Often, U.S. citizens who move to Canada are shareholders of U.S. S Corporations. This can potentially create double tax problems.
Under Canadian tax law, the S Corporation is just like any other foreign corporation. Dividends received are generally fully taxable. In addition, if the S Corporation is a “controlled foreign affiliate”, the shareholder can be taxable on his or her share of underlying investment income and capital gains under Canada’s “foreign accrual property income”(“FAPI”) rules.
Double taxation can arise because of the fact that Canada will generally only grant limited foreign tax credit relief for the U.S. taxes paid by the shareholder on the S Corporation income. This relief is generally limited to 15% of any dividends received. In addition, the tax paid by the shareholder will not be treated as a “foreign accrual tax” for the purposes of the FAPI rules. In a simple situation, undistributed investment income earned by the S corporation can be taxed in the hands of the Canadian resident shareholder by both Canada and the U.S. with very limited ability to avoid double taxation.
However, there is a little-known provision in the Canada-U.S. Tax Convention that can come to the rescue in such situations. Article XXIX(5) states as follows:
“Where a person who is a resident of Canada and a shareholder of a United States S corporation requests the competent authority of Canada to do so, the competent authority may agree, subject to terms and conditions satisfactory to such competent authority, to apply the following rules for the purposes of taxation in Canada with respect to the period during which the agreement is effective:
(a) The corporation shall be deemed to be a controlled foreign affiliate of the person;
(b) All the income of the corporation shall be deemed to be foreign accrual property income;
(c) For the purposes of subsection 20(11) of the Income Tax Act, the amount of the corporation’s income that is included in the person’s income shall be deemed not to be income from a property; and
(d) Each dividend paid to the person on a share of the capital stock of the corporation shall be excluded from the person’s income and shall be deducted in computing the adjusted cost base to the person of the share.”
If a Canadian resident successfully applies to the Canada Revenue Agency to have this special rule apply, the end result should be that double tax will be avoided. The applicable share of the S Corporation’s income will be included in income for Canadian tax purposes, and a full foreign tax credit should be allowed. Distribution of dividends will not be taxable, but will be treated as a reduction of cost base, which should be offset by the increase in cost base that will occur as the result of the income inclusion.
In this regard, it is significant to note that, in response to questions posed of the Canada Revenue Agency as part of the 2015 National Conference of STEP Canada in June of 2015 (Question 4), the CRA stated:
“A Canadian-resident shareholder of an S corporation seeking to enter into an S Corporation Agreement with the Canadian Competent Authority should be aware that, for Canadian tax purposes…the income of the S corporation is computed under US tax rules (this means, for example, that the full amount of any capital gain realized by the S corporation is treated as FAPI)”
This will be surprising to many Canadian tax practitioners, and may be a significant drawback to making this election.
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