14 March 1995 External T.I. 9407135 - FOREIGN AFFILIATES - 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 Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

		940713
XXXXXXXXXX	O. Laurikainen
		957-2116

Attention: XXXXXXXXXX

March 14, 1995

Dear Sirs:

Re: Subparagraph 95(2)(a)(ii) of the Income Tax Act

This is in reply to your letter dated March 16, 1994 wherein you request clarification regarding the application of the above provision in the following hypothetical situation.

1) A corporation resident in Canada ("Canco") is the sole shareholder of two corporations resident in the United States ("Usco1 and Usco2").

2) Usco2 carries on an active business in the United States in the course of which it purchases and develops land for resale.

3) Usco1 makes an interest bearing loan (the "Loan") to Usco2. Such Loan is not part of an active business carried on by Usco1 and accordingly subject to the application of subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act"), the interest thereon represents passive income to Usco1 and would be included in computing its foreign accrual property income. The funds are used by Usco2 in its active business.

4) Under the IRS Code, Usco2 is permitted to deduct only a portion of the interest on the Loan currently in computing its income from the active business, the remainder (the "Excess interest") is added to the cost of its land inventory. As a result, the Excess interest will reduce the income reported by Usco2 for U.S. income tax purposes in the year the land is sold.

You request our opinion whether the full amount the interest including the Excess interest, earned by Usco1 on the loan would be included in computing its active business income pursuant to subparagraph 95(2)(a)(ii) of the Act in the year it is earned.

In our view, subparagraph 95(2)(a)(ii) of the Act will apply to characterize the entire amount of the interest received by Usco1 on the Loan as income from an active business in the year it is received notwithstanding that the Excess interest would generally not reduce the earnings of Usco2 from an active business until it sells the property. In the event that Usco2 ceases to be a foreign affiliate of Canco before the property is sold, it is our view that subparagraph 5907(2)(j)(i) of the Regulations will apply to reduce the earnings of Usco2 from an active business by the amount of the Excess interest for the year in which the interest was paid or became payable.

Under clause 95(2)(a)(ii)(B) of the Act in the Revised Draft Amendments to the Income Tax Act issued January 23, 1995, the full amount of the interest would be included in computing the income from an active business of Usco1. However, draft subsection 5907(2.7) of the Regulations to the Act provides that where an amount is included in computing the income or loss from an active business of a foreign affiliate under subparagraph 95(2)(a)(i) or (ii) and the amount included is in respect of an amount paid by another non-resident corporation described in subparagraph 95(2)(a)(i) or (ii) (i.e. Usco2) in computing its earnings or loss from an active business, the amounts paid or payable shall be deducted in its taxation year that includes the earlier of the day on which the amount was paid and the day on which the amount became payable and not in any other taxation year. Therefore, pursuant to the provisions of subsection 5907(2.7) of the Regulations the full amount of the interest including the Excess interest would be deducted by Usco2 in the year it first becomes paid or payable. When the land is sold, the earnings of Usco2 from an active business as computed under the IRS Code would be adjusted upward in computing its earnings from an active business for the purposes of he Regulations to the extent that cost of goods sold includes interest that was deducted pursuant to subsection 5907(2.7) of the Regulations in an earlier year.

We trust this is the information you require.

Yours truly,

for Director
Reorganizations and Foreign Division
Rulings Directorate
Policy and Legislation Branch