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.
942987
XXXXXXXXXX Olli Laurikainen
(613) 957-2116
Attention: XXXXXXXXXX
April 25, 1995
Dear Sirs:
Re: Subparagraph 95(2)(a)(ii) of the Income Tax Act
This is in response to your facsimile dated November 21, 1994 wherein you request our views concerning the application of subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act") under the following hypothetical set of facts.
1) A is a corporation resident in Canada.
2) B and C are wholly owned subsidiary corporations of A, resident in the United States.
3) B makes an interest bearing loan (the "Loan") to C. The interest paid by C to B on the Loan:
a) is added to the cost of inventory property of C in computing its income from an active business for the purposes of the IRS Code (in which case when the inventory is sold, the cost of the property including the portion attributable to the interest, will be deducted in computing the earnings of C from an active business for the purposes of the IRS Code)
b) is added to the cost of a depreciable capital asset (in which case the depreciation deducted under the IRS Code in computing the earnings of C from an active business over the life of the asset will include an amount equal to the capitalized interest provided the asset is not sold),
or
c) is added to the cost of a non-depreciable capital asset used in the active business of C.
4) Subject to the application of subparagraph 95(2)(a)(ii), the interest income derived by B on the Loan represents passive income and would be included in computing its foreign accrual property income.
You question whether under the above circumstances, subparagraph 95(2)(a)(ii) of the Act would apply to cause the interest on the Loan to be included in computing the active business income of B.
It would be necessary to review the relevant U.S. legislation and the circumstances of a particular case in order to reach a definitive conclusion. However, assuming that the rules of the I.R.S. Code governing the treatment of cost of goods sold and depreciable capital property are substantially the same as those in Canada we provide the following general comments.
Interest is Added to the Cost of Inventory or a Depreciable Capital Asset
In our view, where the interest on the Loan is included in the cost of inventory or is added to the cost of a depreciable capital asset, subparagraph 95(2)(a)(ii) of the Act will apply to characterize the interest received by B on the Loan as income from an active business in the year it is received notwithstanding it would generally not reduce the earnings of C from an active business for the purposes of section 5907 of the Regulations of the Act (the "Regulations") until it sells the inventory property or depreciation is allowed under the IRS Code in respect of the interest included in the cost of the depreciable capital asset. In the event that C ceases to be a foreign affiliate of A before the inventory property is sold or the depreciable asset is fully depreciated, it is our view that subparagraph 5907(2)(j)(i) of the Regulations will apply to reduce the earnings of C from an active business for the year the interest was first paid or payable by the amount of capitalized interest remaining in the affiliate's assets at the time the affiliate is sold. In the event a depreciable capital asset (the cost of which has been increased by an amount in respect of interest) is sold before it has been fully depreciated for tax purposes, the circumstances of the sale will have to be examined to determine whether and to what extent subparagraph 5907(2)(j)(i) should then have application to the taxation year in which the interest was paid or became payable. For example, if a depreciable capital property is sold for its undepreciated capital cost, a deduction under subparagraph 5907(2)(j)(i) of the Regulations equal to the interest reflected in such undepreciated capital cost would be required. On the other hand, in the event the property is sold for less than its undepreciated capital cost subparagraph 5907(2)(j)(i) may, depending upon the circumstances, apply to lesser a amount.
Under proposed clause 95(2)(a)(ii)(B) of the Act as set out in Bill C-70 which received first reading in the House of Commons February 16, 1995 ("Bill C-70"), the interest would also be included in computing the income from an active business of B. However, pursuant to the provisions of proposed subsection 5907(2.7) of the Regulations, the interest would be deducted by C in computing its earnings from an active business for the purposes of section 5907 of the Regulations, in the year it first becomes paid or payable. When the inventory is sold or a deduction is taken in respect of the cost of a depreciable capital property, the earnings of C 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 subsection 5907 of the Regulations, to the extent that cost of goods sold or the deduction in respect of the cost of a depreciable capital asset includes interest that was deducted pursuant to proposed subsection 5907(2.7) of the Regulations in an earlier year.
Interest is Added to the Cost of a Non-depreciable Capital Asset
In our view where the interest on the Loan is added to the cost of a non-depreciable capital asset used in the active business of C, it would be deductible by C in computing the its "earnings amount" pursuant to subparagraph 5907(2)(j)(i) of the Act in the year the interest is paid. Accordingly, subparagraph 95(2)(a)(ii) would apply to include the interest received by B in its income from an active business. Proposed subparagraph 95(2)(a)(ii) which is set out in Bill C-70 also provides for this same result.
We trust this is the information you require.
for Director
Reorganizations and Foreign Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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