22 February 2024 External T.I. 2016-0667251E5 - Compensatory payments made to an LLC

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: (i) Whether a compensatory payment made by a corporate shareholder to a fiscally transparent limited liability company is a foreign accrual tax pursuant to subsection 5907(1.3) and, where applicable, subsection 5907(1.5) of the Regulations; (ii) whether the CRA’s position expressed in Technical Interpretation 2003-0037291I7 has changed in light of subsequent amendments to subsection 5907(1.3) of the Regulations.

Position: (i) Yes; (ii) partially.

Reasons: (i) On a textual reading, the conditions in paragraph 5907(1.3)(b) are satisfied; (ii) the 2014 amendments to paragraph 5907(1.3)(b) extended its application to certain compensatory payments made to fiscally transparent entities.

XXXXXXXXXX									2016-066725
  										Ina Eroff

February 22, 2024

Dear XXXXXXXXXX:

Re: Compensatory payments made to a fiscally transparent LLC

This is in reply to your request to comment on the implications of the amendments to subsection 5907(1.3) of the Income Tax Regulations (the “Regulations”) introduced in the 2014 budget and enacted in Bill C-43 (the “2014 Amendments”) on our position expressed in Technical Interpretation 2003-0037291I7, dated April 8, 2004. In that technical interpretation, we state that compensatory payments made under a tax-sharing agreement by or to a fiscally transparent limited liability company (“LLC”) resident in the United States (the “U.S.”) do not qualify as a foreign accrual tax (“FAT”) under subsection 5907(1.3) of the Regulations. We apologize for the delay in responding to your request.

Unless otherwise stated, all references to a section, subsection, paragraph, subparagraph, clause or subclause, is a reference to the relevant provision of the Regulations and all terms used herein that are defined in the Regulations have the meaning given in such definition unless otherwise indicated.

Hypothetical facts:

The taxpayer (the “Taxpayer”) is a corporation resident in Canada.

The Taxpayer holds all of the issued and outstanding shares of a “C” corporation resident in the U.S. (“Holdco”). Holdco earns foreign accrual property income (“FAPI”) for Canadian tax purposes.

Holdco is the sole member of several LLCs. Holdco and the LLCs are “controlled foreign affiliates” of the Taxpayer within the meaning of subsection 95(1) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended, (the “Act”).

The LLCs are flow-through entities for the U.S. tax purposes and as such are not liable to income or profit taxes in the U.S. under the Internal Revenue Code (the “Code”).

Holdco files U.S. tax returns and in each taxation year, the income or loss of each LLC is included in computing the income or loss of Holdco for purposes of the Code. Holdco and the LLCs are not members of a U.S. consolidated group.

In the relevant taxation year (the “FAPI Year”), Holdco uses losses incurred by the LLCs to fully offset its taxable income for the U.S. tax purposes. In the FAPI Year, Holdco makes compensatory payments under a group tax sharing agreement to two 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”) within the meaning assigned in subsection 5903(3). The loss of Loss LLC 2 is neither FAPL, nor a “foreign accrual capital loss” (“FACL”) within the meaning assigned in subsection 5903.1(3).

Queries:

Whether the Compensatory Payments made by Holdco to Loss LLC 1 and Loss LLC 2 qualify as FAT pursuant to subsection 5907(1.3) and if so, whether subsections 5907(1.4)-(1.6) apply to the Compensatory Payments made to Loss LLC 2.

Whether the position expressed in Technical Interpretation 2003-0037291I7 regarding the application of subsection 5907(1.3) to compensatory payments made to and by fiscally transparent entities has changed in light of the 2014 Amendments.

Our comments:

This technical interpretation provides general comments about the provisions of the Act, the Regulations and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.

Subsection 5907(1.3) prescribes certain compensatory payments made between members of a corporate group pursuant to a tax-sharing agreement or otherwise to be FAT. It was our position, as was stated in Technical Interpretation 2003-0037291I7, that compensatory payments made to or by a disregarded LLC would not be deemed FAT under subsection 5907(1.3) because that subsection as it read at the time the Technical Interpretation was issued applied to a group where the members were otherwise taxable. Subsection 5907(1.3) has subsequently been amended by S.C. 2014, c. 39 (Bill C-43). The October 2014 Explanatory Notes specify that subsection 5907(1.3) is amended to modernize its language and to accommodate the use in certain foreign jurisdictions of fiscally transparent entities that are considered to be corporations under Canadian tax principles (such as LLCs). The 2014 Amendments make subsection 5907(1.3) expressly applicable to fiscally transparent entities, superseding our position expressed in Technical Interpretation 2003-0037291I7.

Paragraph 5907(1.3)(b) applies when, under the income tax laws of the country in which the particular affiliate is resident, the particular affiliate deducts, in computing its income or profits subject to tax in that country for a taxation year, an amount in respect of a loss of another corporation resident in that country (referred to in that subsection as a “loss transferor”) and pays an amount to that loss transferor that may reasonably be regarded as being in respect of income or profits tax that would otherwise have been payable by the particular affiliate in respect of a particular amount that is included under subsection 91(1) of the Act in computing income of the relevant taxpayer in respect of that particular affiliate if the tax liability of the particular affiliate had been determined without deducting the loss of the loss transferor.

The conditions for the application of paragraph 5907(1.3)(b) are satisfied on the hypothetical facts at issue in this technical interpretation. Specifically, for purposes of paragraph 5907(1.3)(b), Holdco is the “particular affiliate” resident in the U.S. and each of Loss LLC 1 and Loss LLC 2 is a “loss transferor”. Based on CRA’s long-standing position, the LLCs are corporations for Canadian tax purposes. Loss LLC1 and Loss LLC2 are resident in the U.S. and would not be viewed otherwise for purposes of section 5907 pursuant to paragraph 5907(11.2)(b). As a result of the LLCs being treated as fiscally transparent for purposes of the U.S. income tax laws, 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. Absent deeming provisions analogous to subsections 5907(1.21) and (1.22), the losses of the LLCs cannot be viewed as losses of Holdco itself; they are losses of other corporations resident in the U.S. (the loss transferors) for the purpose of paragraph 5907(1.3)(b).

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, paragraph 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 subsection 5907(1.4).

Subsection 5907(1.4) will deny the amount prescribed to be FAT of Holdco under paragraph 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, 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, subsections 5907(1.5) and (1.6) would apply to reinstate the FAT.

We hope this information is of assistance to you.

Yours truly,

Charles Taylor
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch