CRA narrowly interprets foreign affiliate income recharacterization rule. In 2012-0439661I7 (released February 5, 2014), the CRA narrowly construed the foreign affiliate income recharacterization rule in s. 95(2)(a)(i), which can operate to convert income from property (FAPI) of a foreign affiliate (FA 1) into active business income where: (A) the income from property is directly related to the active business activities of another foreign affiliate (FA 2), and (B) such income would be included in the active business income of FA 2 if that income had instead been earned by FA 2. The facts involved passive income generated in FA 1 from the investment of surplus funds which were earmarked for future (active business) projects in FA 2. The CRA said this did not meet the threshold for recharacterization on either branch of the above two-part test. More specifically:
- The concept of “directly related” in (A) requires a relationship of immediate closeness or causality, such that the investment of funds would not have occurred but for current active business activities in FA 2. The asserted link here was to a future activity in FA 2, which was not sufficient to meet the first test.
- In any event, in order to satisfy the hypothetical in (B) of otherwise being included in FA 2’s active business income, the active business of FA 2 must have a substantial financial relationship of dependence on the surplus funds – such that the funds are truly employed and risked in the existing business, and their removal from the existing business would have a decidedly destabilizing effect (Atlas Industries Ltd. v. MNR; Ensite Ltd. v The Queen; March Shipping Ltd v. MNR). The simple holding of surplus funds for future projects of FA 2 would not meet this hypothetical second test.