Deeming Rules Under Section 93.2 of the Income Tax Act: An Unintended Trap for LLC Incentive Units?

Section 93.2 of the Income Tax Act (Canada) (“Tax Act”) can create several unexpected complications when a Canadian-resident employee receives incentive units in a Delaware LLC. For Canadian tax purposes, the employee is deemed to own shares of a non-resident corporation through two distinct steps. First, Canadian law classifies the LLC as a corporation based on its legal attributes, regardless of its United States (“U.S.”) tax treatment. Section 93.2 then deems the LLC interests to be shares. Although neither rule targets employee compensation, together they can depart sharply from the intended U.S. treatment. Section 7 may tax the interest’s value without cash to fund the liability, while denying the paragraph 110(1)(d) deduction. Later distributions are fully taxable dividends without a gross-up or credit. U.S. tax on allocated income may also arise before Canada recognizes corresponding income, potentially preventing foreign tax credits. Disregarded single-member LLCs raise separate subsection 93.2(1) issues. This article examines these concerns, including possible FAPI implications.

Illustrative scenario

Take for example Ms. Tremblay, an Ontario resident that is entitled to benefits under the Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital (the “Treaty”). She works for Tommy Guzman LLC (“Guzman”), a multi-member Delaware LLC treated as a partnership for U.S. federal income tax purposes that has not elected corporate status.

Ms. Tremblay works for Guzman in Michigan and Ontario. This year, she receives 500,000 no-cost incentive units that participate only in value above Guzman’s US$40 million grant-date enterprise value, vest 25% annually over four years, and are forfeited upon pre-vesting termination. She is not part of a Canadian-resident group controlling Guzman. For Canadian tax purposes, Guzman is a corporation, and section 93.2 deems her units as shares—a subtle, difficult-to-reverse result.

What are the issues here?

(i) Classification is a question of Canadian law

The CRA classifies a foreign entity in two steps: (1) identify its characteristics under its governing foreign law, constating documents, and relevant agreements; then (2) compare them with recognized Canadian entity types—For Canadian purposes, the LLC’s lack of share capital simply makes it a corporation without shares.

(ii) The U.S. election, classification, and section 93.2

Guzman’s treatment as a partnership for U.S. federal income tax purposes is irrelevant to the Canadian classification. The CRA has confirmed that a later election by an LLC previously treated as fiscally transparent “would not alter the US LLC’s classification as a corporation for Canadian tax purposes” This is not a refusal to follow the U.S. classification; rather, the U.S. election cannot affect the Canadian classification and the tax outcome.

Guzman is a corporation for Canadian purposes, but as a Delaware LLC, it issues membership interests rather than shares.

Section 93.2 – what it does and does not do

Subsection 93.2(1) defines a “non-resident corporation without share capital” as one that, “determined without reference to this section, does not have capital divided into shares.” The provision therefore presupposes that the entity is a corporation; section 93.2 does not itself determine the entity’s classification.

Subsection 93.2(2) applies broadly “for the purposes of this Act.” Paragraphs 93.2(2)(b) and (d) deem each equity-interest class to consist of 100 shares with corresponding rights and obligations. These deemed shares qualify under the Tax Act, including as “securities” under subsection 7(7) and for subsection 95(4)’s equity-percentage rules. Thus, lacking conventional share capital does not itself preclude section 7.

There is, however, a separate question whether the requirements of subsection 7(1) are satisfied. Subsection 7(1) requires an agreement under which a corporation agrees to sell or issue securities, whereas paragraph 93.2(2)(c) deems shares based on the holding of an equity interest. It is therefore not clear that the grant of an incentive unit necessarily constitutes an agreement to sell or issue a security for purposes of section 7. This uncertainty should be considered in advising Ms. Tremblay.

Foreign affiliate status – T1134 compliance complexity

Foreign affiliate status turns on class-level equity, not overall ownership. Although Ms. Tremblay holds only 0.5% of Guzman and has no current liquidation value, subsection 233.4(1) requires her to file Form T1134 within ten months after year-end, with no de minimis exemption. Employees may overlook this obligation because the LLC interest appears insignificant.

Subsection 93.2(2) deeming rule

Under subsection 95(4), a person’s “direct equity percentage” is the highest percentage owned in any issued share class, not the percentage of total corporate equity.

Paragraph 93.2(2)(a) groups interests with identical rights and obligations into separate share classes. Paragraphs (b) and (c) deem 100 shares per class and allocate them by proportionate fair market value. Under paragraphs (b) and (c), a holder’s deemed shares—and direct equity percentage—equal the holder’s proportionate fair market value in the class.

Identical thresholds and vesting terms form one class; differing terms may create separate classes and complicate compliance.

