S. 95(2)(a)(ii)(D)(IV)2 requires that, for each disregarded 2nd or 3rd affiliate and for each of their relevant taxation years that end in the taxation year of the foreign affiliate making the loan, their members/shareholders at the end of such year be subject to tax in a country other than Canada on all or substantially all of their income for such year.
a) If either the 2nd (2nd LLC) or 3rd (3rd LLC) affiliate has a loss in a taxation year ending after the CFA subsidiary of the Canadian parent made the loan to 2nd LLC, and all other “Cap D” conditions are met, would interest on the loan be eligible for recharacterization under Cap D notwithstanding the reference to “income” in 95(2)(a)(ii)(D)(IV)2 thereof?
b) If the 2nd affiliate (US Holdco), which owns 40% of 3rd LLC (a partnership for Code purposes, with a 60% interest therein held by an arm’s length U.S. resident) sells its 40% interest to an arm’s length U.S. purchaser on June 1, with US Holdco being subject to U.S. tax on its share of 3rd LLC’s income for the stub period up to May 31, would the “end of year” requirement to be met notwithstanding that US Holdco is not a member of 3rd LLC at its calendar year-end?
CRA indicated that:
(a) Interest-income of the CFA making the loan to the 2nd LLC would be eligible for recharacterization (based on all the other conditions of Cap D being met) so that its interest income would still be eligible for recharacterization under Cap D, notwithstanding that either 2nd LLC or 3rd LLC, or both, had a loss in the particular year.
(b) S. 95(2)(a)(ii)(D)(IV)(2) likely would not be satisfied as the members of the 3rd LLC at the end of its taxation year likely will not be subject to U.S. income taxation on substantially all of 3rd LLC’s income, because the 40% of 3rd LLC’s income in the period of January-May that would be allocated to US Holdco. This issue has been brought to the attention of the Department of Finance.