7 August 1996 External T.I. 9605735 - MEANING OF "DIRECTLY OR INDIRECTLY" IN 95(2)(A)

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 subparagraph 95(2)(a)(ii) in back to back loan situation.

Position:

Question of fact - would have to be able to directly trace payments. Note that this interpretation should not adversely restrict the interpretation of paragraph 95(2)(a.3). The phrase "amounts...paid or payable, directly or indirectly" in subparagraph 95(2)(a)(ii) can be given a more restrictive interpretation than the words "income...derived directly or indirectly" in paragraph 95(2)(a.3).

Reasons:

Intent (and see 951744, 952686).

									960573
XXXXXXXXXX							J. Stalker

Attention: XXXXXXXXXX

August 7, 1996

Dear Sirs:

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

We are writing in response to your letter dated February 13, 1996 in respect of the application of subparagraph 95(2)(a)(ii) of the Act to a back to back loan situation.

You have presented a situation where a wholly-owned foreign subsidiary (Forco) of a Canadian taxpayer (Canco) loans money at interest (the Original Loan) to a related foreign subsidiary (XCo) which is a resident of country X to finance its active business operations carried on exclusively in country Y. Each of country X and country Y is a "designated treaty country" as defined in proposed subsection 5907(11) of the Regulations. The interest charge would be deductible in computing the exempt earnings of XCo if XCo were a foreign affiliate of Canco. Forco assigns the Loan to a bank operating in country X (the Bank) which has a branch in country Y. At the time of the assignment, the principal of the Loan is $1,000 and there is $10 of accrued interest. In consideration for assignment of the Loan Forco receives $1,010 in cash which it deposits at the Bank (the Deposit). The Bank arranges for its branch in country Y to loan money (i.e. $1,010) at interest to XCo (the New Loan). XCo repays the Original Loan and the accrued interest. We assume that interest payments are made on a regular and continuous basis on both the New Loan and the Deposit.

You have asked if the interest income earned by Forco on the Deposit and the $10 representing accrued interest which Forco receives from the Bank as part of the consideration for assignment of the Original Loan would be included in the income of Forco from an active business pursuant to subparagraph 95(2)(a)(ii) of the Act.

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 by the appropriate Taxation Services Office of Revenue Canada.

However, we offer the following general comments on the applicability of subparagraph 95(2)(a)(ii) of the Act to amounts paid or payable in back to back loans. It is a question of fact whether payments are made directly or indirectly and, as such, can only be determined by an examination of all the relevant facts. In our view, in order to meet the words "the income is derived from amounts that were paid or payable, directly or indirectly" in subparagraph 95(2)(a)(ii) of the Act the amounts in question would have to be able to be directly traced. For example, subparagraph 95(2)(a)(ii) will apply in a back to back loan situation where the agreements set out clearly that one loan is conditional on the other loan or deposit, and the documentation for the transactions establish clearly that the flow of income can be directly traced and that the bank or third party involved in a back to back loan is acting as a conduit and is in effect receiving an accommodation fee for that service.

In addition, the time lag between the two payments in a back to back loan situation (that is, the payment to the bank or third party by the related non-resident corporation (the "first payment") and the payment by the bank or third party to the particular foreign affiliate (the "second payment")) would have to be reasonable in order for the amounts to be directly traceable. The fact that the second payment may be made shortly before the first payment would not necessarily mean that the income could not be recharacterized as active business income under subparagraph 95(2)(a)(ii) of the Act if it were evident by the documentation for the transactions and the short time lapse between the payments that the transactions were all part of one back to back loan arrangement.

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