Principal Issues: Situation where a U.S. individual owns two S Corporations, each of which owns part of a Canadian ULC, which is disregarded for U.S. tax purposes, and one of the S Corporations had lent money at interest to the ULC.
Would paragraph IV(7)(b) of the Convention be applicable on the interest payments from the ULC to the S corporation, denying the benefits of the Convention?
Position: Article IV(7)(b) of the Convention would not apply.
Reasons: U.S. tax treatment of the interest payment would be the same whether ULC is treated as a partnership or not in this scenario.
XXXXXXXXXX 2010-037675 Nancy Turgeon, CGA Attention: XXXXXXXXXX
May 24, 2011
Sir:
Re: S Corporation and application of Article IV(7)(b).
This is further to your email of July 29, 2010 in which you asked us to confirm whether paragraph IV(7)(b) of the Convention between Canada and The United States of America with Respect to Taxes on Income and on Capital Signed on September 26, 1980, as amended by the Fifth Protocol signed on September 21, 2007, ("the Convention") could be applicable in a hypothetical situation.
Hypothetical situation submitted
You have presented a hypothetical situation where a U.S. individual owns two S Corporations, each of which owns part of a Canadian ULC, which is disregarded for U.S. tax purposes, and one of the S Corporations had lent money at interest to the ULC.
Questions
You ask whether the paragraph IV(7)(b) of the Convention would be applicable on the interest payments from the ULC to the S Corporation, denying the benefits of the Convention?
Comments
The particular circumstances outlined in your letter seem to relate to a factual situation involving specific taxpayers. As explained in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, the Income Tax Rulings Directorate of the Canada Revenue Agency ("CRA") does not comment on transactions involving specific taxpayers except by way of an advance income tax ruling in respect of proposed transactions. When the situation involves a specific taxpayer and a completed transaction, the question should be directed to the appropriate Tax Services Office of the CRA for their views, along with all relevant facts and documentation. Nevertheless, we are prepared to offer the following general comments, which may be of assistance. Our comments constitute technical interpretations. They are not income tax rulings and they are not binding on the CRA.
Paragraph 7(b) of Article IV of the Convention contains rules that consider certain amounts as not having been paid to or derived by a resident of a Contracting State.
Article IV(7)(b) applies to an amount of income, profit or gain received by a resident of one of the Contracting States, herein United States, from an entity that is a resident of the other state, herein Canada, in the following circumstances:
1) The entity is fiscally transparent under the taxation laws of the United States;
and
2) The treatment of the amount under the taxation laws of the United States would not be the same if the entity were not fiscally transparent.
The determination of same treatment (or, more accurately, "not the same" treatment) for the purposes of Article IV(7)(b) involves an analysis of the quantum, character and timing of the item of income, profit or gain under United States tax laws in two scenarios: (1) if the entity (i.e., ULC) is disregarded under the taxation laws of the United States, and (2) if the entity is not disregarded (i.e., not fiscally transparent) for the purposes of those laws.
Under the U.S. entity classification rules, an entity with at least two owners can elect to be classified as a corporation or a partnership. In your hypothetical situation, because ULC has two S Corporations as direct owners, ULC cannot be a disregarded entity and may only be treated as a partnership.
We are of the view that, according to the structure you describe, the U.S. tax authority would see an interest payment being made to the lending S Corporation, whether ULC is treated as a partnership or not. Thus, since the U.S. tax treatment is the same in both cases, Article IV(7)(b) of the Convention would not apply.
Canada usually accepts that an S Corporation is considered resident of the United States for the purposes of the Convention. Thus, Canada should, in theory, grant the benefits of the Convention to the S Corporation in its own right. Because S Corporations, even if they pass income, losses, deductions and credits through to their shareholders for federal tax purposes, remain responsible for tax on certain built-in gains and passive income. S Corporations are undeniably liable to tax unlike LLCs which are seen as partnerships and not liable to tax on their own on any items under the U.S. tax laws.
We trust the above comments will be of some assistance.
Yours truly,
Alain Godin, Manager
for Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch