2016-0642041C6 IFA 2016 Q.8: s. 95(2)(a)(ii)(B) and borrowing to return capital

Principal Issues: (1) Canco holds two classes of shares in an FA (FA1). The proceeds from the issuance of the Class A shares were used to fund an active business while the proceeds from the issuance of the Class B shares were used to purchase shares in another FA (FA2) that are not excluded property. If FA1 borrows funds from another FA (FA3) and uses those funds to return capital to Canco in respect of its Class A shares, would FA3’s interest income on the loan be recharacterized as active business income? (2) Would the answer be different if there was only one class of shares issued by FA1?

Position: (1) Yes. (2) Yes.

Reasons: (1) It is our view that the loan to FA1, which replaced capital that was being used for eligible purposes, would have qualified for interest deductibility under paragraph 20(1)(c) if FA1 had borrowed the money for that purpose, as such, the interest income received by FA3 on the loan should be recharacterized into income from an active business pursuant to clause 95(2)(a)(ii)(B). (2) In the situation where FA1 has issued only one class of shares the pro-rata treatment should be used such that income from the loan to FA1 is recharacterized proportionate to borrowed funds used by FA1 to return capital that was used by it in its active business.

Author: Helmer, Shelley
Section: 95(2)(a)(ii)(B), 20(1)(c)

2016 International Fiscal Association Conference
CRA Roundtable

Question 8 - Borrowing to return capital and clause 95(2)(a)(ii)(B)

A Canadian corporation (“Canco”) owns all the shares of a foreign affiliate (“FA1”) which in turn owns all the shares of another foreign affiliate (“FA2”). Canco also owns all the shares of another foreign affiliate (“FA3”). FA1 carries on an active business.  However, the shares of FA2 are not excluded property. FA1 has issued two classes of common shares with a total paid-up capital of $1 million. The class A common shares were issued for $800,000 and were used to fund the active business of FA1 while the class B common shares were issued for $200,000 and were used to acquire the shares of FA2. FA1 wishes to borrow $350,000 from FA3 to return capital to Canco. 

a)    FA1 borrows $350,000 and makes a capital distribution as a reduction of capital in respect of class A common shares. On the view that the borrowed money of $350,000 is used to replace the capital on the class A common shares that was used to finance the active business assets, would the interest income on the $350,000 loan be recharacterized as active business income of FA3 pursuant to clause 95(2)(a)(ii)(B)?

b)    Would the answer be different if FA1 had only one class of common shares?

CRA Response:

a)    In the case where borrowed money of $350,000 is used by FA1 to replace the capital on the class A common shares that was used by FA1 to finance its active business assets, it is our view that the interest income FA3 receives from FA1 should be recharacterized as active business income pursuant to clause 95(2)(a)(ii)(B). The issue is whether the interest paid by FA1 meets the requirement in clause 95(2)(a)(ii)(B) that it be deductible in computing the amount prescribed to be FA1’s earnings from an active business.

If FA1 computes its earnings from its active business pursuant to subparagraph (a)(i) or (a)(ii) of the definition of “earnings” in subsection 5907(1) of the Income Tax Regulations (the “Regulations”) in accordance with the income tax law of the country in which it is resident or carries on the business and the interest paid to FA3 is deductible pursuant to the relevant country’s income tax law in computing such earnings, it will be considered to be deductible in computing the amount prescribed to be FA1’s earnings.

If the interest paid to FA3 is not deductible by FA1 in any taxation year under the relevant foreign country’s income tax law, it will be deductible in computing FA1’s earnings pursuant to paragraph 5907(2)(j) of the Regulations.

If FA1 computes its earnings under subparagraph (a)(iii) of the definition of “earnings” in subsection 5907(1) in accordance with Part I of the Act, the interest paid to FA3 would be deductible by FA1 under paragraph 20(1)(c) in computing its income from the active business if it were carried on in Canada because the borrowed funds replaced capital that, at that time, had been used by FA1 for the purpose of earning income from an active business.

As such, it is our view that the interest income received by FA3 on the loan would be recharacterized as income from an active business pursuant to clause 95(2)(a)(ii)(B).

b)    Unlike in the first situation, in scenario b), the capital being replaced by the borrowed funds was not used for a single purpose. Instead, the capital was used for the purpose of earning income from an active business and to earn income from property (i.e., shares of FA2). Therefore, it is our view that clause 95(2)(a)(ii)(B) would not apply to the full amount of the interest income earned on the loan by FA3.

If FA1 computes its earnings from its active business pursuant to subparagraph (a)(i) or (a)(ii) of the definition of “earnings” in subsection 5907(1) and the full amount of the interest paid to FA3 were deductible in computing such earnings under the relevant foreign tax law, a portion of that amount would be added back to earnings pursuant to subsection 5907(2). In this situation, because a portion of the interest would give rise to a foreign accrual property loss, that portion would be added back to earnings from the active business pursuant to paragraph 5907(2)(c). As such, that portion of the interest would not be deductible in computing the amount prescribed to be FA1’s earnings from the active business as required by clause 95(2)(a)(ii)(B).

If FA1 computes its earnings from its active business pursuant to subparagraph (a)(iii) of the definition of earnings, only the interest on the portion of the borrowed funds that were used to return capital used to earn income from that source would be deductible under paragraph 20(1)(c) in computing those earnings.

In summary, since FA1’s capital that was replaced by the borrowed funds had been used to earn both income from an active business and income from property, clause 95(2)(a)(ii)(B) would only recharacterize the portion of the interest earned by FA3 that related to the replaced capital that had been used by FA1 to earn income from an active business.  In this context, in our view, the portion to which clause 95(2)(a)(ii)(B) applies should be determined on a pro-rata basis based on the current use of the capital (i.e., prior to its replacement with the borrowed funds). Based on the example provided above, that would mean that 20% of the interest income of FA3 would not be recharacterized.

Shelley Helmer
2016-064204
May 26, 2016

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