FAPI Recharacterization and LLCs

The foreign accrual property income (FAPI) recharacterization rule in clause 95(2)(a)(ii)(B) may not have the expected favourable result when disregarded US limited liability companies (LLCs) are involved.

An LLC may elect to be treated for US federal income tax purposes as a flowthrough entity that is not subject to US income tax (a disregarded entity). Instead, its members are required to report and pay tax on their share of the LLC's income. For Canadian income tax purposes, however, the CRA considers that LLCs are corporations (see, for example, CRA document no. 2001-0085845, January 29, 2002) and can therefore be foreign affiliates (FAs) and controlled foreign affiliates (CFAs) of Canadian shareholders.

If a Canadian taxpayer's CFA earns property income that constitutes FAPI, subsection 91(1) will apply to include the FAPI in the taxable income of the Canadian parent on an accrual basis. However, property income will not be FAPI if the income recharacterization rule in clause 95(2)(a)(ii)(B) applies.

Suppose, for example, that a CFA earns interest income on a loan to an FA that is a disregarded LLC that carries on an active business in the United States. Under this income recharacterization rule, one of the conditions that must be met is that the interest amounts earned by the CFA must be deductible by the FA (the LLC) in computing its foreign active business income. This would typically be a straightforward determination in accordance with the tax laws of the jurisdiction in which the FA is resident if the FA were a non-flowthrough entity. However, because a disregarded LLC is a flowthrough entity and does not compute its income for US tax purposes, the deductibility of an interest expense will normally be determined according to Canadian tax rules (see subparagraph (iii) of the definition of "earnings" in regulation 5907(1)(a)).

Continuing this example, suppose that the loan to the LLC was for the purpose of returning amounts that were contributed to the LLC by its members as subscriptions for LLC units. Under Canadian tax rules, could the interest on the loan be deductible because the loan replaces capital? This would be an application of the "fill-the-hole" doctrine--interest is deductible if borrowed money replaces capital used for certain eligible purposes such as the redemption of shares (Trans-Prairie Pipelines Ltd. v. MNR, 70 DTC 6351 (Ex. Ct.)). However, neither the CRA nor the courts have clearly acknowledged that amounts of this type can be considered to be capital under this doctrine. The CRA has stated that whether payments of such amounts from LLCs can be considered capital is a question of fact (see, for example, CRA document no. 9M19190, October 8, 1999, at question 3). It is thus uncertain whether these payments will qualify, in all cases, as returns of capital. If the payment is not a return of capital, the interest is not deductible under the fill-the-hole concept, in which case the income recharacterization rule in clause 95(2)(a)(ii)(B) will not apply, and the Canadian parent will be subject to current tax on the FAPI.

From a policy perspective, this outcome does not appear to be the correct one: clause 95(2)(a)(ii)(B) generally allows property income to be recharacterized when the active business income of one FA is shifted to another FA within the same corporate group. However, this result may not be possible for a disregarded LLC because of its flowthrough nature and funding structure.

Clara Pham
KPMG LLP, Toronto
claratpham@kpmg.ca

Canadian Tax Focus
Volume 3, Number 1, February 2013
©2013, Canadian Tax Foundation