2018-0766441I7 Article XXIX(5) and 91(5)

Principal Issues: Where an agreement with the Canadian competent authority entered into pursuant to paragraph 5 of Article XXIX provides that a US S Corporation is a controlled foreign affiliate as defined in subsection 95(1) (“CFA”) of an individual, is a deduction from income under subsection 91(5) or any other provision available in respect of a dividend paid after the cancellation of the agreement? In particular, is a deduction available in respect of a dividend paid by a US S corporation where, at the time of the dividend payment, the US S corporation was either i) a CFA of the individual; or ii) not a foreign affiliate as defined in subsection 95(1) of the individual. Would the adjusted cost base (“ACB”) of the shares of the US S corporation to the shareholder be reduced?

Position: In the circumstances, i) the dividend would be deductible and the ACB of the shares would be reduced and ii).

Reasons: i) A deduction under subsection 91(5) would be available as the S corporation is a controlled foreign affiliate of the individual at all times and the dividend paid after the expiry of the agreement is prescribed to have been paid from its taxable surplus under subsection 5900(3) of the Regulations and a corresponding adjustment to the ACB would result from that. ii) A deduction under subsection 91(5) would not be available given that the S corporation is not a foreign affiliate of the individual at the time of the dividend payment and the dividend paid after the expiry of the agreement is not prescribed to have been paid from taxable surplus under subsection 5900(3) of the Regulations, hence the ACB would not be adjusted. Subsection 248(28) would not apply because the FAPI inclusion and the amount of the dividend received.

Author: Chang, Jack Yu-Fan
Section: 91(5), 248(28), 5900(3) of the Regulations and Article XXIX(5) of Canada-US Income Tax Treaty

August 30, 2019

Mr. Patrick Massicotte                                                        HEADQUARTERS
Competent Authority Services Division                           Income Tax Rulings
International and Large Business Directorate               Directorate
Canada Revenue Agency
                                                                                              Jack Chang
                                                                                             (416) 954-5164

                                                                                              2018-076644

           

Deduction Pursuant to Subsection 91(5)

We are writing in response to your request for us to comment on whether a Canadian resident individual (“Canadian Resident”), who is the shareholder of an S Corporation that resides in the United States (“S Corporation”), may claim a deduction from income in respect of a dividend paid by the S Corporation after the invalidation of an agreement (the “Agreement”) with the Canadian Competent Authority entered into pursuant to paragraph 5 of article XXIX of the Canada-US Income Tax Treaty (“Treaty”).

More specifically, you ask us to consider whether a deduction is available under subsection 91(5) of the Income Tax Act (the “Act”) or otherwise, where, subsequent to the invalidation of the Agreement and at the time of the dividend payment, S Corporation was:

i) XXXXXXXXXX% owned by Canadian Resident and a controlled foreign affiliate as defined in subsection 95(1) (“CFA”) of Canadian Resident at all times; or

ii) XXXXXXXXXX% owned by Canadian Resident and not a foreign affiliate as defined in subsection 95(1) (“FA”), of Canadian Resident.

Any reference to a statutory provision in this document is a reference to a provision of the Act.

You indicate that, under the Agreement, the income earned by S corporation was deemed to be foreign accrual property income as defined in subsection 95(1) (“FAPI”) and included in the income of Canadian Resident in the taxation year that preceded the invalidation of the Agreement.

Also, if a deduction is available, you ask whether the adjusted cost base as defined in subsection 248(1) and adjusted under subsections 53(2) and 92(1) (“ACB”), to Canadian Resident of the shares of S Corporation, would be reduced.

In summary, it is our view that:

i) Where S Corporation is a CFA of Canadian Resident at all times, a deduction under subsection 91(5) would be available in respect of the dividend paid by S Corporation after the invalidation of the Agreement and there would be a corresponding reduction to Canadian Resident’ ACB of the shares of S Corporation.

ii) Where S Corporation is not a FA of Canadian Resident at the time the dividend is paid, a deduction under subsection 91(5) is not available in respect of the dividend paid by S corporation. There would be no resulting reduction in the ACB to Canadian Resident of the shares of S Corporation. Subsection 248(28) would not be applicable to cancel the income inclusion of the dividend received from S Corporation in the income of Canadian Resident under subsection 90(1).

I. Facts

Canadian Resident owned voting shares of S Corporation (for purposes of our analysis, it has been assumed that S Corporation only has one class of shares). S Corporation was treated as fiscally transparent for US tax purposes. Canadian Resident paid taxes to the United States on the income of S Corporation.

