be satisfied. However, the CCRA takes a restrictive interpretation in this situation effectively requiring a back-to-back loan arrangement where the interest income derived by NR1 from a loan to a non-resident corporation is specifically earmarked for payment by NR1 to FA1. In this case, as such tracing of the payments does not appear possible, none of the of the income derived by FA1 would satisfy the provisions of clause 95(2)(a)(ii)(A).

In actual cases where clause 95(2)(a)(ii)(A) applies, the CCRA would generally examine the facts to determine whether section 17 applies or where it has been circumvented whether the GAAR could be applied.

Prepared by:	Tim Kuss
		International section

Date:		November 2001

File #		2001-011094