Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principle Issue: Whether interest expense incurred by a foreign affiliate for the purpose of acquiring an interest in a partnership that is carrying on an active business is deductible when computing the amounts prescribed to be its earnings from an active business under clause 95(2)(a)(ii)(B) of the Income Tax Act.
Position: YES
Reasons: The interest paid by the foreign affiliate is deductible when computing its earnings from an active business in accordance with the income tax law of the country in which the affiliate is resident. (Subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Income Tax Regulations.)
October 25, 2002
Mr. Roger Sanson Sophie Chatel
Team Coordinator, International
Audit Services Section Calgary TSO
220 - 4th Avenue South East, Suite 420
Calgary AB
Attention: Laurie Wills/Maureen Chrusch 2002-014997
Re: Subparagraph 95(2)(a)(ii) of the Income Tax Act (Canada) (the "Act")
We are writing in response to your memorandum of June 28, 2002 requesting our comments on the application of subparagraph 95(2)(a)(ii) of the Act to two situations you are considering involving loans between foreign affiliates.
Our understanding of the facts is as follows:
1. Canco subscribes for common shares of Irishco, a corporation resident in Ireland. We assume that Canco has a qualified interest in Irishco throughout the years in which the transactions described below occur.
2. Irishco loans US$XXXXXXXXXX to US Holdco (a wholly owned subsidiary of Canco resident in the United States) at a market rate of interest.
3. US Holdco uses the funds to acquire a XXXXXXXXXX% interest in a US partnership from another wholly owned US subsidiary of Canco.
4. US Holdco pays interest to Irishco. Irishco adds the interest to its exempt surplus pool. Canco argues that the interest income earned by Irishco is not foreign accrual property income ("FAPI") based on its interpretation of clause 95(2)(a)(ii)(B).
5. In the second situation you are considering, the only salient differences from the above case are that the loan amount is US$XXXXXXXXXX and US Holdco injects the funds directly into the US Partnership as a capital contribution as opposed to purchasing the partnership interest from another Canco subsidiary.
6. In each case, the partnership carries on an active business as defined in subsection 95(1) of the Act.
Our Comments
The issue is whether the interest paid by US Holdco to Irishco is deductible by US Holdco in the year, or a subsequent year, in computing the amount prescribed to be its earnings or loss from an active business, other than an active business carried on in Canada, as required by clause 95(2)(a)(ii)(B) of the Act.
Clause 95(2)(a)(ii)(B) of the Act states that when computing the income of a foreign affiliate from an active business, income from foreign sources that would otherwise be property income of the foreign affiliate shall be included, to the extent that such income is derived from amounts that were paid or payable to the affiliate by another foreign affiliate, so long as they are for expenditures that were deductible by the other affiliate in computing the amounts prescribed to be its earnings or loss from an active business. Earnings or loss from an active business is prescribed under subsection 5907(1) in the Income Tax Regulations (the "Regulations"). Subparagraph (a)(i) of the definition of "earnings" in the Regulations provides that earnings from an active business carried on by the affiliate are to be computed in accordance with the income tax law of the country in which the affiliate is resident and adjusted in accordance with subsections 5907(2), (2.1), (2.2) and (2.9) of the Regulations.
It is our understanding that, for U.S. federal income tax purposes, the U.S. partner can deduct interest expense incurred to acquire an interest in a partnership when computing the U.S. partner's share of a partnership's active business income. Consequently, and since there is no further adjustment pursuant to subsections 5907(2), (2.1), (2.2) and (2.9) of the Regulations (in particular, subsection 5907(2) of the Regulations), the interest expense is deductible from US Holdco's earnings from an active business for the purpose of clause 95(2)(a)(ii)(B) of the Act.
Moreover, if the interest were not deductible for U.S. federal income tax purposes in this situation, we are of the opinion that the interest expense would still be deductible in computing the prescribed earnings from an active business by reason of paragraph 5907(2)(j) of the Regulations. Such an interpretation is in accordance with previous opinions we have issued regarding the application of paragraph 5907(2)(j) of the Regulations to situations where interest expense was denied under U.S. thin capitalization rules.
To conclude, it is our view that, in both the situations at hand, the requirement under clause 95(2)(a)(ii)(B) of the Act that the amounts paid are for expenditures that were deductible by US Holdco in computing the amounts prescribed to be its earnings or loss from an active business is met, and the interest income earned by Irishco from US Holdco would be included when computing Irishco's income from an active business.
However, in order for the interest income to be included in Irishco's exempt earnings, the active business of the partnership must be carried on in Canada or in a designated treaty country. Clause 5907(1)(d)(ii)(E) of the definition of "exempt earnings" requires that the interest income paid to Irishco by US Holdco be deductible from the exempt earnings of US Holdco. Pursuant to subparagraph 5907(1)(d)(i) of the definition of "exempt earnings", the exempt earnings of US Holdco are its net earnings from an active business carried on by it in Canada or in a designated treaty country. Accordingly, even if the interest income is income from an active business to Irishco pursuant to clause 95(2)(a)(ii)(B), it will not be included in Irishco's exempt earnings unless the partnership's active business is carried on in Canada or in a designated treaty country.
File # 972976 which you refer to in your memorandum deals with a different issue. In that Round Table Response, we stated that "a business carried on by a partner through a partnership is always separate and distinct from any business that the partner may carry on directly." Therefore, when the income from that partnership flows through the partner's hands, it retains its character as active or investment business income. However, in that file, the partnership was carrying on an investment business. In contrast, we understand that in the cases at hand, each partnership is carrying on an active business as defined under subsection 95(1) which retains its character as active business to US Holdco.
We hope our views assist you. Please contact the author if you have any further questions.
Yours truly,
for Director
International and Trusts Division
Income Tax Rulings and Interpretations Directorate