Special Election For U.S. Expats In Canada With S Corporations Can Avoid Double Tax

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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 accordance with Circular 230 Disclosure


Mr. Atlas is a Toronto-based Chartered Accountant who practices as an independent consultant on a wide-range of international and domestic tax issues. Most of his practice consists of advising accounting and law firms on high-level tax issues. Prior to forming an independent tax practice in 1991, was Partner in charge of tax practice of major independent accounting firm in Toronto. Advises clients worldwide. Author of leading book, Canadian Taxation of Non-Residents, considered one of the few Canadian tax professionals, outside of the big accounting and law firms, who is an expert on high-level international tax matters.

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