2016-0642131C6 IFA 2016 Q.9: Article IV(7) and S-Corporations

Principal Issues: Does subparagraph 7(b) of Article IV of the Treaty apply to the interest paid by a Canadian unlimited liability company that is disregarded for U.S. tax purposes to a US S corporation that is the holder of a 100% interest in a qualified subchapter S subsidiary that owns a 100% interest in the aforementioned Canadian unlimited liability company?

Position: Yes

Reasons: To the extent that a Canadian ULC is disregarded for U.S. tax purposes, the interest income paid by the ULC would not receive the “same treatment” as it would have received if the ULC was treated as being a regarded entity for U.S. tax purposes and as such, subparagraph 7(b) of Article IV of the Treaty would apply to deny Treaty benefits to the US S Corporation parent in respect of that interest income.

Author: Chang, Jack Yu-Fan
Section: Article IV(7)(b)

2016 International Fiscal Association Conference
CRA Roundtable

Question 9 – Application of Subparagraph 7(b) of Article IV to S-corporations

Assume the following hypothetical facts:

a)    US Parent, a U.S.-incorporated corporation, owns all the shares of US Sub, another U.S.-incorporated corporation.

b)    For U.S. tax purposes, US Parent has elected to be treated as an “S-corporation” and US Sub has elected to be treated as a “Qualified Subchapter S Subsidiary”. Thus, both corporations are fiscally transparent for U.S. tax purposes and the shareholders of US Parent are taxable in respect of their income.

c)    US Sub owns all the shares of Can ULC, an unlimited liability company formed under the laws of Nova Scotia.  Can ULC is a disregarded entity for U.S. tax purposes.

d)    Can ULC has an outstanding interest-bearing loan owing to US Parent.

Based on these facts, will subparagraph 7(b) of Article IV of the Canada-U.S. Income Tax Convention (the “Treaty”) apply such that US Parent will be denied Treaty benefits in respect of the interest paid by Can ULC?

CRA Response

It is our understanding that, for U.S. tax purposes, an S corporation can own a 100 percent ownership interest in a Qualified Subchapter S Subsidiary (“QSSS”) and upon election of the parent S corporation under 1361(1)(b)(3) of the Internal Revenue Code, the QSSS would not be treated as a separate corporation and all the assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary would be treated as that of the parent S corporation.

Based on the above understanding, to the extent that Can ULC is disregarded for U.S. tax purposes, the loan owing by Can ULC to US Parent should also be disregarded for U.S. tax purposes.  As a result, the interest income would not receive the “same treatment” for U.S. tax purposes as it would have received if Can ULC were treated as being a regarded entity for U.S. tax purposes.  That is, the interest payment made by Can ULC to US Parent is disregarded for U.S. tax purposes, whereas, if U.S. tax law regarded Can ULC as a corporation, the payment would be treated as interest. As such, we are of the view that subparagraph 7(b) of Article IV of the Treaty will apply to deny Treaty benefits to the US Parent in respect of that interest income.

Jack Chang
Terry Young
2016-064213
May 26, 2016

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