1 June 2009 External T.I. 2009-0319481E5 - Dividends Paid to S Corporation

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Rate of Part XIII withholding tax applicable to dividends paid by taxable Canadian corporation after 2009 to S-corporation where S-corporation holds greater than 10 percent of the dividend payer's voting shares and dividend payer is fiscally transparent for U.S. tax purposes.

Position: Even if the S-corporation is a qualifying person under Article XXIX-A of the Canada-United States Income Tax Convention (or is entitled to limited treaty benefits under Article XXIX-A(4)) and beneficially owns the dividends, the rate of withholding tax will be 25% of the amount of the dividend due to Article IV(7)(b). Furthermore, the U.S. resident shareholder(s) of the S-corporation would not be considered to derive the dividend income received by the S-corporation.

Reasons: The dividend payer is fiscally transparent for U.S income tax purposes. Consequently, the treatment of the dividend payment under U.S income tax laws is not the same as its treatment would be if the dividend payer were not treated as fiscally transparent under U.S. income tax laws. For U.S. income tax purposes, the shareholders of the S-corporation would not be considered to derive dividend income for U.S. income tax purposes and therefore would not satisfy the requirements of Article IV(6).

XXXXXXXXXX 								2009-031948
J. MacGillivray
(613) 957-2053
June 1, 2009

Dear Madam:

Re: Dividend Withholding Tax - Effect of Fifth Protocol

We are writing in response to your letter of April 21, 2009, in which you requested our views with respect to the taxes that must be deducted, withheld and remitted under Part XIII of the Income Tax Act (Canada) (the "Act") from dividends that may be paid after 2009 by a "taxable Canadian corporation", as defined pursuant to subsection 89(1) of the Act, (referred to herein as "Canco") to a corporation that is incorporated under the laws of the United States ("USco"). USco holds 50 percent of the sole class of issued shares of Canco. The shares of USco are held by an individual who is a resident of the United States for the purposes of the Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital Signed on September 26, 1980, as amended by the Fifth Protocol signed on September 21, 2007 (the "Convention").

You have advised that USco is considered an "S-corporation" for United States income tax purposes because it has elected to be taxed in accordance with subchapter S of Chapter 1 of subtitle A of the Internal Revenue Code, 26 U.S.C., and that Canco is a fiscally transparent entity for United States income tax purposes. As a result, the shareholder of USco is required to include Canco's earnings in his income. The shareholder may also claim foreign tax credits, subject to certain limitations, for Canadian income taxes paid by Canco and for withholding taxes exigible pursuant to Part XIII of the Act from dividends paid by Canco to USco. You have also advised that the payment of dividends by Canco to USco is not treated as the receipt of dividend income by USco or USco's shareholder for United States income tax purposes, but that such dividends reduce the cost basis of the investment in Canco.

Please note that it is not this Directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. For more information about how to obtain a ruling, please refer to Information Circular 70-6R5, "Advance Income Tax Ruling", dated May 17, 2002. This Information Circular can be accessed on the Canada Revenue Agency's website, http://www.cra-arc.gc.ca. We are, however, prepared to provide the following general comments, which we trust will be of some assistance.

Paragraph 212(2)(a) of the Act provides that every non-resident person shall pay an income tax of 25% on every amount that a corporation resident in Canada pays or credits, or is deemed by Part I or Part XIV to pay or credit, to the non-resident person as, on account of or in lieu of payment of, or in satisfaction of taxable dividends. The amount of taxes payable under this provision and the corresponding amount of taxes to be withheld from the payment of dividends under Part XIII of the Act may be reduced under Article X(2) of the Convention if, among other things, the dividend is paid to or derived by a person who is a resident of the United States for the purposes of the Convention.

Dividend income received by an entity that is fiscally transparent for United States income tax purposes may be considered to be derived by a person who is a resident of the United States pursuant to Article IV(6) of the Convention. In such circumstances, Article IV(6) will apply to treat the dividend income to be derived by a resident of the United States if the person is considered under United States income laws to have derived the dividend through the entity (provided the entity is not a resident of Canada for the purposes of the Convention) and, by reason of the fiscal transparency of the entity, the treatment of the dividend under United States income tax laws is the same as its treatment would be had the dividend been derived directly by the person.

In the case of the payment of a dividend to an S-corporation, which is considered a fiscally transparent entity for United States income tax purposes, Article IV(6) may apply to treat an amount of the dividend income allocated to a shareholder of the S-corporation to be dividend income derived by the shareholder. However, in light of Canco's fiscal transparency and the resulting United States income tax treatment of the payment of dividends by Canco to USco, it is our view that Article IV(6) will not apply to treat a dividend paid by Canco to USco to be derived by the shareholder of USco because, for United States income tax purposes, the shareholder will not be considered to have derived a dividend (i.e., an amount of income) through USco.

While an S-corporation is a fiscally transparent entity, it is ordinarily accepted that an S-corporation is itself a resident of the United States for the purposes of the Convention. Therefore, a dividend paid by a Canadian-resident corporation to an S-corporation may be considered to be derived by the S-corporation, which may result in a reduction to the taxes exigible under Part XIII on the payment of the dividend to the S-corporation by virtue of Article X(2). However, with respect to dividends paid by USco to Canco after 2009, Article IV(7)(b) will apply, with the result that the dividends paid by USco to Canco will be considered not to be paid or derived by a person who is a resident of the United States. Article IV(7)(b) provides that a dividend shall be considered not to be paid to or derived by a person who is a resident of the United States where the person is considered under Canadian income tax laws to have received the dividend from a Canadian-resident corporation, but by reason of the fiscal transparency of the Canadian-resident corporation under United States income tax laws, the treatment of the dividend under United States income tax laws is not the same as its treatment would be if the Canadian-resident dividend payer were not considered fiscally transparent.

Consequently, in the scenario you have described above, dividends paid by Canco to USco after 2009 will not be considered to have been paid to or derived by a person who is a resident of the United States, with the result that Canco will be required to deduct, withhold and remit 25% of the amount of each dividend it pays to USco.

Our comments are provided in accordance with the practice outlined in paragraph 22 of Information Circular IC-70-6R5.

Yours truly,

for Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch