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: (a) In the context of sub-subclause 95(2)(a)(ii)(D)(IV)2., whether a U.S. LLC that has a loss in the year could meet the requirement that all or substantially all of its income is subject to taxation in the hands of its members.
(b) If the second affiliate sells its interest in the third affiliate part way through the year, can the second affiliate be considered a member of the third affiliate at the end of the year for purposes of determining if "all or substantially all" of the third affiliate's income is subject to taxation?
Position: (a) Yes. (b) No.
Reasons: (a) Consistent with our position in 2015-061056.
(b) The provision refers to members. Since the second affiliate is not a member at the end of the year, its income allocation cannot be considered in determining whether the requirement is met.
2017 International Fiscal Association Conference
Question 7 – Clause 95(2)(a)(ii)(D) issues regarding U.S. LLCs
Clause 95(2)(a)(ii)(D) (“Cap D”) recharacterizes, as income from an active business, income derived by a foreign affiliate (the first affiliate) of a taxpayer from amounts paid or payable by another affiliate (the second affiliate) of the taxpayer as interest on borrowed money used to acquire – or on unpaid purchase price from the acquisition of – shares of another foreign affiliate (the third affiliate) of the taxpayer, provided that certain conditions set out in Cap D are satisfied.
a) Assume a hypothetical scenario where the second affiliate, the third affiliate, or both, are disregarded U.S. LLCs and had a loss in a particular taxation year that ended after the loan was made. The members or shareholders in respect of each of the second affiliate and the third affiliate, as applicable, are residents of the U.S. and are subject to income taxation in the U.S.
In respect of such a disregarded U.S. LLC, sub-subclause 95(2)(a)(ii)(D)(IV)2. (“Sub-sub 2”) requires that the members or shareholders of the LLC be subject to income taxation in a country other than Canada on, in aggregate, all or substantially all of the income of the LLC.
Can the CRA confirm that, notwithstanding that Sub-sub 2 simply refers to “income” (as opposed to “income or loss”), the interest paid or payable in respect of the loan would still be eligible for recharacterization assuming that all other requirements of Cap D are met?
b) As a variant of the previous scenario, assume that the third affiliate (“3rd LLC”) is characterized as a partnership for U.S. tax purposes with the second affiliate (“U.S. Holdco”) owning 40% of 3rd LLC’s interests and arm’s length U.S. taxable residents owning the remaining 60%. 3rd LLC and its members have a December 31st taxation year-end. The operating agreement of 3rd LLC is such that each member is allocated its share of the income or loss of 3rd LLC for the period in a particular taxation year during which it was a member.
U.S. Holdco sells all of its ownership interests in 3rd LLC to an arm’s length U.S. taxable resident on June 1st, 2016, and the disposition does not give rise to a taxation year-end of 3rd LLC for U.S. tax purposes. U.S. Holdco is a regarded corporation and is subject to U.S. tax on its share of any income or loss of 3rd LLC for the period from January 1st to May 31st, 2016, notwithstanding that U.S. Holdco is not a member of 3rd LLC on December 31st, 2016.
Sub-sub 2 requires that the members or shareholders of 3rd LLC at the end of 3rd LLC’s taxation year (December 31st, 2016) be subject to income taxation in their taxation years (ending December 31st, 2016) on all or substantially all of the income of 3rd LLC for its taxation year ending December 31st, 2016.
Would the CRA consider that the “end of the year” requirement in Sub-sub 2 is met notwithstanding that U.S. Holdco is not a member of 3rd LLC on that date and (due to the timing of the disposition occurring in mid-year) the members of 3rd LLC at the end of its taxation year may not be subject to tax on “all or substantially all” of the income of 3rd LLC for that year?
a) The CRA previously addressed a similar question at the 2015 CTF round table (Q.9). The situation considered involved the second and the third affiliates being fiscally transparent under the tax law of a foreign jurisdiction and the second affiliate incurring interest and other expenses, which reduced the income ultimately included in the income of the indirect member or shareholder of the third affiliate. The question was whether, in respect of the third affiliate, the requirement of Sub-sub 2 that the member or shareholder of that affiliate be subject to income taxation in a country other than Canada on, in aggregate, all or substantially all of the income of that affiliate was met.
The CRA stated that the member or shareholder would still be considered to be subject to income taxation on all or substantially all of the income earned by the third affiliate, notwithstanding that the member or shareholder does not pay any tax in a particular year because the second affiliate incurred interest or other expenses in the year. The CRA expressed the view that the “subject to income taxation… on all or substantially all of the income” requirement does not preclude the second affiliate from incurring expenses, but rather, this requirement will not be met where, generally, more than 10% of the income of the third affiliate is ultimately not subject to income taxation in a country other than Canada (e.g., a 20% shareholder or member is tax-exempt or otherwise not subject to income tax in the foreign jurisdiction).
The CRA continues to be of this view. Accordingly, in the situation described above, interest income of the first affiliate will still be eligible for recharacterization under Cap D, notwithstanding that either the second or the third affiliate or both had a loss in a particular taxation year.
b) In the CRA’s view, the words of Sub-sub 2 do not support such an interpretation. U.S. Holdco is not a member of 3rd LLC on December 31st, 2016. As a result, the portion of 3rd LLC’s income that would be subject to taxation in the hands of the entities that were members on December 31st would likely not be sufficient to meet the “all or substantially all” requirement in Sub-sub 2 because of the significant portion of income allocated to U.S. Holdco.
The CRA recognizes that this result may not be consistent with the underlying tax policy and has brought this matter to the attention of the Department of Finance.
April 26, 2017
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2017
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2017