21 May 1996 External T.I. 9526865 - 95(2)(A) - 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.

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.

Principal Issues:

Meaning of "directly or indirectly" in new paragraph 95(2)(a).

Position:

Question of fact. Would have to be able to directly trace payments.

Reasons:

Intent (and see 951744).

XXXXXXXXXX							952686

Attention: XXXXXXXXXX

May 21, 1996

Dear Sir:

Re: Paragraph 95(2)(a) of the Income Tax Act (Canada)

We are writing in response to your letter dated October 4, 1995 in respect of the application of 95(2)(a) of the Income Tax Act (Canada) (the "Act") to interest earned by a foreign affiliate.

You have presented a situation where a corporation resident in Canada (Canco) has a qualifying interest in a foreign affiliate (FA). NR1 and NR2 are non-resident corporations which are related to Canco and FA, but are not foreign affiliates. FA, NR1 and NR2 are all resident in a "designated treaty country" within the meaning of proposed subsection 5907(11) and (11.2) of the Regulations. FA makes an interest-bearing loan to NR1. NR1 uses the funds solely to acquire intellectual property, which it licenses to NR2. NR2 uses the intellectual property in the course of its manufacturing business. The royalties paid by NR2 to NR1 in consideration for the use of the intellectual property are deductible in computing the income of NR2 from its manufacturing business pursuant to the tax laws applicable to it in its country of residence.

It would appear that your query involves a factual situation involving a possibly completed transaction. As indicated in paragraph 21 of Information Circular 70-6R2, we are not in a position to deal with factual proposed transactions other than in the form of an advance ruling request where the identity of the parties is known and all the facts surrounding the proposed transaction are presented to us. Issues involving completed transactions should be addressed to the appropriate Taxation Services Office of Revenue Canada.

In any event, we have no basis to make the determination of whether the interest income earned by FA would be included in the income of FA from a active business pursuant to paragraph 95(2)(a) of the Act without looking at the specific facts, including the repayment terms and the recourse features of the loan, and the licensing agreement. In particular, it is our opinion that in order to meet the words in subparagraph 95(2)(a)(ii) of the Act, "derived from amounts that were paid or payable, directly or indirectly", the amounts in question would have to be able to be directly traced. For example, the royalty payments would have to be entirely earmarked to pay off the interest on the loan to be direct or indirect payments and would only qualify as direct or indirect payments to the extent that they were paid. Also, while it is not apparent that subparagraph 95(2)(a)(i) of the Act would apply in the above situation, it is our view that if it did apply the same conditions would have to be met for the interest income to be derived from activities "that can reasonably be considered to be directly related to the active business activities" of the related corporation as required by subparagraph 95(2)(a)(i).

We also note that if the transactions which you have presented to us were part of a series of transactions that was designed to avoid the application of subsection 15(2) to moneys acquired by a shareholder or a corporation connected to the shareholder or a corporation connected to the shareholder of Canco, the series of transactions may be considered a misuse of subsection 15(8) of the Act (proposed subsection 15(2.2)) and subsection 245(2) may apply.

The above comments represent our general views with respect to the subject matter of your letter. These comments do not constitute an advance income tax ruling and therefore, as described in paragraph 21 of Information Circular 70-6R2, are not binding on the Department.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch