CRA indicated that where a loan from one controlled foreign affiliate (FA Finco) of Canco to a second CFA of Canco (FA Holdco) meets the conditions in s. 95(2)(a)(ii)(D), a prepayment penalty paid by FA Holdco to FA Finco also can be recharacterized as active business income by s. 95(2)(a)(ii)(D) if the penalty is first recharacterized as interest under s. 18(9.1)(e). The loan had arm’s length terms including a clause that, upon FA Holdco opting to repay a portion of the principal amount before its maturity date, required it to pay a penalty not exceeding the present value of the interest that would otherwise have been payable by it. CRA stated:
Once the penalty amount is paid, paragraph 18(9.1)(e) (which applies for the purposes of the Act, including the computation of income from property described in the pre-amble to paragraph 95(2)(a)) will in the above circumstances deem the amount of the penalty to have been paid by FA Holdco and received by FA Finco as interest on the Loan.