Numerical Illustration:

Presently, Guzman is worth US$40 million. Its incentive units have the same threshold and no liquidation value, but an assumed aggregate option value of US$2 million.

 Applying paragraph 93.2(2)(c) to the incentive class:

100 × (US$200,000 ÷ US$2,000,000) = 10 deemed shares of 100

Ms. Tremblay’s 10% class interest produces 10% direct and overall equity percentages, satisfying paragraph 95(1)(a)’s 1% and paragraph 95(4)(b)’s 10% thresholds. Yet her US$200,000 interest is only 0.5% of Guzman’s US$40 million value and has no liquidation value.

Dependence of share class

The outcome depends on a single, highly sensitive variable: Ms. Tremblay’s share of the class.

Paragraph 95(4)(b), not 95(1)(a), would normally satisfy the 1% test. Successive grants at current enterprise value may create narrower deemed classes and inflate holders’ percentages—an unintended result U.S. counsel may miss. Because paragraph 93.2(2)(c) uses fair market value, deemed share counts fluctuate with valuations. Meeting the threshold at any time in the year creates foreign affiliate status and a T1134 filing obligation under subsection 233.4(1), an easily missed compliance trap.

What foreign affiliate status actually costs

Foreign affiliate obligations arise without corresponding relief: section 113’s surplus deduction applies only to Canadian-resident corporations, while subsections 90(2) and 90(5) characterize distributions. Form T1134 is due ten months after year-end with no percentage- or dollar-based de minimis exemption, exposing small holders like Ms. Tremblay to unexpected filing costs and penalties.

The dormant affiliate exemption is unavailable because the interest’s cost exceeds $100,000. Paragraph 53(1)(j) adds the US$200,000 section 7 benefit to adjusted cost base—about C$270,000 at a 1.35 exchange rate, subject to section 261. The dry-income inclusion therefore also exceeds the reporting threshold and, absent foreign affiliate status, Form T1135’s $100,000 threshold.

FAPI and hybrid mismatch

Subsection 91(1) applies FAPI only to controlled foreign affiliates. Because paragraph 93.2(2)(d) preserves the rights of typically non-voting units, even a 50% equity interest may not confer control where a U.S. sponsor retains voting control. Operating income is generally active business income, not FAPI.

For a Canadian-resident sole member, the United States taxes LLC income as earned, while Canada generally taxes it later as a deemed dividend or FAPI. This mismatch may limit section 126 foreign tax credits and Treaty relief under Articles IV(6) and (7), added by the Fifth Protocol; see Income Tax Folio S5-F2-C1, Foreign Tax Credit. Advisers should generally avoid single-member LLCs for U.S. businesses because section 93.2 reinforces their Canadian corporate treatment—a key consideration for Ms. Tremblay.

Planning options

Although not aimed at employee equity, subsection 95(4)’s class-by-class test can create overlooked annual filings and penalties, warranting planning for Ms. Tremblay.

• Test the class, not the cap table: measure the holder’s share of identical units by fair market value, not overall Guzman ownership.
• Obtain grant histories, tranche terms, and class valuations required by paragraph 93.2(2)(c). Because employees rarely have this information, award agreements should require annual disclosure from the grant date. A class-level section 7 appraisal can support both analyses.
• Different thresholds create separate deemed classes and raise each holder’s percentage. If Canadian participation is material, consider a single class with a common formula, although paragraph 93.2(2)(a) remains untested.
•  Form T1134 is due ten months after year-end. The dormancy exemption requires cost below $100,000, often exceeded when paragraph 53(1)(j) adds the section 7 benefit. Penalties apply per return and affiliate.
• Reassess annually: status applies if met anytime during the year, and class values change deemed share counts. Reporting may shift between T1134 and T1135.
• Consider cash-settled phantom units, taxed under paragraph 6(1)(a) on receipt. They avoid deemed shares, foreign affiliate status, and foreign reporting, but forgo capital-gains treatment and remain subject to salary deferral rules. For missed filings, consider voluntary disclosure before CRA action.
• Practitioners should also consider that section 6204 of the Regulations tests at the time the share is sold or issued – this is relevant to see if there is a subsection 110(1)(d)(i.1) deduction applicable – although that issue does not arise on the facts considered here.

About the Author

I provide value add advice on tax planning and advisory assistance for Canadian businesses and individuals. I contribute to the Canadian Tax Foundation and Thomson Reuters on tax issues of topical interest; some of these articles are also cited within PITA for specific legislation. I have presented on tax matters in regional and national tax conference hosted by the Canadian Tax Foundation as well as in different tax network forums. I am also an instructor for select tax courses provided by CPA, Alberta and have taught for the CPA In-depth tax program.

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