CRA finds that revocation of a Treaty S Corp. agreement with CASD resulted in double taxation of the S Corp income when now dividended to Canada

A Canadian resident (and US citizen) had an agreement with the Canadian Competent Authority under Art. XXIX(5) of the Canada-US Treaty, by virtue of which he included his share of the S Corporation’s income as FAPI, claimed a s. 126 credit for the US taxes on that income, and added such FAPI to the ACB of his shares. However, before he received any dividend, he revoked the S Corp’s status as a fiscally transparent entity for US purposes, so that the Agreement thereupon terminated. The S Corp then paid a dividend to him of income that previously had been included in his income as FAPI (and now was included in his income under s. 90(1).)

The Directorate indicated that where the S Corp was a CFA of the individual, he could take a s. 91(5) deduction of the dividend paid after the Agreement invalidation, with a corresponding reduction to the ACB of his shares.

However, where the S Corp was not a FA at the time of the dividend, no s. 91(5) deduction would be available (but with no corresponding ACB reduction) because in such absence of FA status, Reg. 5900(3) would not deem the dividend to come out of taxable surplus.

The Directorate noted that it could be argued that s. 248(28) would apply to exclude the dividend from his income given that “both the dividend and FAPI arise from the same source, namely the shares of S Corporation.” However, the Directorate preferred the double inclusion alternative:

[T]he better view … is that the dividend income and FAPI inclusion are not the same amount …

[T]he dividend income is a cash distribution on the shares of S Corporation while the FAPI is a notional allocation of the income of S Corporation deemed to be FAPI on its shares of S Corporation … [so that] the dividend income and FAPI are separate amounts of a different nature … [which] would preclude the application of subsection 248(28).

Neal Armstrong. Summary of 18 July 2018 Internal T.I. 2018-0766441I7 under s. 91(5) and s. 248(28).