Effective XXXXXXXXXX, Canadian Resident and the Canadian Competent Authority entered into the Agreement under article XXIX(5) of the Treaty. The Agreement provided that:

a) S Corporation was deemed to be a CFA of Canadian Resident, such that the income or loss of S Corporation for a year covered by the Agreement was deemed to be FAPI.

Consequently, Canadian Resident included his share of the FAPI in his income of that year pursuant to subsection 91(1) and claimed a foreign tax credit under section 126 in respect of taxes paid by him to the United States that year on his share of the income of S Corporation.

b) The amount of FAPI included in income was added to the ACB of the shares of S Corporation to Canadian Resident pursuant to paragraph 92(1)(a).

c) Dividends paid by S Corporation did not have to be included in Canadian Resident’s income to the extent that they could otherwise have been deducted under subsection 91(5) (no inclusion of the amount of the dividend in income and no corresponding deduction under subsection 91(5) either).

During the taxation year ending XXXXXXXXXX, S Corporation earned income and this income was included in Canadian Resident’s income as FAPI. Pursuant to paragraph 92(1)(a), Canadian Resident’s ACB of the shares of S Corporation was increased by the FAPI included in income for the XXXXXXXXXX taxation year. When read in conjunction with the Agreement, paragraph 92(1)(a) reads as follows:

In computing, at any time in a taxation year, the adjusted cost base to a taxpayer resident in Canada of any share owned by the taxpayer of the capital stock of a foreign affiliate of the taxpayer,

(a) there shall be added in respect of that share any amount included in respect of that share under subsection 91(1) or (3) in computing the taxpayer's income for the year or any preceding taxation year [a portion of the amount of income of S Corporation was deemed by the Agreement to be FAPI of a controlled foreign affiliate and included under 91(1)]; and

No distributions were made by S Corporation to Canadian Resident during the 2017 taxation year.

On XXXXXXXXXX, Canadian Resident revoked S Corporation’s status as a fiscally transparent entity for US tax purposes. As a result, the Agreement ceased to be effective as of that day.

On XXXXXXXXXX, S Corporation made a distribution of income that was previously included in the income of Canadian Resident as FAPI.

Since the dividend was paid after the invalidation of the Agreement, the amount of the dividend was included in the income of Canadian Resident under subsection 90(1) and paragraph 12(1)(k).

II. General objective of the Agreement

Generally, had Canadian Resident been a corporation instead of an individual and S Corporation not been a fiscally transparent entity for US tax purposes, the tax treatment would have been resulted in:

a) a FAPI income inclusion;

b) a deduction under subsection 91(4) on account of foreign taxes paid;

c) an addition to the taxable surplus of the FAPI income inclusion net of foreign taxes paid;

d) an addition to the ACB to Canadian Resident of the shares of S Corporation on account of the FAPI income inclusion;

e) the inclusion in income under subsection 90(1) on account of the amount of a future dividend;

f) a deduction under paragraph 113(1)(b) on account of a future dividend;

g) a deduction under subsection 91(5)on account of the dividend;

h) a reduction to the ACB to Canadian Resident of the shares of S Corporation on account of the deduction under subsection 91(5).

The Agreement mimicked that result by providing for a FAPI inclusion and a foreign tax credit (points a) and b)), replacing the inclusion and deduction under d) and f) by an exemption of the amount of the dividend and by deeming the application of subsection 91(5) for purposes of matching the ACB adjustment described in g).

As far as c) and e), the S Corporation, being a CFA of an individual, does not have taxable surplus as defined under Regulation 5907(1). The ability of an individual to claim a deduction under subsection 91(5) arises as a function of subsection of 5900(3) of the Regulations. Individuals do not get to claim a deduction under section 113 (this is discussed below).

III. Analysis – deductibility of the dividend under subsection 91(5)

A. S Corporation is XXXXXXXXXX% owned by Canadian Resident after the expiry of Agreement

In order for Canadian Resident to claim a deduction under subsection 91(5), the following conditions of that provision need to be met:

Where in a taxation year a taxpayer resident in Canada has received a dividend on a share of the capital stock of a corporation that was at any time a controlled foreign affiliate of the taxpayer, there may be deducted, in respect of such portion of the dividend as is prescribed to have been paid out of the taxable surplus of the affiliate, in computing the taxpayer's income for the year, the lesser of

(a) the amount by which that portion of the dividend exceeds the amount, if any, deductible in respect thereof under paragraph 113(1)(b), and

(b) the amount, if any, by which

(i) the total of all amounts required by paragraph 92(1)(a) to be added in computing the adjusted cost base to the taxpayer of the share before the dividend was so received by the taxpayer

    exceeds

(ii) the total of all amounts required by paragraph 92(1)(b) to be deducted in computing the adjusted cost base to the taxpayer of the share before the dividend was so received by the taxpayer.

