CRA confirms that compensatory payments made by a US C-corp to LLC subsidiaries were FAT pursuant to Regs. 5907(1.3) and (1.5)

A corporation resident in Canada wholly owns a US “C” corporation (“Holdco”), which earns foreign accrual property income (“FAPI”) and is the sole member of two fiscally-transparent LLCs. In each relevant taxation year (the “FAPI Year”), Holdco both uses losses incurred by the LLCs to fully offset its taxable income for the U.S. tax purposes and makes compensatory payments under a group tax sharing agreement to the LLCs (“Loss LLC 1” and “Loss LLC 2”) for the utilization of their losses (the “Compensatory Payments”). The loss of Loss LLC 1 is a “foreign accrual property loss” (“FAPL”); and the loss of Loss LLC 2 is neither a FAPL, nor a “foreign accrual capital loss” (“FACL”).

Do the Compensatory Payments made to the two LLCs qualify as foreign accrual tax (FAT) pursuant to Reg. 5907(1.3); and, if so, do Regs. 5907(1.4) to (1.6) apply to the Compensatory Payments made to Loss LLC 2?

In finding that Reg. 5907(1.3)(b) would be satisfied, CRA noted that, as a result of the two LLCs being treated as fiscally transparent, in computing its income or profits subject to tax in the U.S. for the FAPI Year, Holdco deducts the losses incurred by the LLCs, which are losses of other corporations. Holdco, as the particular affiliate, pays the Compensatory Payments to the loss transferors and such payments may reasonably be regarded as being in respect of income or profit tax that would otherwise have been payable by Holdco. Thus, Reg. 5907(1.3)(b) would deem the Compensatory Payments made to Loss LLC 1 and Loss LLC 2 to be FAT, subject to the application of Reg. 5907(1.4).

Reg. 5907(1.4) will deny the amount prescribed to be FAT of Holdco under Reg. 5907(1.3)(b) to the extent it relates to the Compensatory Payment made to Loss LLC 2 - on the basis that the Compensatory Payment cannot reasonably be considered to be in respect of a FAPL or a FACL. However, Regs. 5907(1.5) and (1.6) would reinstate the FAT if for the subsequent 5 years, Holdco earns active business income in excess of its losses, and any losses of Loss LLC 2 for the FAPI Year, as well as their losses that can be carried back and used in those five years.

Neal Armstrong. Summaries of 22 February 2024 External T.I. 2016-0667251E5 under Reg. 5907(1.3) and Reg. 5907(1.5).