23 February 2004 External T.I. 2003-0051851E5 - S Corporations

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: Taxation of shareholder in US "S" Corporation.

Position: Unless the S-Corp is a controlled foreign affiliate, Canada taxes shareholder when shareholder receives dividends unless an election is made under Article XXIX(5) of the Canada-U.S. Treaty.

Reasons: Words in section 90.

						2003-005185
XXXXXXXXXX 					Suzanie Chua
						613 957-2115
February 23, 2004 

Dear XXXXXXXXXX:

Re: U.S. Sub Chapter "S Corporation"

We refer to your request for our views on the taxation of a taxpayer resident in Canada in respect of his shareholding in a U.S. Sub Chapter "S" Corporation ("S-corp").

The following are the hypothetical facts:

1. The taxpayer is an individual resident in Canada ("Mr. X").

2. Mr. X owns 50% of the shares in a S-corp.

3. A S-corp is a corporation incorporated in the U.S. whose shareholders are comprised only of individuals. An election can be filed in the U.S. under the provisions of the Internal Revenue Code of the United States such that for U.S. tax purposes, all the income of the S-corp in a taxation year will be treated as income of its shareholders. As a result, the shareholders must pay U.S. taxes on the income of another taxpayer (i.e. the S-corp). For the purposes of the analysis below, we have assumed that the S-corp under consideration has filed this election.

Our Comments

Written confirmation of the tax implications inherent in real transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5. However, we are prepared to provide you with the following general comments.

Taxation of Canadian Shareholder

Under Canadian law, a taxpayer resident in Canada is generally only taxed on dividends received on shares owned in a widely held corporation not resident in Canada pursuant to section 90 of the Income Tax Act (Canada) (the "Act"). However, where the non-resident corporation is a "controlled foreign affiliate" ("CFA") of the taxpayer (e.g. in this case if either a resident of Canada or a person with whom Mr. X did not deal at arm's length held at least one voting share in the S-corp, the S-corp would be a CFA of Mr. X), the taxpayer will include its share of the "foreign accrual property income" ("FAPI") (if you require our opinion whether certain income or gain would be FAPI, we would require details) earned by the CFA for Canadian tax purposes, as those terms are defined in subsection 95(1), and be taxed on it pursuant to section 91 in the taxation year of the taxpayer in which the taxation year of the CFA ends.

On the assumption that the S-corp is not a CFA of Mr. X, he will not be taxed where no dividends have been received by way of a distribution from the S-corp. This may create a problem for Mr. X because he has to pay tax to the IRS for a taxation year on the income which for Canadian tax purposes is income of another taxpayer. While the Canada Revenue Agency ("CRA") takes the view that the tax paid by Mr. X qualifies as an income or profits tax for the purposes of section 126 of the Act (i.e. a Canadian foreign tax credit provision) because we associate the U.S. tax with the dividends that will ultimately be paid on the shares by the S-corp to the shareholder, in order to calculate a foreign tax credit under the provisions of subsection 126(1), Mr. X has to have income from sources in the country to which the taxes are paid in the taxation year for which the taxes are paid. If the S-corp does not pay dividends in the particular taxation year and Mr. X does not have other U.S. sources of income, no Canadian foreign tax credit may be claimed; rather, Mr. X will be limited to taking deductions when computing his taxable income under subsections 20(11) and 20(12) of the Act. In a later year when the S-corp pays dividends, there may be no U.S. tax paid by Mr. X and therefore no Canadian foreign tax credit but Canada will tax the dividend received by Mr. X. The result would be double taxation.

To remedy the timing problem described above, Canada and the U.S. have agreed to the provisions of Article XXIX(5) of the Canada-U.S. Income Tax Convention (the "Convention") which applies to a Canadian taxpayer who enters into an agreement with the Canadian competent authority. The effect of the agreement which is subject to certain terms and conditions is basically that all the income of the S-corp will be treated as FAPI and the Canadian shareholder's share thereof is included in his income for Canadian tax purposes under the provisions of section 91 in the year it is earned by the S-corp. FAPI is income from a share (i.e. U.S. source property income) for the purposes of section 126. Accordingly, the individual shareholder who enters into the competent authority agreement and has paid U.S. tax on the income of a S-corp can then claim a foreign tax credit under section 126. When dividends are later paid by the S-corp, the agreement will provide that they will be excluded from the shareholder's income.

The agreement simply removes the timing problem that would otherwise exist and facilitates the operation of the Canadian foreign tax credit provisions so as to eliminate double taxation.

The provisions of Article XXIX(5) of the Convention do not apply automatically; the client must enter into the competent authority agreement. The procedures for requests for CRA Competent Authority consideration are detailed in the CRA's Information Circular 71-17R4 dated May 12, 1995 (enclosed herewith). Please mail requests to:

"Canada Revenue Agency,

Competent Authority Services Division
International Tax Directorate
Compliance Programs Branch
5th Floor, 344 Slater Street
Ottawa, ON
K1A 0L5"

Taxation of the S-corp

A U.S. S-corp itself is treated under the Act like any other non-resident corporation. Accordingly, it would generally be subject to tax in Canada on its Canadian source income subject to relief under the Convention.

We trust the above comments will be helpful.

Yours truly,

Olli Laurikainen
Section Manager
for Division Director
International & Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch