29 June 2012 Internal T.I. 2012-0441601I7 - "directly or indirectly"

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.

Principal Issues: Whether, subparagraph 95(2)(a)(ii) (as it applies to taxation years that begin before 2009) would apply to include the interest payment on Loan 1 received by a non-resident corporation in computing its income from an active business?

Position: No

Reasons: There is only one payment of interest in this case from a non-resident corporation which does not carry on an active business.

							June 29, 2012

	Monique Poirier					Income Tax Rulings
	Auditor - International Tax and Non-Residents	Directorate
	305 Boulevard René-Lévesque West 		Angelina Argento
	Montreal QC  H2Z 1A6				(514) 283-7895

							2012-044160 

Foreign Affiliates – Subparagraph 95(2)(a)(ii) of the Act

This is in response to your email dated March 29, 2012, wherein you asked us whether, in the facts provided below, subparagraph 95(2)(a)(ii) of the Income Tax Act (“Act”) (as it applies to taxation years that begin before 2009) would apply to include the interest payment on Loan 1 received by Luxco in computing Luxco’s income from an active business? Our understanding of the facts (which is based on the email you sent) is as follows:

1. Mereco is a corporation which is not resident in Canada within the meaning of the Act.
2. Mereco does not carry on an active business.
3. Canco is a corporation which is resident in Canada.
4. Luxco is a corporation which is resident in Luxembourg.
5. US Co is a corporation which is resident in the United States.
6. US Co carries on an active business in the United States.
7. Mereco owns 100% of the issued and outstanding shares of Canco.
8. Canco owns 100% of the issued and outstanding shares of Luxco and US Co.
9. Luxco made an interest bearing loan to Mereco (“Loan1”);
10. Mereco used the funds received from Loan1 to make a non-interest bearing loan to US Co (“Loan2”).
11. US Co uses the funds in an active business it carries on in the United States.

OUR COMMENTS

Subparagraph 95(2)(a)(ii)

(as it read in its application to taxation years that begin prior to 2009):

For taxation years, of a foreign affiliate of a taxpayer, that end after 1999 and begin before 2009, subparagraph 95(2)(a)(ii) provides, in part, as follows:

“(a) in computing the income or loss from an active business for a taxation year of a particular foreign affiliate of a taxpayer in respect of which the taxpayer has a qualifying interest throughout the year or that is a controlled foreign affiliate of the taxpayer throughout the year, there shall be included any income or loss of the particular foreign affiliate for that year from sources in a country other than Canada that would otherwise be income or loss from property of the particular foreign affiliate for the year to the extent that
(ii) the income or loss is derived from amounts that were paid or payable, directly or indirectly, to the particular foreign affiliate ….
(A) by
(I) a non-resident corporation to which the particular foreign affiliate and the taxpayer are related throughout the year ….

to the extent that those amounts that were paid or payable are for expenditures that would, if the non-resident corporation … were a foreign affiliate of the taxpayer, be deductible by it in computing the amounts prescribed to be its earnings or loss for a taxation year from an active business (other than an active business carried on in Canada)” or

(B) by
(I) another foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest throughout the year…

to the extent that those amounts that were paid or payable are for expenditures that were deductible by the other foreign affiliate …. in computing the amounts prescribed to be its earnings or loss for a taxation year from an active business (other than an active business carried on in Canada).”

Clause 95(2)(a)(ii)(A)

Pursuant to clause 95(2)(a)(ii)(A) interest paid or payable by a related non-resident corporation to a foreign affiliate (that would otherwise be income from property) will be re-characterized as active business income to the extent that the interest paid or payable would be deductible by the non-resident corporation in computing the amount prescribed to be its earnings or loss from an active business carried on outside Canada on the assumption that the non-resident corporation was a foreign affiliate of the taxpayer.

According to the facts in your email, Mereco is a non-resident corporation to which Canco is related throughout the year and Canco has a qualifying interest (footnote 1) in Luxco. Absent the application of subparagraph 95(2)(a)(ii), the interest income derived by Luxco from Loan 1 is income from property. In order for the interest paid or payable in respect of Loan1 to be re-characterized as active business income of Luxco pursuant to clause 95(2)(a)(ii)(A), the interest paid or payable by Mereco in respect of Loan1 must be for expenditures that are, or would be if Mereco were a foreign affiliate of Canco, be deductible in the year or a subsequent year in computing the amounts prescribed to be Mereco’s earnings or loss from a non-Canadian active business. Since Mereco neither earns income from an active business nor any income that would, if it were a foreign affiliate of Canco, be re-characterized by paragraph 95(2)(a) of the Act to be income from an active business, the interest it pays to Luxco cannot be viewed as deductible in computing such income. As a result, clause 95(2)(a)(ii)(A) does not apply.

Clause 95(2)(a)(ii)(B)

Pursuant to clause 95(2)(a)(ii)(B) interest paid or payable by another foreign affiliate of the taxpayer in which the taxpayer has a qualifying interest throughout the year will be re-characterized as active business income to the extent that the interest paid or payable is deductible by the foreign affiliate in computing the amount prescribed to be its earnings or loss from an active business carried on outside Canada.

In your situation, although Canco has a qualifying interest in US Co, since Loan2 is a non-interest bearing loan, there is no interest payment made by US Co (which is deductible in computing its non-Canadian active business income) which could be re-characterized as active business income of Mereco. As well, although the words “directly or indirectly” in subparagraph 95(2)(a)(ii) are meant to deal with back-to-back loan arrangements (footnote 2) , since Loan2 is non-interest bearing, there is no indirect interest payment by US Co which is deductible from its income from an active business carried on in the US, which could be traced from US Co to Luxco. Thus, the conditions of clause 95(2)(a)(ii)(B) are not satisfied in your situation.

Conclusion

Since there is only one payment of interest in this case from a non-resident corporation (Mereco) which does not have any income from an active business, such interest cannot be re-characterized as active business income of Luxco by virtue of the provisions of subparagraph 95(2)(a)(ii).

We trust that these comments will be of assistance.

Yours Truly,

Olli Laurikainen
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 As that term is defined in paragraph 95(2)(m).
2 Wallace G. Conway, "The New Foreign Affiliate Provisions: The Department of Finance's Perspective," Report of Proceedings of Forty-Seventh Tax Conference, 1995 Tax Conference (Toronto: Canadian Tax Foundation, 1996), 40:1-7 at 40:3, Question 5 Finance’s view.