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 should the base erosion test in subparagraph 2(e) of Article XXIX-A of the Canada-U.S. Tax Convention be applied to a qualified subchapter S subsidiary ("QSSS")?
Position: The base erosion test is to be applied as if the QSSS was not fiscally transparent and was required to compute its gross income and expenses in its own right
Reasons: Consistent with the purpose of Article XXIX-A(2)
XXXXXXXXXX 2010-036125
Henry Leung
613-957-9232
June 16, 2010
Dear XXXXXXXXXX :
Re: Base Erosion Test for Qualified Subchapter S Subsidiary
This is in response to your letter dated March 17, 2010 asking us to confirm how the base erosion test in subparagraph 2(e) of Article XXIX-A of the Canada-U.S. Tax Convention (the "Treaty") should be applied to a qualified subchapter S subsidiary ("QSSS") to determine if the QSSS is a "qualifying person" for the purposes of the Treaty. In your letter you noted that, for United States tax purposes, a QSSS does not file its own tax return, but instead the taxable income of the QSSS is included in the tax return of the QSSSs' shareholder (i.e. the parent subchapter S corporation) or the ultimate subchapter S corporation shareholder in the event that the QSSS is owned indirectly through one or more other QSSSs. Accordingly, a QSSS does not, under the taxation laws of the United States, have its own gross income or deductible expenses.
Our Comments
This Directorate does not provide assurances regarding the tax consequences relating to proposed transactions that involve specific taxpayers other than in the form of an advance income tax ruling. For more information about how to obtain a ruling, please refer to Information Circular 70-6R5, "Advance Income Tax Ruling", dated May 17, 2002. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on the internet at http://www.cra-arc.gc.ca. Where the particular transactions are complete, the inquiry should be addressed to the relevant tax services office, a list of which is available on the "Contact Us" page of the CRA website. We are, however, prepared to provide the following general comments.
Article XXIX-A(2) of the Treaty provides that certain residents of a Contracting State are required to satisfy both an ownership and a base erosion test to be considered a qualifying person. In general terms, the base erosion test in subparagraph 2(e) of Article XXIX-A of the Treaty asks whether the amount of the deductible expenses of an entity for a particular fiscal period that are paid or payable (either directly or indirectly) to persons that are not qualifying persons is less than 50 percent of the gross income of the entity for that period.
The Technical Explanation to the Fifth Protocol explains the purpose of the base erosion test in subparagraph 2(e) as follows:
The second test of subparagraph 2(e) is the so-called "base erosion" test. A company or trust that passes the ownership test must also pass this test to be a qualifying person under this subparagraph. This test requires that the amount of expenses that are paid or payable by the entity in question, directly or indirectly, to persons that are not qualifying persons, and that are deductible from gross income (with both deductibility and gross income as determined under the tax laws of the State of residence of the company or trust), be less than 50 percent of the gross income of the company or trust. This test is applied for the fiscal period immediately preceding the period for which the qualifying person test is being applied. If it is the first fiscal period of the person, the test is applied for the current period.
The ownership/base erosion test recognizes that the benefits of the Convention can be enjoyed indirectly not only by equity holders of an entity, but also by that entity's obligees, such as lenders, licensors, service providers, insurers and reinsurers, and others. For example, a third-country resident could license technology to a Canadian-owned Canadian corporation to be sub-licensed to a U.S. resident. The U.S.-source royalty income of the Canadian corporation would be exempt from U.S. withholding tax under Article XII (Royalties) of the Convention. While the Canadian corporation would be subject to Canadian corporation income tax, its taxable income could be reduced to near zero as a result of the deductible royalties paid to the third-country resident. If, under a convention between Canada and the third country, those royalties were either exempt from Canadian tax or subject to tax at a low rate, the U.S. treaty benefit with respect to the U.S.-source royalty income would have flowed to the third-country resident at little or no tax cost, with no reciprocal benefit to the United States from the third country. The ownership/base erosion test therefore requires both that qualifying persons substantially own the entity and that the entity's tax base is not substantially eroded by payments (directly or indirectly) to nonqualifying persons.
(underlining added)
Consistent with the purpose of Article XXIX-A(2) of the Treaty and subparagraph 2(e) of Article XXIX-A in particular, it is our view that the base erosion test is intended to apply to an entity, like a QSSS, that is treated as a resident of the United States for the purposes of the Treaty but that is fiscally transparent under the taxation laws of the United States. In our view, the test is applied as if the entity was not fiscally transparent and was required to compute its gross income and expenses in its own right.
We trust this information is of assistance to you.
Yours truly,
Daryl Boychuk
Manager, International Section I
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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