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Purchased Debt Between Foreign Affiliates Triggers Subsection 17(1) Benefit - by Raphael Barchichat 

Global Tax Adviser

March 20, 2012


Raphael Barchichat
Montreal, International Corporate Tax


In a recent internal technical interpretation, the CRA concluded that debt of one controlled foreign affiliate that is acquired by another controlled foreign affiliate of a corporate group is not a "loan or advance" for purposes of the exception to the deemed interest rule in subparagraph 17(8)(a)(ii). As a result, the acquired debt is subject to a deemed interest income inclusion in Canco's hands where the criteria of subsection 17(1) are met.

A controlled foreign affiliate of the Canco corporate group (CFA2) owed an outstanding loan (Loan 2) to another Canadian corporation (Canco2). CFA2 used the proceeds of Loan 2 to earn active business income within the meaning of subsection 95(1).


As part of a series of transactions relating to the withdrawal of one of the shareholders from the corporate group, a taxable Canadian corporation (Canco1) granted a non-interest bearing loan (Loan 1) to a non-resident corporation that is a controlled foreign affiliate of Canco (CFA1).


CFA1 immediately used the proceeds of Loan 1 to acquire Loan 2 from Canco2.


All of these corporations deal at non-arm's length and all share capital is held directly or indirectly by Canadian resident individuals.


The rules that apply when a non-resident person owes an amount to a corporation resident in Canada are found in section 17 of the Act. Generally, subsection 17(1) applies where a debt is outstanding for more than one year and no interest, or interest calculated at less than a reasonable rate, is included in the Canadian corporation's income for the year. In this case, the Canadian resident corporation is deemed to have received interest income on the amount, calculated at the prescribed rate, at the end of each taxation year during which the amount is owing less any interest payments actually made.


In our example, Loan 2 (i.e., Canco2's loan to CFA2) should not be subject to a section 17(1) unreported interest benefit since CFA2 used the money to earn active business income by virtue of subparagraph 17(8)(a)(i) of the Act.


In the case of a loan by one foreign affiliate to another, we need to look to the exception in subparagraph 17(8)(a)(ii). Under this exception, a loan or advance of money that is due from a controlled foreign affiliate that used the loan proceeds to make a loan or advance to another controlled foreign affiliate who used the funds to earn income from an active business is excepted from subsection 17(1).


At issue is whether the exception in subparagraph 17(8)(a)(ii) applies to Loan 1.


CRA comments
The CRA stated that, in this case, the essential question is whether CFA1 used the proceeds of Loan 1 to make a loan to CFA2.


The CRA referred to various jurisprudence, including the Tax Court of Canada's decision in Bradley v. R. (96 D.T.C. 2040) and the Supreme Court of Canada's decision in T.E. McCool Ltd. v. MNR (49 DTC 700), to support its conclusion that a loan and advance both require the delivery of money between two parties and the existence of a relationship of borrower and lender. Contrary to the relationship of debtor and creditor, the CRA considers the relationship between a borrower and lender to be more restrictive and that it requires the existence of a loan. According to the CRA, a concrete gesture is needed between the parties, such as the delivery and acceptance of an amount of money.


The CRA concluded that the contractual relationship between CFA1 and CFA2 for Loan 1 did not establish a borrower and lender relationship because there was no agreement, explicit or tacit, and there was no delivery or acceptance of money between CFA1 and CFA2. Although CFA1 became CFA2's creditor when it acquired Loan 2, CFA1 never granted a loan. As a result, the CRA concluded that the exception in subparagraph 17(8)(a)(ii) does not apply to Loan 1.


For more information, contact your KPMG adviser.

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