18 June 2015 STEP Roundtable Q. 4, 2015-0581931C6

CRA Tags
Treaties Article XXIX
Text of Severed Letter

Principal Issues: Guidance on how to request assistance from the Canadian Competent Authority with respect to paragraph 5 of Article XXIX of the Canada – US Tax Convention.

Position: Response provided by CPB - General comments provided

Reasons: See below.

STEP CRA Roundtable - June 18 2015

Question 4. Canadian Resident Shareholder of US S Corporation

Paragraph 5 of Article XXIX of the Canada-US Tax Convention reads as follows:

Where a person who is a resident of Canada and a shareholder of a United States S corporation requests the competent authority of Canada to do so, the competent authority may agree, subject to terms and conditions satisfactory to such competent authority, to apply the following rules for the purposes of taxation in Canada with respect to the period during which the agreement is effective:

(a) the corporation shall be deemed to be a controlled foreign affiliate of the person;

(b) all the income of the corporation shall be deemed to be foreign accrual property income;

(c) for the purposes of subsection 20(11) of the Income Tax Act, the amount of the corporation's income that is included in the person's income shall be deemed not to be income from a property; and

(d) each dividend paid to the person on a share of the capital stock of the corporation shall be excluded from the person's income and shall be deducted in computing the adjusted cost base to the person of the share.
[our emphasis]

We recognize that the CRA provides its guidance on how to request assistance from the Canadian Competent Authority in Information Circular IC 71-17R5. However, can the CRA provide specific guidance with respect to paragraph 5 of Article XXIX of the Canada – US treaty? Are there any circumstances where such a request would be denied? When filing tax returns, should the returns be filed contemporaneously with the competent authority request assuming that such a request will be granted?

CRA Response

An S corporation is a United States (US) "small business corporation" that elects, for US federal income tax purposes, to be a flow-through entity. The effect of the election is that the shareholders of the S corporation are taxed, for US tax purposes, on their proportionate share of the corporation's income in the year it is earned. For Canadian tax purposes, the S corporation is not a flow-through entity such that a Canadian resident shareholder of an S corporation is not subject to Canadian income tax on the active business earnings of the S corporation until they are distributed. As a result, in the absence of an S Corporation Agreement, the shareholder may not qualify for foreign tax credit relief, or may qualify for only limited foreign tax credit relief, for US taxes paid.

Under paragraph 5 of Article XXIX of the Canada-United States Tax Convention (Convention), the Canadian Competent Authority may agree to allow a shareholder of an S corporation to treat his or her share of the S corporation's income as foreign accrual property income (FAPI). The agreement (S Corporation Agreement) synchronizes the recognition of income in Canada with that of the US and allows the shareholder to claim a foreign tax credit in respect of the full amount of US tax paid on his or her share of the S corporation's income.

It is important to note that paragraph 5 of Article XXIX of the Convention does not apply automatically. This provision only applies to a shareholder of an S corporation who enters into an S Corporation Agreement with the Canadian Competent Authority. In addition, if the shareholder has an interest in more than one S corporation, a separate S Corporation Agreement is required for each corporation.

A Canadian-resident shareholder of an S corporation seeking to enter into an S Corporation Agreement with the Canadian Competent Authority should be aware that, for Canadian tax purposes:

  • the income of the S corporation is computed under US tax rules (this means, for example, that the full amount of any capital gain realized by the S corporation is treated as FAPI);
  • dividends paid to the shareholder by the S corporation are excluded from the shareholder's income only to the extent that they do not exceed the cumulative net amount of FAPI included in the shareholder's income under the S Corporation Agreement;
  • S corporation losses cannot be deducted against other income (including income reported from another S corporation) - generally, losses from an S corporation may be carried forward and deducted against income of the S corporation realized in subsequent years;
  • the income of the S corporation attributed to a shareholder is not earned income for purposes of the RRSP contribution limit;
  • an S Corporation Agreement does not relieve the shareholder from a requirement to file Form T1134; and
  • the S Corporation Agreement imposes an obligation on the shareholder to prepare worksheets and to retain those worksheets in the event of an audit – those worksheets must include annual and cumulative information on:
    1. the FAPI included in the shareholder's income,
    2. the amount of dividends excluded from the shareholder's income, and
    3. the adjustments to the cost base of the shares of the S corporation.

Refusal to Grant an S Corporation Agreement

The Canadian Competent Authority may refuse to provide an S Corporation Agreement if the shareholder does not submit the information requested by the Competent Authority or the shareholder is seeking to revise his or her Canadian tax reporting for past tax years.

Filing Returns

Ideally, the request for an S Corporation Agreement would be made well in advance of the filing-due date for the first tax year in which the agreement is intended to come into effect. However, it is not uncommon for a shareholder to request an S Corporation Agreement and, while the request is under consideration, to file a Canadian tax return on the expectation that an S Corporation Agreement will be provided.

John Bogdan (for CPB)
2015-058193