CRA accepts a tracing approach to determining whether interest on money borrowed to return capital is considered for s. 95(2)(a)(ii)(B) to be deductible in computing exempt earnings

Where FA1 borrows from a sister (FA3) to make a capital distribution on its Class A common shares, which had previously been issued solely to finance FA1’s active business, CRA would accept that the interest on this loan would be received as deemed active business income by FA3 under s. 95(2)(a)(ii)(B). This signifies that the “fill the whole” approach to determining a source of business income under s. 20(1)(c) is portable to s. 95(2)(a)(ii)(B)(I). It also signifies a tracing approach is at work, as CRA indicated that this result would be so even if FA1 had issued shares of another class (its Class B common shares), to finance the acquisition of shares which were not excluded property, at the same time as it issued the Class A common shares.

If instead, shares of only one class had been issued to fund the two (good and bad) uses of funds, CRA “could consider that the appropriate method would be to apply clause 95(2)(a)(ii)(B) on a pro rata basis.”

Neal Armstrong. Summary of 26 May 2016 IFA Roundtable, Q. 8 under s. 95(2)(a)(ii)(B).