Section 247 of the Income Tax Act ("ITA") requires that related parties operating across borders transact as if they were acting at arm's length. In the case of a loan given by a Canadian corporation to a related non-resident corporation Section 247 would therefore require that the Canadian lender charge interest at fair market value to the non-resident borrower. Although true in some circumstances, there is an exception to the rule that can be found in subsection 247(7).¹

Provided that the interest free loan is given to a controlled foreign affiliate ("CFA") and is used to earn active business income, then interest will not be imputed in the income of the Canadian corporation. Provided that the conditions set out in Section 17(8) of the ITA are satisfied, then there would be no transfer pricing adjustment under Section 247(2) in relation to the interest that was not charged.

Statutory Framework

Section 17(1) of the ITA provides that if a non-resident owes an amount to a Canadian corporation for more than a year, then the difference between the prescribed rate of interest and any interest actually included in the Canadian corporation's income will be deemed to have been received by the Canadian corporation. The Canadian corporation would therefore be required to include this amount in income, although not received.

An exception to the charging of interest to a non-resident exists in the case of a CFA. Section 17(8) provides that interest will not be deemed to have been received by the Canadian corporation for the purposes of Section 17(1) if the following requirements are satisfied:

• The non-resident corporation is a CFA;
• The loan or advance of funds was used throughout the period in which it was outstanding for the purpose of earning income from an active business, as defined in Section 95(1) of the ITA, or income deemed to be active business income by virtue of Section 95(2);

In applying the above statutory framework to a loan made by a Canadian corporation to a non-resident corporation, it is necessary to examine these requirements. The first requirement for the exemption to apply is that the loan be made to a CFA. A CFA is defined in Section 95(1) and modified by Section 17 as:

"controlled foreign affiliate" means at any time, of a taxpayer resident in Canada, a foreign affiliate of the taxpayer that was, at that time, controlled by

1. the taxpayer,
2. the taxpayer and not more than four other persons resident in Canada,
3. not more than four persons resident in Canada, other than the taxpayer,
4. one or more persons resident in Canada with whom the taxpayer does not deal at arm's length, or
5. the taxpayer and one or more persons resident in Canada with whom the taxpayer does not deal at arm's length.

For the purposes of Section 17, resident Canadians must control a non-resident corporation in order for it to be treated as a CFA.

Section 17(13) extends the definition of controlled foreign affiliate. A CFA of a Canadian corporation will be deemed to be a CFA of a corporation resident in Canada who is related to the first corporation (otherwise than because of a right referred to in Section 251(5)(b) of the ITA). Under Section 251 a parent corporation is related to its subsidiary, also two corporations who are controlled by the same person are related. Therefore, this provision would allow sister corporations to make interest free loans to each other's CFAs and take advantage of the exception in Section 17(8). This provision would not operate to allow a subsidiary Canadian corporation to make an interest free loan to its non-resident parent because the requirement of a CFA would not be satisfied.

Secondly, the loan must be used for the purpose of earning active business income while it remains outstanding. Section 95(1) defines active business as:

Any business carried on by the affiliate other than (a) an investment business carried on by the affiliate, or (b) a business that is deemed by subsection (2) to be a business other than an active business carried on by the affiliate;

Having established that the requirements in Section 17(8) have been satisfied, the lack of interest being charged will not result in a deemed income inclusion for the Canadian corporation under Section 17(1). However, because the parties are not dealing at arm's length, there may be a transfer pricing issue under Section 247 of the ITA.

Section 247(7) is the transfer pricing provision applicable to interest free loans. The provision provides that where there is an interest free loan outstanding to a CFA, and the amount advanced was used for the purpose of earning active business income, then there will be no transfer pricing adjustment in relation to the interest. This provision allows interest free status to be granted by a Canadian corporation to its CFA on a loan or amount outstanding, without CRA being able to adjust the Canadian corporation's income to include the interest otherwise payable. However, this provision will not prevent CRA from using Section 247(2) to adjust the amount owing where for example it represents the unpaid purchase price of goods sold to the non-resident, and the purchase price does not represent an arm's length price.

Conclusion

Based on the above analysis of the statutory framework the following conclusions can be drawn:

• A resident Canadian corporation can make a loan to a CFA without charging interest as long as the funds are used while it remains outstanding for the purpose of earning active business income;

• By virtue of Section 17(13), sister corporations can make interest free loans to each other's CFAs and take advantage of the benefit provided in Section 17(8); and

As long as the requirements of Section 17(8) are satisfied then there will be no transfer pricing adjustment in relation to the interest not charged.

1. It is also proposed that this exclusion be applicable to guarantee fees between related parties in specific circumstances as outlined in this paper.