Regulations to the Income Tax Act (Canada) (Act) contain rules with respect to the computation of the earnings of a foreign affiliate of a Canadian-resident taxpayer, which is relevant in calculating the surplus accounts of the foreign affiliate. Historically, the Canada Revenue Agency (CRA) has taken the position that the earnings of a limited liability company (LLC) with only one member should be computed in accordance with Canadian tax rules.1 However, in at least one audit, the CRA International Audit Division has taken the position that an LLC with a single member that is resident in and carrying on an active business in the US should compute its earnings under US tax rules. It appears that the CRA's recent audit position stems from a concern with the possible inflation of the surplus accounts of single-member LLCs. This position appears to be inconsistent with the definition of "earnings" as set out in Regulation 5907(1).
Earnings and Regulation 5907(1)
Regulation 5907(1) defines a foreign affiliate's earnings from an active business for the purposes of computing the foreign affiliate's surplus and deficit accounts. Specifically, Regulation 5907(1)(a) provides that "earnings of a foreign affiliate from an active business" means:
- the income or profit from the active business for the year computed in accordance with the income tax law of the country in which the affiliate is resident, in any case where the affiliate is required by that law to compute that income or profit;
- the income or profit from the active business for the year computed in accordance with the income tax law of the country in which the business is carried on, in any case not described in subparagraph (i) where the affiliate is required by that law to compute that income or profit; and
- in any other case, the amount that would be the income from the active business for the year under Part I of the Act if the business were carried on in Canada, the affiliate were resident in Canada, and the Act were read without reference to certain specified provisions in the Act.
Based on the foregoing, a foreign affiliate that is carrying on an active business and that is not required to compute its income or profit under the income tax laws of the country in which it is resident, or in which it is carrying on the active business, must compute its earnings in accordance with Part I of the Act.
US Tax Status of Single-Member LLCs
We understand that single-member LLCs are disregarded entities for US tax purposes and are therefore not required to compute their income or profit under US tax law.2 Since single-member LLCs are not required to calculate their earnings under US tax law, it follows that such LLCs are required to compute their earnings under Regulation 5907(1)(a)(iii).
CRA Audit Position
In response to a recent audit query, the CRA has stated that the earnings of a single-member LLC resident in and carrying on business in the US should be computed under Regulation 5907(1)(a)(i). The CRA's basis for this position is that the income of the single-member LLC is required to be computed under US tax laws for the purposes of determining its member's taxable income for US tax purposes and, as such, the earnings of the LLC should also be computed in accordance with US tax laws. The CRA further stated that the intention of Regulation 5907(1)(a)(i) is to alleviate the need to completely re-compute the earnings from an active business of a foreign affiliate in accordance with Part I of the Act where its earnings from the business have already been computed under the tax laws of another country.
The foregoing position appears to be inconsistent with a textual, contextual and purposive interpretation of Regulation 5907(1).
From a textual perspective, the definition of earnings is unambiguous in its application; each foreign affiliate of a Canadian resident taxpayer is required to compute its income or profit under prescribed rules, depending on the application of foreign income tax laws to that particular foreign affiliate.
From a contextual perspective, the Act clearly treats each taxpayer separately. Even a partnership, which is not subject to tax (other than a specified investment flow-through partnership), is required by subsection 96(1) of the Act to compute its income as if the partnership were a separate person. There are no provisions in the Act that require or entitle a taxpayer to disregard an entity when computing the taxpayer's earnings or profit. Further, under Canadian tax law, each foreign affiliate determines its surplus accounts on an unconsolidated basis. Issues sometimes arise where a group of foreign affiliates determine their foreign tax liability on a consolidated basis, such as a group of foreign affiliates resident in and carrying on business in the US. In these circumstances, Regulation 5907(1.1) specifically provides for adjustments to the surplus balance of each member of a group of foreign affiliates where the liability for income or profits tax is computed on a consolidated basis and one of the foreign affiliates is responsible for paying, or claiming a refund of, tax on behalf of a group member. For example, if the total tax liability of the consolidated group has been paid by a single foreign affiliate without any tax-sharing payments being made, Regulation 5907(1.1)(a) adjusts the surplus balance of the foreign affiliate that pays the tax or receives a refund of tax only. If a member of the consolidated group makes a tax-sharing payment to the paying foreign affiliate, Regulation 5907(1.1)(b) adjusts the surplus balances of all members. Regulation 5907(1.1) expressly recognizes that each foreign affiliate is to be treated as a distinct legal entity for purposes of computing its surplus accounts (which are based on its "earnings") even where it is a member of a consolidated group for foreign tax purposes. This rule would not be necessary for a single-member LLC if its business earnings could be attributable to its member.
From a purposive perspective, the definition of earnings contained in Regulation 5907(1) appears to provide a clear starting point for each foreign affiliate in computing its earnings that are relevant in computing its surplus accounts. This purpose is served by providing a default set of rules under which each foreign affiliate must calculate its earnings where that foreign affiliate is not required to compute its income under the income tax laws of the jurisdiction in which it is resident, or in which it carries on its active business. In all circumstances a foreign affiliate can compute its income with certainty.
Lastly, the CRA’s audit position also appears to be inconsistent with longstanding CRA assessing practices that do not disregard the existence of single-member LLCs. For example, before the adoption of the Fifth Protocol to the Canada – US Tax Convention, the CRA denied treaty benefits to an LLC on the basis that the LLC was not liable to tax in the US, yet because of the LLC’s separate legal personality, the LLC’s member was not treated as having carried on the LLC’s business and could not claim treaty benefits on a flow-through basis.3
The CRA has also commented on whether US tax paid by a US foreign affiliate, where that foreign affiliate was the single member of an LLC that earns foreign accrual property income, would be foreign accrual tax and underlying foreign tax. Specifically, the CRA stated:
- the foreign accrual tax deduction will be allowed under subsection 91(4) of the Act in the year in which the LLC pays the dividend to its single member, being the US foreign affiliate; and
- the tax is considered "underlying foreign tax" in the year in which dividends are paid by the LLC.4
Similar CRA administrative positions exist in relation to the direct holding of an LLC by a Canadian company.5