Principal Issues: Is interest on an inter-affiliate borrowing used by the borrower affiliate to pay a dividend, not exceeding the borrower affiliate's accumulated earnings, deductible by the borrower affiliate in computing its earnings or loss from an active business?
Position: Yes.
Reasons: If not deductible under foreign law, then deductible under Reg. 5907(2)(j).
2015 International Fiscal Association Conference
CRA Roundtable
Question 11
FA Borrowing to Pay a Dividend
Paragraph 95(2)(a) of the Act re-characterizes, in various circumstances, amounts that would otherwise be income from property of a foreign affiliate as income from an active business. Provided all the other requirements for the application of clause 95(2)(a)(ii)(B) are satisfied, it applies to income derived by a foreign affiliate from amounts paid or payable by another foreign affiliate provided the amounts paid or payable were for expenditures that were "deductible" by that other affiliate in computing the amounts prescribed to be its earnings or loss from an active business.
Assume that a foreign affiliate (the "Borrower FA") of a taxpayer resident in Canada carries on an active business in a country other than Canada. Borrower FA does not have any other sources of income. Borrower FA borrows money from another foreign affiliate (the "Lender FA") of the taxpayer to pay a dividend. The amount of the dividend does not exceed the accumulated profits of Borrower FA which are currently used by Borrower FA to earn income from its active business. Assuming all other necessary conditions for clause 95(2)(a)(ii)(B) are met (e.g., qualifying interest, etcÂ…), does the CRA view the interest as deductible by Borrower FA in computing the amount prescribed to be its earnings or loss from an active business such that the interest will be included in computing the active business income of Lender FA?
CRA Response
In the circumstances described above, if Borrower FA computes its earnings from its active business pursuant to subparagraph (a)(i) or (a)(ii) of the definition of "earnings" in subsection 5907(1) of the Regulations in accordance with the income tax law of the country in which it is resident or carries on the business and the interest expense is deductible pursuant to the relevant foreign country's income tax law, it will be considered deductible by Borrower FA for purposes of clause 95(2)(a)(ii)(B).
If the interest expense is not deductible by Borrower FA in any taxation year under the relevant foreign country's income tax law, it will nevertheless be deductible in computing Borrower FA's earnings pursuant to paragraph 5907(2)(j) of the Regulations because it will be considered to have been made or incurred by Borrower FA for the purpose of gaining or producing earnings from an active business carried on by it as determined under subparagraphs (a)(i) or (ii) of the definition of "earnings" in subsection 5907(1) of the Regulations.
Furthermore, the interest paid by Borrower FA will be deductible under paragraph 20(1)(c) in computing Borrower FA's earnings if those earnings are computed under subparagraph (a)(iii) of the definition of "earnings" in subsection 5907(1) of the Regulations, in accordance with the Act.
In summary, in the circumstances described above, the interest paid by Borrower FA will be "deductible" in computing the amount prescribed to be its earnings from an active business regardless of whether those earnings are computed under the tax laws of a country other than Canada or under the provisions of the Act. Therefore, provided the requirements for the application of clause 95(2)(a)(ii)(B) are otherwise met, it will apply to include the income derived by Lender FA from the interest payments received from Borrower FA in Lender FA's income from an active business.
Julia Belova
2015-058157
May 28, 2015