Moreover, as Canadian Resident is an individual who is a shareholder of an FA, it is important to highlight subsection 5900(3) of the Regulations:

For the purposes of subsection 91(5) of the Act, if a person resident in Canada (other than a corporation) receives a dividend on a share of any class of the capital stock of a foreign affiliate of the person, the dividend is prescribed to have been paid out of the affiliate's taxable surplus.

We note in passing that it appears that the word “prescribed” in Regulation 5900(3) is to be read as “deemed”. It is only if we read the word in that sense that an individual who is the sole shareholder of a foreign corporation can claim a deduction under subsection 91(5) on a dividend received from that corporation.

If S Corporation were XXXXXXXXXX% owned by Canadian Resident after the expiry of Agreement, a deduction under subsection 91(5) would be available to Canadian Resident as (i) Canadian Resident would have received a dividend on the shares of the capital stock of S Corporation (a CFA of Canadian Resident at all times); and (ii) the dividend would be prescribed to have been paid out of S Corporation’s taxable surplus for purposes of subsection 91(5) under subsection 5900(3) of the Regulations because S Corporation would still be a FA of Canadian Resident after the invalidation of the Agreement.

The amount of the deduction would not be limited under paragraphs 91(5)(a) and (b) as the amount in both paragraphs would equal the amount of the dividend since: (i) the amount under paragraph 91(5)(a) would equal the amount of the dividend as no portion of the dividend would be deductible under paragraph 113(1)(b); and (ii) the amount under paragraph 91(5)(b) would equal the amount of the dividend as the amount of income of S Corporation would not be reduced by the payment of taxes (no taxes were paid by S Corporation), such amount would be FAPI included in income under subsection 91(1) and added to the Canadian Resident’ ACB of the shares of S Corporation under paragraph 92(1)(a) and there would be no offset by an ACB reduction (no taxes were paid by S Corporation and although the Agreement provided for a reduction of the ACB of the shares on account of dividends, no dividends were paid while the Agreement was in force).

As a result of the subsection 91(5) deduction, paragraph 92(1)(b) would reduce the ACB to Canadian Resident of the shares of S Corporation. Subsection 92(1) reads as follows:

In computing, at any time in a taxation year, the adjusted cost base to a taxpayer resident in Canada of any share owned by the taxpayer of the capital stock of a foreign affiliate of the taxpayer,

[…]

(b) there shall be deducted in respect of that share

(i) […], and

(ii) any dividend received by the taxpayer before that time, to the extent of the amount deducted by the taxpayer, in respect of the dividend, under subsection 91(5) [the amount of the dividend is deemed by the Agreement to have been deducted under that provision but no such dividends were paid]

in computing the taxpayer's income for the year or any preceding taxation year (or that would have been deductible by the taxpayer but for subsection 56(4.1) and sections 74.1 to 75 of this Act and section 74 of the Income Tax Act, chapter 148 of the Revised Statutes of Canada, 1952).

As a consequence, the resulting deduction under subsection 91(5) would also result in a reduction in Canadian Resident’ ACB of the shares of S Corporation under subparagraph 92(1)(b)(ii) and clause 53(2)(b)(i)(A) equal to the amount of the dividend.

B. US S Corporation is not a FA after the expiry of Agreement

If S Corporation is not a FA of Canadian Resident after the invalidation of the Agreement, no portion of the dividend paid by S Corporation after the invalidation of the Agreement would be prescribed by subsection 5900(3) of the Regulations to have been paid out of S Corporation’s taxable surplus for purposes of subsection 91(5). Thus, a deduction under subsection 91(5) would not be available to Canadian Resident. Given that a deduction under subsection 91(5) would not be available, there would also be no resulting reduction in the ACB to Canadian Resident of the shares of S Corporation under subparagraph 92(1)(b)(ii) and clause 53(2)(b)(i)(A).

