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: How the current use approach would apply in analyzing clauses 95(2)(a)(ii)(B) and (D) to two specific examples.
Position: When the principles of paragraph 20(1)(c) are relevant in determining whether an amount paid or payable is deductible in computing earnings from an active business for purposes of clause 95(2)(a)(ii)(B), or in determining the use and purpose of borrowed money for purposes of clause 95(2)(a)(ii)(D), the current use approach can be relevant.
Reasons: See below.
2021 CTF Annual Conference
CRA Roundtable
Question 15: “Current Use” Approach and Clauses 95(2)(a)(ii)(B) and (D)
Where one foreign affiliate (“FA Finco”) of a taxpayer makes a loan to another foreign affiliate of the taxpayer, clauses 95(2)(a)(ii)(B) and (D) of the Income Tax Act (Canada) are often the provisions relied upon to deem interest income earned by FA Finco to be income from an active business. Please describe how the current use approach, developed by the courts in the context of interpreting subparagraph 20(1)(c)(i), would apply in the following examples.
Example 1:
FA Finco lends money to FA Acquireco LLC, which uses the money to purchase all of the shares of FA Target LLC from an arm’s length vendor. FA Target LLC merges into FA Acquireco LLC (the survivor) which is then renamed FA Mergeco LLC. After the merger, FA Mergeco LLC only earns income from carrying on an active business.
The shares of FA Acquireco LLC and FA Target LLC are excluded property and all of the properties of FA Acquireco LLC and FA Target LLC are excluded property. FA Acquireco LLC, FA Target LLC and FA Mergeco LLC are Delaware limited liability companies that have not elected to be taxed as corporations for U.S. tax purposes. FA Holdco is a corporation formed in Delaware that is taxed as a corporation for U.S. tax purposes.
Example 2:
FA Finco lends money to FA Holdco, which uses the money to purchase all of the shares of FA Target from an arm’s length vendor. Shares of FA Target are not excluded property (more than 10% of the fair market value of its assets are not excluded property). A few days after the acquisition of FA Target, FA Target and FA Opco merge and become FA Mergeco. On the merger, FA Holdco receives shares of FA Mergeco, replacing its shares of FA Target and FA Opco. After the merger, all or substantially all of the properties of FA Mergeco are excluded property.
CRA Response
In dealing with interest deductibility under paragraph 20(1)(c), courts have held, among other things, that in determining whether borrowed money is used for the purpose of earning income from a business or property, it is the current use of the money, and not the original use, that is relevant. Furthermore, a link must be established between the money that was borrowed and its current use. This is known as the current use approach. It is CRA’s longstanding position that the current use approach applied in the context of paragraph 20(1)(c) could also be relevant in the application of clauses 95(2)(a)(ii)(B) and 95(2)(a)(ii)(D).
The following describes how the current use approach would be applied in the examples provided in the question, in the context of clauses 95(2)(a)(ii)(B) and (D).
Example 1:
After the merger of FA Acquireco LLC and FA Target LLC, interest will be paid or payable by FA Mergeco LLC to FA Finco. In order to qualify for active business income recharacterization under clause 95(2)(a)(ii)(B) after the merger, one of the conditions is that the interest be deductible by FA Mergeco LLC in computing its earnings or loss for a taxation year from an active business (other than an active business carried on in Canada).
Since FA Mergeco LLC is a disregarded entity for U.S. tax purposes, pursuant to subparagraph (a)(iii) of the definition of “earnings” in subsection 5907(1) of the Income Tax Regulations, its earnings from an active business is the amount that would be the income from the active business for the year as computed under Part I of the Income Tax Act if the business were carried on in Canada and FA Mergeco LLC were resident in Canada. As a result, paragraph 20(1)(c) is relevant in determining whether interest is deductible in computing the earnings from an active business of FA Mergeco LLC.
After the merger, if the proceeds of the loan can be linked to a current eligible use (such as the property of FA Mergeco LLC which are used in an active business carried on by FA Mergeco LLC), the interest should be deductible in computing the earnings from an active business of FA Mergeco LLC, and the interest income recharacterized as income from an active business of FA Finco subject to all other requirements being satisfied.
Example 2:
One of the conditions in clause 95(2)(a)(ii)(D) requires that the money borrowed by FA Holdco from FA Finco be used for the purpose of earning income from property that are shares of a foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest and is excluded property of FA Holdco. Generally, the use of money borrowed for purposes of clause 95(2)(a)(ii)(D), is to be determined based on the principles that apply for purposes of paragraph 20(1)(c).
Prior to the merger, FA Holdco used borrowed money to purchase shares of FA Target. As a result of the merger, FA Holdco receives shares of FA Mergeco replacing shares of FA Target. A reasonable argument could be made that, for purposes of clause 95(2)(a)(ii)(D), the current use of the borrowed money is linked to the shares of FA Mergeco. To the extent that there is a reasonable expectation that FA Holdco receives dividends on the shares of FA Mergeco, that the shares of FA Mergeco are excluded property at all relevant times, and that FA Mergeco is a foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest at all relevant times, the “use” and “purpose” test described in subclauses 95(2)(a)(ii)(D)(I) and (III) should be met after the merger, and the interest income recharacterized as income from an active business of FA Finco subject to all other requirements being satisfied.
Gina Yew
2021-091192
November 25, 2021
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