FA1 which is wholly-owned by Canco is formed to acquire all the shares of FA2 (which carries on an active business in a designated treaty country) using $100 borrowed from an arm’s length bank. In a subsequent year FA2 pays an exempt surplus dividend of $75 to FA1. FA1 uses $10 from the dividend to pay interest to the Bank, and pays an exempt surplus dividend of $65 to Canco.
Would the interest paid by FA1 to the Bank be deductible in computing its foreign accrual property income, thereby resulting in a net loss in respect of FAPI (a “FAPL”)? May Canco may choose to forgo the interest deduction in computing the FAPI/FAPL in respect of FA1? CRA responded:
Paragraph … 95(2)(f.11) would not have any impact on the computation of FA1’s FAPI/FAPL. Therefore, the interest deductibility provision in paragraph 20(1)(c) would apply to provide an interest deduction in the computation of FA1’s FAPI/FAPL, provided that all the conditions of that paragraph were met. Further … clause 95(2)(a)(ii)(D) would not apply to the interest paid or payable by FA1 to the Bank. Therefore, if FA1 does not have any other amounts to be included in the computation of FAPI, the interest deduction for the interest paid or payable to the Bank would result in a FAPL in respect of FA1.
… Canco is not required to deduct the interest expense paid or payable by FA1 to the Bank when computing FAPI of FA1, since paragraph 20(1)(c) is a discretionary deduction … . However, if Canco does not deduct an amount of interest in computing FA1’s FAPI/FAPL for the year in which that interest is paid or payable, that interest may not be deducted in computing FA1’s FAPI/FAPL for any subsequent year.
… Since FA1 does not carry on an active business or earn income that is deemed to be from an active business ... Regulation 5907(2.03) would not apply to require that Canco deduct the interest expense paid or payable by FA1 to the Bank in computing FA1’s income/loss from property.
Regulation 5907(2.7), which otherwise requires a foreign affiliate to claim deductions in the earliest year in which an amount is paid or payable and deems the affiliate to be carrying on an active business, also would not apply to FA1 as the Bank is not a foreign affiliate of Canco.