Canada: Deemed shares in a US LLC
25 August 2014
Posted by: Author: Paul Barnicke
Authors: Paul Barnicke and Melanie Huynh (PricewaterhouseCoopers LLP)
Proposed section 93.3 was introduced in July 2013 to determine the share capital for income tax purposes of a non-resident entity that is treated as a corporation under the Act but whose equity interests are not divided into shares. The explanatory notes cite the example of a US LLC whose "members . . . have membership interests in the LLC and do not own shares of the LLC.” A recent TI (2014-0522971C6) comments on related questions that were asked at the 2014 STEP CRA round table.
The proposal deems the following: that (1) a corporation has share capital, (2) equity interests with identical rights and obligations constitute a separate class that has 100 shares issued and outstanding, and (3) the 100 shares in each class are allocated pro rata on the basis of the FMV of the holders’ interests in that class.
Equity interests have identical rights and obligations if the differences in those rights and obligations are proportionate (proposed paragraph 93.3(2)(a)). The explanatory notes give the example of a two-member LLC: one member has a right to 30 percent of LLC income and three votes, and the second member has a right to 40 percent of the income and four votes. The percentages of income entitlements are proportionate to the related votes, and thus the two interests have identical rights and obligations and constitute one class.
The questions asked of the CRA deal with a US LLC whose equity interests are referenced by a formula. The formula provides that one party (the manager) receives 2 percent of the LLC’s profit as incentive compensation, plus a 20 percent profit share in certain circumstances; the residual profit is shared according to a ratio.The CRA was asked the following questions:
- Are there three classes of shares, each entitled to one profit-sharing allocation (2 percent, 20 percent, and residual)?
- If the manager has a special voting right, does that constitute another class?
- If the residual profit is allocated on the basis of revenue or net income for the year between two holders (A and B), are those interests shares of two classes or one class?
- If A’s and B’s interests constitute one class, is there a disposition and acquisition of the deemed shares as the FMVs of their equity interests change and the number of shares deemed to be owned changes accordingly?
The CRA said that the first step is to determine the legal rights and obligations of all equity interests in the corporation. An equity interest that is unique compared with other equity interests is deemed to be a separate class of shares.
To address the first two questions, the CRA used other examples to illustrate its reasoning. The TI assumes that a corporation has four members and that the only non-proportionate differences between the members’ equity interests is that one member’s interest (say, the manager’s) gives special voting rights to the holder, an allocation of income for management services, and an additional allocation of income as a performance incentive.
Each of the four members may legally have a single equity interest under the corporation’s constituting documents, the relevant law that governs the corporation, and any other relevant agreements. In that case, the CRA considers the corporation to have two classes of shares because the manager has one equity interest that has non-proportionate differences. The other three members have one class of shares, and the manager owns the second class.
Alternatively, if the manager legally has two different equity interests, the CRA said that there may still be two classes but that the allocation may be different. For example, each member may be deemed to own a portion of one class, and the manager may also be deemed to own all of a second class that has the right to the additional income allocation and votes.
With respect to the entitlements to income and votes described in the first two questions, the CRA said that, depending on the facts, there may be more than two classes of shares. For example, the equity interests may be divided into distinct units, or they may be divisible and transferable with particular rights and obligations attached to particular equity interests or portions thereof. Thus, if the manager can transfer to a fifth member part or all of his equity interest to which the incentive income allocation rights are attached and still retain an equity interest, there may be three or more classes. The determination of the number of classes of shares is fact-specific, depending on the rights and obligations of a corporation’s entire equity interests. Thus, the CRA declined to provide guidance on the last two broadly worded questions. The CRA said that the income allocations and therefore the result may vary from case to case or from jurisdiction to jurisdiction.
The TI illustrates the need to dissect the legal rights and obligations of equity interests to determine the number of classes of shares that a corporation is deemed to have if its capital is not divided into shares. Having more than one class of shares may affect a non-resident’s FA status if a taxpayer has only a small equity interest: generally, FA status requires at least 10 percent ownership in any one class of shares. If a taxpayer’s equity interest is deemed to be allocated to different classes, then allocation and tracking of the cost basis are required for each class and for distributions received on each class (particularly if a distribution results in a basis grind and a subsection 40(3) gain).
The TI involves a US LLC that is formed "in a way similar to a partnership, with the equity interests being referenced by a formula.” In practice, a US LLC’s constituting documents, such as an LLC agreement, are commonly drafted to divide the LLC’s capital into separate units that are labelled as shares, sometimes with different classes (commons and preferreds). It is unclear whether, in those circumstances, proposed section 93.3 requires a taxpayer to go through the TI’s analysis to determine whether there are different classes for the purposes of the Act and whether those classes differ from the legal classification.
Proposed section 93.3 applies to a non-resident corporation’s taxation years ending after 1994, unless an election is made to apply the rules prospectively to taxation years ending after July 12, 2013 (when the proposals were issued). For years in which proposed section 93.3 does not apply, questions remain. Regardless of how a US LLC is formed, does its entire capital comprise one single class divided into 100 shares, based on the CRA’s administrative position in Interpretation Bulletin IT-392? If the answer is yes, how does a taxpayer deal with the transition from the ownership of shares in one class to the ownership of shares in other classes? None of the rollover provisions for share-for-share exchanges applies.
This article first appeared on ctf.ca.