In determining whether the inclusion of the dividend in the income of Canadian Resident under subsection 90(1) could be offset by another deduction or otherwise excluded from income on the basis that the income earned by S Corporation and supporting the payment of the dividend was previously included in Canadian Resident’ income as FAPI, subsection 248(28) should be considered:

Unless a contrary intention is evident, no provision of this Act shall be read or construed

(a) to require the inclusion or permit the deduction, either directly or indirectly, in computing a taxpayer's income, taxable income or taxable income earned in Canada, for a taxation year or in computing a taxpayer's income or loss for a taxation year from a particular source or from sources in a particular place, of any amount to the extent that the amount has already been directly or indirectly included or deducted, as the case may be, in computing such income, taxable income, taxable income earned in Canada or loss, for the year or any preceding taxation year;

In this context, subsection 248(28) would not apply if the amount of the dividend paid by S Corporation that was included in computing Canadian Resident’s income under subsection 90(1) is not the same as the amount of FAPI that was directly or indirectly included in computing Canadian Resident’s income for a preceding taxation year under subsection 91(1).

Given the intended liberal application of subsection 248(28) through the use of the phrase “either directly or indirectly” twice, it could be argued that consistent with that purpose, the dividend income inclusion should not be differentiated from the prior FAPI inclusion for purposes of subsection 248(28). The premise of that argument would be that just like the dividend, the FAPI inclusion is also derived from the shares of S Corporation as subsection 91(1) provides that FAPI is added to the income of Canadian Resident “in respect of each share owned by the taxpayer of the capital stock of a controlled foreign affiliate of the taxpayer, as income from the share”. The amount to be added to income is based on Canadian Resident’s participating percentage in S Corporation as defined in subsection 95(1). The argument would be that both the dividend and FAPI arise from the same source, namely the shares of S Corporation. That argument would support the view that, under paragraph 248(28)(a), subsection 90(1) cannot be read to require the inclusion of the dividend income in computing the income of Canadian Resident from the shares of S Corporation as that amount had indirectly been included in computing the income of Canadian Resident as FAPI earned on the shares of S Corporation in a preceding taxation year.

However, despite the apparent merits of a source based argument, the better view in this case is that the dividend income and FAPI inclusion are not the same amount and thus, subsection 90(1) would not require the inclusion in income of a particular amount that would already have been included in income. In particular, the subsection 90(1) dividend income inclusion that arises from the dividend paid on the shares that Canadian Resident owns in S Corporation is not the same as the subsection 91(1) income inclusion on account of S Corporation’s income earned that was deemed to be FAPI under the Agreement. Subsection 90(1) requires the inclusion in income of a dividend paid from a FA notwithstanding that an amount had been included in income as FAPI in any case.

A similar rationale was expressed in documents 2000-005649 and 2000-0011895 in connection with back to back loans where the Act provides for two income inclusions despite the fact that the inclusions might arguably be traced to the same sum of money. In those documents, it was the CRA’s view that although two income inclusions were related to one same original loan from the taxpayer, the two income inclusions were two different amounts. More specifically, the two separate amounts were an inclusion to the income of a corporation resident in Canada in respect of an amount owed to it by a non-resident person pursuant to subsection 17(1) and a separate inclusion of an amount deemed to be owed to it pursuant to subsection 17(2) because the non-resident person made another loan as a consequence of the initial debt to the corporation resident in Canada (eg: a Canadian resident corporation loans money to a FA which, because of that loan, loans money to non-affiliated, non-resident corporations).

In this case, the dividend income is a cash distribution on the shares of S Corporation while the FAPI is a notional allocation of the income of S Corporation deemed to be FAPI on its shares of S Corporation. Consistent with those positions, in these circumstances, the dividend income and FAPI are separate amounts of a different nature and thus, this would preclude the application of subsection 248(28).

Moreover, this conclusion is also consistent with document 2003-0008795 which dealt with the application of subsection 248(28) in the context of employee stock options and deemed dividends. In those circumstances, the CRA was of the view that subsection 248(28) would not apply as the tax benefit included in income under section 7 as a result of the exercise of a stock option and the subsequent deemed dividend included in income under subsection 84(3) as a result of the redemption of those shares were the result of different events and thus, separate amounts, even though they might arguably be viewed as sourced from the same economic accrued value on the shares.

Documents XXXXXXXXXX and 1999-0007005 discuss the application of subsection 248(28) in respect of the redemption of shares that were not held as capital property. The redemption of such shares gave rise to a deemed dividend under subsection 84(3) and also to an income gain under section 142.5. The CRA was of the view that subsection 248(28) was applicable as there was a double income inclusion because the exclusion under paragraph (j) of the definition of proceeds of disposition in section 54 did not apply to the deemed dividend. That conclusion appears to have been informed by the view that the income inclusion under subsection 84(3) and the income inclusion resulting from section 142.5 might in certain circumstances be viewed as being of the same nature and designed to capture one single income inclusion in different circumstances, probably the growth in value of a relevant share.

