A foreign corporation (“FP”) owns 100% of Canco, which wholly-owns two non-resident corporations (“FA1,” a Holdco, and “FALuxco”). FA1 and FP are the 40% and 60% members, respectively, of a partnership (“MLP”). MLP borrows $200M (bearing interest of $10M per annum) from FALuxco for use in its active U.S. business and has no borrowings from FP.
The taxpayer considers that the phrase “deductible by the partnership in computing that other foreign affiliate’s share of any income … of the partnership” requires solely that the interest amounts be deductible in computing the income of MLP as a whole, suggesting that this would not be the case only if under the partnership agreement the interest amounts were borne entirely, or not at all, by a particular partner. CRA stated respecting the purpose of s. 95(2)(a)(ii)(B)(II):
[S]ince a partnership is treated as a flow-through for Canadian tax purposes, for the purpose of subclause 95(2)(a)(ii)(B)(II) the interest paid by a partnership should be viewed as interest paid proportionately by each of its members. As such, in the Example, to the extent that a portion of the interest paid to FALuxco by MLP is considered to be paid by a member that is not described in subclause 95(2)(a)(ii)(B)(I), that portion should not be recharacterized as income from an active business since it would not be so recharacterized if it had been paid directly by that member.
After indicating that this purpose was indirectly confirmed by an amendment made to s. (d)(ii)(C) of the “exempt earnings” definition in Reg. 5907(1), CRA concluded:
[O]nly 60% of the $10M interest received by FALuxco should be recharacterized as income from an active business (resulting in FALuxco having FAPI of $6M) … because only $4M would be deductible in computing that portion of MLP’s income that is included in computing the amounts prescribed to be FA1’s earnings as determined for purposes of paragraph (a) of the “earnings” definition in subsection 5907(1) of the Regulations.