16 June 2014 STEP Roundtable, 2014-0522971C6 - STEP CRA Roundtable – June 2014 - Question 3

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: How are equity interests in foreign corporations without share capital divided into deemed classes of capital stock?

Position: Equity interests are divided into deemed classes of capital stock based on their actual underlying rights and obligations as compared to all other equity interests in the corporation. Equity interests are considered to have identical rights and obligations provided any differences in those rights and obligations are proportionate.

Reasons: Text of proposed 93.3

STEP CRA Roundtable – June 2014

QUESTION 3. U.S. LLC/Share Capital

In amendments issued July 12, 2013, proposed section 93.3 contains specific rules for determining the share capital of a non-resident corporation which does not actually have share capital. Many types of foreign entities are constituted as companies without share capital, which, for Canadian income tax purposes, are considered foreign corporations (on the basis that a corporation includes a company with or without share capital). The most common example would be a U.S. LLC, where the capital may be divided into units, or may be stated as a percentage of income.

The purpose of this amendment seems to be, first and foremost, to characterize entities such as U.S. LLCs, for purposes of the foreign affiliate rules, but these rules apply throughout the Income Tax Act.

The amendment provides that the equity interests are to be separately viewed to the extent that they are not identical, on the basis that each represents a class of capital stock, and each class has notionally 100 issued and outstanding shares. Each owner is considered to have ownership proportionate to the fair market value of each distinct equity interest.

We have a number of questions concerning this proposed amendment. Firstly, consider the situation of a U.S. LLC, which is constituted in a way similar to a partnership, with the equity interests being referenced by a formula. The formula might provide for one party (say the manager) to receive incentive compensation in the form of a 2% income allocation for management, and a 20% profit share in certain circumstances. The residual profits may then be shared in accordance with a sharing ratio.

Would it be correct to assume that in this instance there would be 3 classes of equity interests, the first providing for the 2% income allocation, the second for the 20% incentive allocation, and the third for the residual amounts.

Secondly, if the manager had a special voting right, would this also constitute another class of equity interest?

Thirdly, if the income is to be allocated based on, for example, the revenue or net income for the year, as between 2 owners say, A and B, would it be correct to say that A and B each have a distinct equity interest, where the value of these equity interests may change from year to year (like 2 separate classes of common shares). Alternatively would there be 1 class of equity interest and the ownership of equity interests changes from year to year between A and B?

Fourthly, if it is the latter, is there a disposition or acquisition when the equity interests change?

CRA Response

An "equity interest" in a non-resident corporation without share capital is defined in proposed subsection 93.3(1) and is described in Finance's Explanatory Notes as follows:

"An equity interest in a non-resident corporation without share capital is defined to mean any right, whether absolute or contingent, conferred by the non-resident corporation to receive, either immediately or in the future, an amount that can reasonably be regarded as all or any part of the capital, of the revenue or of the income of the non-resident corporation. However, this does not include a right to receive an amount as creditor. For example, a contingent right, analogous to those of corporate shareholders, to receive a portion of an entity's income for the year, or a share of the entity's capital on its dissolution, would constitute an equity interest."

The first step in dividing the equity interests of a non-resident corporation without share capital (which is itself defined in proposed subsection 93.3(1) and herein referred to as the "non-resident corporation") into one or more deemed classes of the capital stock of the non-resident corporation under proposed subsection 93.3(2) would be to determine the rights and obligations of all the equity interests of the non-resident corporation. In our view, the determination of those rights and obligations may require looking to the constituting documents of the non-resident corporation, the law under which it was formed, and the agreements between the holders of the equity interests. Pursuant to proposed paragraph 93.3(2)(a), equity interests having identical rights and obligations, save for proportionate differences, would be deemed to be the same class of shares of the capital stock of the non-resident corporation.

For example, if all of the equity interests of the non-resident corporation have identical rights and obligations, save for proportionate differences, the non-resident corporation would be deemed to have a single class of capital stock. This is illustrated in the Department of Finance's explanatory notes which read in part:

"For example, if one member of a U.S. LLC has, by virtue of its equity interest, a right to 30% of the LLC's income and three votes at a meeting of the partnership's members, and another member has a right to 40% of the LLC's income and four votes at a members meeting, these differences as to income entitlements and votes would not preclude the members' equity interests from being considered to have identical rights and obligations because in this case the differences in income entitlements are proportionate to the differences in number of votes."

Equity interests that are unique as compared to the other equity interests of the non-resident corporation would be deemed to be their own separate class of capital stock.

In response to your first two questions, consider the case of a non-resident corporation in which four individual members have equity interests, and the only non-proportionate differences between those members' equity interests is that one member's equity interest (say the manager's) grants special voting rights and allows for the receipt of an additional allocation of income for management services as well as the potential to receive a further additional allocation of income as a performance incentive. Assuming that under the non-resident corporation's constituting documents, the relevant law, and any applicable agreements each of the four members has a single equity interest, it is our view that there would be deemed to be two classes of capital stock of the non-resident corporation. We are of this view because the manager would have one equity interest and that equity interest has non-proportionate differences as compared to the equity interests of the other three members. If, in the alternative, the manager had two different equity interests under the non-resident corporation's constituting documents, the relevant law, and any applicable agreements, there could still be two deemed classes of capital stock but the allocation could be different. For example, each of the four members could be deemed to own a portion of one class of capital stock and the manager could be deemed to own all of a second class of capital stock to which the additional income allocation and voting rights were attached. In both situations the focus is on comparing the equity interests for non-proportional differences, not the number of those differences.

As a further example, the income allocation and voting schemes described in your first two questions could be the product of equity interests which would be deemed to be more than two classes of capital stock. This could be the result where the non-resident corporation's equity interests are divided into distinct units, or are otherwise divisible and transferable with particular rights and obligations attached to particular equity interests or portions thereof. For instance, if the manager could transfer his equity interest (or a portion thereof) in which the incentive allocation rights are attached to a fifth member while still retaining an equity interest, there could be three or more classes of deemed capital stock. Only after reviewing all the factors which impact the rights and obligations of the various equity interests could the number of deemed classes of capital stock be determined.

In response to your third and fourth questions, in cases where the non-resident corporation's income allocation could vary from time to time, we would expect that, in most cases, the differences in allocation would be due to differences in the rights and obligations of the equity interests which would result in different classes of shares being deemed to exist under proposed paragraph 93.3(2)(a). However, exact guidance in an abstract case such as that presented in this question is not possible since there are numerous ways such income allocation variability could be accomplished and could differ from case-to-case and jurisdiction-to-jurisdiction.

In conclusion, the number of classes of capital stock deemed to exist under proposed section 93.3 and the allocation thereof in each situation may be unique and specific to the non-resident corporation without share capital in question since the rights and obligations attached to its equity interests would be dependent on its constituting documents, governing law, and the agreements between the holders of its equity interests. Only after reviewing all the pertinent facts specific to the non-resident corporation in question could the number of deemed classes of capital stock, and the allocation of the shares thereof at any time, be determined.

Eli Kae Moore
2014-052297