The amount of the dividend received by Canadian Resident on the shares of S Corporation and the amount deemed to be FAPI that was allocated to Canadian Resident in this file are closer to the precedents in the other documents referred to in this letter as, unlike documents XXXXXXXXXX and 1999-0007005, the income inclusions are of two separate natures and not designed to result in one single income inclusion. As such, the views expressed in 2000-005649, 2000-0011895 and 2003-0008795 support the non-application of subsection 248(28) in the current circumstances.

As a result, based on the above discussion, subsection 248(28) would not have application in the current circumstances given that the dividend income inclusion under subsection 90(1) and the inclusion of deemed FAPI under subsection 91(1) as a result of the Agreement are separate and different amounts. Our conclusion is based on both the precedents referred to above and the statutory scheme, as in our view, it could be said that “a contrary intention is evident” within the opening words of subsection 248(28).

An additional indication that the application of both subsections 90(1) and 91(1) in this case is consistent with the context and purpose of those provisions and of subsection 248(28) is that absent the application of paragraph 5 of article XXIX of the Treaty in some specific circumstances, the Act supports that result. Without having regard to paragraph 5 of article XXIX of the Treaty, the scheme of the Act requires Canadian Resident to include in income a dividend paid by S Corporation and the dividend income inclusion under subsection 90(1) will not always be fully offset by the US income taxes paid on the income attributed to Canadian Resident for US tax purposes. This happens where income is not distributed in the same taxation year that the income is earned.

To address this timing issue, paragraph 5 of Article XXIX of the Treaty was added by the third protocol, 1995 and the technical explanation to that protocol states:

New paragraph 5 provides a rule for the taxation by Canada of a Canadian resident that is a shareholder in a U.S. S corporation. The application of this rule is relatively limited, because U.S. domestic law requires that S corporation shareholders be either U.S. citizens or U.S. residents. Therefore, the rule provided by paragraph 5 would apply only to an S corporation shareholder who is a resident of both the United States and Canada (i.e., a "dual resident" who meets certain requirements), determined before application of the "tie-breaker" rules of Article IV (Residence), or a U.S. citizen resident in Canada. Since the shareholder would be subject to U.S. tax on its share of the income of the S corporation as it is earned by the S corporation and, under Canadian statutory law, would be subject to tax only when the income is distributed, there could be a timing mismatch resulting in unrelieved double taxation. Under paragraph 5, the shareholder can make a request to the Canadian competent authority for relief under the special rules of the paragraph. Under these rules, the Canadian shareholder will be subject to Canadian tax on essentially the same basis as he is subject to U.S. tax, thus eliminating the timing mismatch.

Paragraph 5 of article XXIX was introduced to, in certain circumstances, relieve the aforementioned timing mismatch. The relief under paragraph 5 of article XXIX is not automatic and is at the discretion of the Canadian competent authority and is then only valid while any agreement is effective. Where a taxpayer has revoked the status of a US S corporation as a fiscally transparent entity for US tax purposes, the explicit intent was that paragraph 5 of article XXIX would no longer apply and the provisions of the Act would govern the taxation of the subsequent dividend paid by the US S Corporation.

Moreover, although subsection 248(28) was not discussed, document 2001-009334 appears to provide implicit support for the non-application of subsection 248(28) in the current circumstances. More specifically, in document 2001-009334, the shares of a CFA (CFA 1) that had earned FAPI (which was included in the income of the taxpayer) were transferred by a taxpayer to a newly formed CFA (CFA 2) of the same taxpayer under subsection 85.1(3). In those circumstances, it was concluded that a subsection 91(5) would not be allowed to the taxpayer on a subsequent dividend paid from CFA 1 up the chain to the taxpayer since the FAPI included in the income of the taxpayer before the transfer of the shares of CFA 1 was not added to the ACB of the shares of CFA 2 for which the taxpayer received the dividend, even though indirectly, because of the rollover provided under subsection 85.1(3), the ACB of the shares of CFA2 includes the equivalent of this amount of FAPI that was itself added to the ACB of the CFA1 shares. Even though the circumstances results in a double income inclusion in the form of FAPI and the subsequent dividend received by the taxpayer because of the non-application of subsection 91(5), the taxpayer was without recourse to subsection 248(28).

As such, we conclude that subsection 248(28) does not apply and that it is appropriate to include the dividend in the income of Canadian Resident in the circumstances.

Yves Moreno
Manager, International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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