This content was originally published in the Canadian Tax Foundations newsletter: Canadian Tax Focus. Republished with permission.
CRA clarified that in determining surplus of a US LLC Foreign Affiliate, the affiliate’s UCC of its assets should be the lesser of the capital cost and fair market value.
Establishing the undepreciated capital cost (UCC) of a U.S. limited liability company’s assets after the LLC becomes a foreign affiliate of a Canadian corporation can be complex where limited historical records are available. To satisfy the CRA’s interpretation of regulation 5907(2.03), it may be necessary to review past tax filings, financial statements and internal asset records to help support capital cost and fair market value (FMV) calculations.
When a Canadian corporation receives dividends from a foreign affiliate, those dividends must be included in its income. However, the corporation may be eligible for a deduction that reduces its taxable income. The amount of this deduction depends on the foreign affiliate’s surplus accounts linked to the Canadian taxpayer. These surplus accounts reflect the economic earnings of the foreign affiliate that are potentially available for distribution to shareholders.
The calculation of surplus accounts starts with determining the foreign affiliate’s earnings under regulation 5907(1). A foreign affiliate’s earnings from an active business are calculated under either the tax laws of the country where it is resident or the tax laws of the country where the business is conducted. If neither applies, the earnings are calculated as though the income were taxed under Part I of Canada’s Income Tax Act.
The CRA’s current position is that the earnings of a foreign affiliate that is a single-member disregarded U.S. LLC should be determined under subparagraph (a)(iii) of the definition of “earnings” in regulation 5907(1) (that is, Canadian law). In addition, regulation 5907(2.03) requires that the maximum allowable deductions under Canadian law, including capital cost allowance (CCA), be deemed claimed for the current and prior taxation years ending after August 19, 2011. This rule was introduced following the release of CRA document no. 2011-0404501C6 (May 20, 2011), where the CRA stated that it would challenge taxpayers that inflated their surplus by not claiming the maximum CCA. A prior article (Nakul Kohli and Simon Townsend in the February 2023 issue of Focus) noted that this interpretation could be open to question.
A crucial question arises regarding how to determine the UCC of a U.S. LLC’s depreciable assets when the U.S. LLC becomes a foreign affiliate of a Canadian corporation through an acquisition, for the purpose of calculating the U.S. LLC’s “earnings.” This issue is important because it affects the amount of CCA deductible in future years and, consequently, influences the calculation of the foreign affiliate’s surplus. This, in turn, determines the amount of deduction available on dividends received from foreign affiliates.
The CRA’s new view on how regulation 5907(2.03) operates for computing the U.S. LLC’s income under Canadian rules in the case of an arm’s-length acquisition of the U.S. LLC is that the UCC of its depreciable assets will be the lesser of the assets’ capital cost and their FMV on the date of acquisition (CRA document no. 2025-1052631C6, May 28, 2025).
Applying this principle in practice often presents significant challenges. U.S. LLCs may have acquired assets years before becoming foreign affiliates, and historical documentation such as invoices or contracts may be incomplete, inconsistent, or unavailable. Furthermore, obtaining an FMV appraisal can be costly and time-consuming, particularly for specialized or older assets.
A more practical approach involves obtaining multiple sources of information to substantiate UCC claims. Historical tax returns, prior depreciation schedules, and previous owners’ filings may contain detailed asset cost and depreciation data that can support capital cost. Additionally, internal accounting records, including fixed asset schedules and trial balances, may offer evidence to assist with estimating the capital cost. This documentation approach may satisfy CRA requirements and strengthen the taxpayer’s position in the event of an audit or reassessment.
One approach may be to leverage accounting depreciation to approximate FMV, since accounting depreciation can provide a useful middle ground when CCA data or appraisals are not readily available. Though not determinative for tax purposes, this approach may provide a reasoned estimate of the asset’s value based on its expected useful life and economic wear and tear.
