Canco wholly-owns two controlled foreign affiliates (“FA Finco” and “FA Holdco”). Canco, FA Finco and FA Holdco have calendar year ends. FA Holdco uses funds borrowed from FA Finco under the “Loan” (which satisfies the conditions under s. 95(2)(a)(ii)(D) (“Clause D”) respecting the interest thereon) to acquire all the shares of FA Opco. The Loan has arm’s length terms including a clause that, upon FA Holdco opting to repay a portion of the principal amount before its maturity date, requires it to pay a penalty not exceeding the present value of the interest that would otherwise have been payable by it. Would Clause D recharacterize the penalty? In responding favourably, CRA itemized four requirements of Clause D, of which the following three required most of the analysis:
(2) the penalty received by FA Finco is an amount paid or payable by FA Holdco “under a legal obligation to pay interest on borrowed money;”
(3) the penalty received by FA Finco is an amount paid or payable by FA Holdco “in respect of any particular period in the year;” and
(4) the borrowed money is used for the purpose of earning income from property that is shares of a foreign affiliate.
CRA stated:
[Under] the second condition…[o]nce the penalty amount is paid, paragraph 18(9.1)(e)…will…deem the amount of the penalty to have been paid by FA Holdco and received by FA Finco as interest on the Loan.
[Respecting] the third condition…the grammatical structure of paragraph 95(2)(a)… confirms that the “year” in the phrase “in respect of any particular period in the year” in Clause D is the taxation year of FA Finco.
…The importance of the reference to a particular period is based on the requirement of Clause D that FA Holdco holds shares of a corporation that is a foreign affiliate of Canco throughout that period and that the shares are excluded property of FA Holdco throughout the same period. However, since the penalty payment occurs at a particular time (unlike interest which is accruing on a daily basis over a period of time), the relevant period during which FA Holdco must meet the above requirements for purpose of recharacterizing the penalty payment under Clause D is effectively represented by the time at which the payment is made by FA Holdco and received by FA Finco. …
[Respecting] the last condition…provided that at the time FA Finco receives the amount of penalty, FA Holdco continues to hold the shares of FA Opco that constitute a source of income for FA Holdco, the fourth condition of Clause D would be satisfied.