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How United States S-Corporations are Taxed by Canada

Author: Brad Howland
First Posted: Aug. 18, 2007

A client of mine, a US citizen living in Canada, would normally have a straightforward situation except for one thing: he is a shareholder in a United States S-Corporation (or S-Corp). My client faces double taxation, as we shall see, and he can't use corporate losses to offset other income on his Canadian tax return.

A big disclaimer: before we roll up our sleeves and dig in, let me say that I am not sure I have it all right! The situation is complicated by barely comprehensible language in Canada's Income Tax Act (ITA). I invite and welcome other tax professionals to contact us and comment on this article!

The problem is that for US tax purposes S-Corps are treated essentially the same as partnerships, with income flowing through to the shareholder's returns to be taxed on the individual level. In Canada however, S-Corps are considered to be corporations by Canada Revenue Agency.

Double taxation, according to Wikipedia, is "a situation in which two or more taxes may need to be paid for the same asset, financial transaction and/or income and arises due to overlap between different countries' tax laws and jurisdictions. The liability is often mitigated by 'tax treaties' between countries."

Let's take a look at the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, which has the following to say in Article XXIX(5):

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:

  1. the corporation shall be deemed to be a controlled foreign affiliate of the person;
  2. all the income of the corporation shall be deemed to be foreign accrual property income;
  3. 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
  4. 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.

Wow. Did you get all that?

S-Corps could be considered to be "Controlled Foreign Affiliates" under ITA 95(1). Shareholders of Controlled Foreign Affiliates must report "Foreign Accrual Property Income" (FAPI) to Canada under ITA 91(1), even if that income has not been paid out to them directly. I did my best to plow through these complicated sections of the ITA–didn't get very far–but came away with the impression that Canadian-resident shareholders in US S-Corps, where the corporation falls under the definition of a Controlled Foreign Affiliate, have to report their share of interest, dividend, and certain other kinds of income earned by the corporation (defined under the FAPI rules) on their Canadian tax returns, but not necessarily other income of the corporation, such as business income.

There also appear to be two forms that an S-Corp shareholder should consider filing:

There is no guidance available on the CRA website related to these forms, other than the instructions to the forms themselves. It is suggested in Preparing Your Income Tax Returns Section 495 (Michael Mallin) that CRA is able to levy up to $2,500 in fines for failing to file these forms. From this I deduce that it would be prudent for S-Corp shareholders to file one of them. The due date would be 15 months after the end of the taxpayer's taxation year.

An Example

Let's look at a simplified example and see what might happen. Consider the hypothetical case of a Canadian resident who owns 100% of the stock of a US S-Corp:

Here's how the US will tax the shareholder:

Here's how Canada would tax the shareholder (without taking into account the Canada/US treaty):

The shareholder has paid tax on the $5,500 income twice, once to the US over years 1 and 2 ($10,500 - $5,000), and then again to Canada in year 3! He/she can't mitigate the situation with Foreign Tax Credits because the income was reportable to Canada and the US in different years.

Things look grim for the beleaguered shareholder. However, I can think of two solutions that might make things better.

Possible Solution A - Treaty Based

To its credit the Canada/US treaty does its level best to fix the problem, but the treaty provisions don't work very well in the above example because of the corporate losses in years 1 and 3, which are not deductible in Canada. Any time corporate losses are flowed through to the shareholder's 1040, income is probably going to be overstated on the Canadian side, and double taxation will rear its ugly head.

It would help if the losses could be claimed as investment expenses, but I have received conflicting reports about whether or not such investment expenses would be allowed. I don't see anything in Canada's definition of an investment expense that allows S-Corp losses, so I wouldn't want to chance it.

Application of the tax treaty rules might save some tax if the shareholder structured the corporate income to get rid of any loss flow-throughs. The income reporting would perhaps match up better between the two countries, with the shareholder able to make some use of Foreign Tax Credits to reduce double taxation.

The competent authority of Canada (CRA) has to agree to the treaty interpretation, which means permission would probably have to be obtained from the Rulings Directorate before filing the tax return, taking some major advance planning on the part of the shareholder. For this reason, I feel that application of the treaty provisions would rarely be useful.

Possible Solution B - Non-Treaty Based

A simple approach the shareholder could take, with no need to resort to the treaty or get rulings from CRA, would be to pay out all of the S-Corp's net income in any given year in the form of salary or bonus, cleaning out the corporate coffers as it were. This technique would match up income between the two countries and allow Foreign Tax Credits to be used. The shareholder's Canadian income tax preparation would also be greatly simplified, meaning less accounting fees paid out!


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