From The Tax Adviser:

Determining the Form of Doing Business in Canada

ith its undervalued currency, stable economy and easy access, Canada appears to be the perfect place in which to start a business.

FORM OF THE BUSINESS
Once a company decides to set up shop in Canada, the next issue to be addressed is the structure of the business.

Among the forms that Canadian business activities may take are corporations, limited liability companies (LLCs) and regular or limited partnerships. Also possible (but only in Nova Scotia) is an unlimited liability company, which may be treated as a corporation for Canadian tax purposes but as a partnership for U.S. tax purposes.

U.S. pass-through entities. In the United States, corporate earnings may be subject to double taxation: The corporation is taxed when income is earned, and the shareholder is taxed when the corporation distributes dividends.

To avoid this situation, Americans can structure their businesses as limited partnerships, S corporations or LLCs. Through any of these, the individual shareholder or partner includes the business’s income on his or her personal tax return, thereby avoiding the double taxation problem.

Canadian treatment of U.S. entities. Canadian law does not provide relief from double taxation. When an individual taxpayer makes an investment in a Canadian company, the corporation is subject to Canadian corporate tax and the investor is subject to a U.S. personal tax on dividend distributions. And while the U.S. allows the shareholder to take a foreign tax credit (FTC) (which effectively eliminates most of his or her additional tax burden), there is no corresponding FTC available to a U.S. individual investor for Canadian tax paid at the corporate level.

CANADIAN TAXATION
In general, anyone employed, carrying on business or earning pension or investment income in Canada or disposing of Canadian assets is subject to tax. If a taxpayer meets Canadian residency criteria, the taxpayer is subject to tax on worldwide income rather than just Canadian-source income.

EFFECT OF TREATIES
Canada has entered into treaties with many countries, which serve to reduce (or eliminate) any double taxation that otherwise could result. However, this relief is available only to residents of a treaty country; to be considered as such, the entity must be fully subject to taxation on its worldwide income in the country of residence.

Treaty benefits available to U.S. entities. A corporation that has elected S status is considered subject to full comprehensive U.S. taxation. Canada will recognize an S corporation as a U.S. resident for treaty purposes.

Under U.S. tax law, limited partnerships and LLCs are considered to be partnerships and can elect to be treated as corporations for tax purposes. In Canada, however, a limited partnership is not recognized as a corporation resident in the U.S. Instead, Canada looks to the residency of each limited partner to determine whether such members can obtain treaty benefits.

Possible LLC trap. Canada’s treatment of U.S. LLCs can lead to unexpected, adverse results. Under U.S. tax law, an LLC is considered to be a partnership; all its earnings are included in the shareholder’s (not the LLC’s) income. In Canada an LLC is considered a corporation. As such, the LLC itself is the Canadian taxpayer as to Canadian-source income; Canada will not look through to the LLC members. Therefore, an LLC resident in the United States that derives revenue from Canada cannot rely on the U.S.-Canadian treaty to avoid a corporate-level tax. And without the treaty benefits, the Canadian taxes due on income sourced in Canada will be significantly higher than if the treaty provisions applied.

For a detailed discussion of this and other current developments, see the Tax Clinic, edited by Anthony Bakale, in the August 2002 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser