Where FA1 borrows $350,000 from a sister (FA3) to make a capital distribution to its Canadian shareholder (Canco) on its Class A common shares, which had previously been issued by it to Canco solely to use the subscription proceeds of $800,000 to finance FA1’s active business, CRA would accept that the interest on the $350,000 loan would be received as deemed active business income by FA3 under s. 95(2)(a)(ii)(B). CRA indicated that this result would obtain even if FA1 had issued shares of another class (its Class B common shares) to Canco, to finance the $200,000 acquisition of shares (of FA2) which were not excluded property, at the same time as it issued the Class A common shares. In the situation where FA1 was required to compute its income (pursuant to Reg. 5907(1) – earnings – (a)(iii)) under Part I of the Act, CRA indicated that the interest was deductible under s. 20(1)(c) “because the borrowed funds replaced capital that…had been used by FA1 for the purpose of earning income from an active business,” whereas in the situation where the earnings were computed pursuant to (a)(i) or (iii) of the earnings definition under local tax law and the interest was non-deductible under such law, CRA simply stated that the interest would be deductible under Reg. 5907(2)(j).
If instead, shares of only one class had been issued to fund the two (exempt earnings and non-exempt earnings) uses of funds, CRA would consider that “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)…[so that] 20% of the interest income of FA3 would not be recharacterized.” Before so concluding, CRA stated:
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.