LLC Trap for the Unwary in Canada

As a place to invest or expand, Canada provides vast opportunities, an undervalued currency, a stable economy and easy access. Once the decision to move is made, how should a business or investment be structured?

In the U.S., there is a lack of integration between corporate earnings and the repatriation thereof to the shareholders. As such, most entrepreneurs carrying on business through regular corporations may face double taxation. Assuming both a corporate and personal combined Federal and state tax rate of 40%, the overall taxes payable on $100 of corporate earnings distributed to an individual shareholder would be $64 ($40 corporately ($100 x 40%) and $24 personally ($60 x 40%)). To avoid this result, many entrepreneurial businesses in the U.S. are carried on through limited partnerships (LPs), S corporations or limited liability companies (LLCs).

Each of these alternatives allows individuals to include the business entity's income on their personal returns, thereby eliminating the double-tax potential, while at the same time shielding the entrepreneur from business risk through limited liability.

Canada has enough similarities with the U.S. to be considered the 51st state (or the U.S. the eleventh province), with the perception that what works as a business structure model in the U.S. must also apply to Canada. This may not always be the case.

Canadian tax legislation and jurisprudence have held steady the notion that a corporation is a corporation and a partnership is a partnership. No S elections or check-the-box regulations exist to breach the gap. From a U.S. tax perspective, this is onerous, because an investment in a Canadian company by an individual taxpayer will result in double taxation. The corporation will be subject to Canadian corporate tax and the individual investor will be subject to a U.S. personal tax on the dividend distributions received from the Canadian corporation on repatriation of profits. Even though the payment of this dividend will result in a 15% Canadian withholding tax for a shareholder who is a U.S. resident individual, the U.S. will grant such shareholder a foreign tax credit (FTC) (subject to any U.S. alternative minimum tax (AMT) adjustments), which effectively eliminates most of the additional tax cost of the withholding tax. However, there is no corresponding FTC to a U.S. individual investor for Canadian tax paid at the corporate level. Hence, double taxation exists.

Overview of Canadian Tax Legislation

Canadian tax rules, while similar to U.S. concepts, have enough differences that professional advice is a must.

In general, anyone employed in Canada, carrying on business in Canada, earning pension or investment income in Canada or disposing of Canadian assets is subject to tax on such revenue.

Carrying on business in Canada includes soliciting sales in Canada (whether through a dependent or independent agent) or providing services in Canada, regardless of whether the individual or business has nexus or a permanent establishment in Canada. This type of income will be subject to full comprehensive Canadian taxation.

If a taxpayer (individual or corporation) meets the Canadian residency criteria, the taxpayer will be subject to tax on worldwide income, rather than just Canadian-source income. Canadian-source income (other than property income that qualifies as business income or management, administration and service income) will not be subject to Canadian withholding tax. Property income will be subject to a 25% Canadian withholding tax on gross income, but if earned as part of a business, such withholding tax will be considered as an installment against the regular tax liability.

Management and administrative income, if paid to related parties, will be subject to a 25% withholding tax, whether or not these activities are performed in Canada. All other income from services performed in Canada will be subject to a 15% withholding tax. (The province of Quebec requires withholding tax of 9% for services performed in Quebec.)

Gains on dispositions of, among other things, interests in Canadian real estate (which include interests in trusts, partnerships and corporations, the majority of the value of which is derived from Canadian real estate), shares of Canadian private companies and shares of Canadian public companies (when more than 25% of the shares are held by related nonresidents) will be subject to full Canadian taxation as well, but only 50% of capital gain is subject to tax. In addition, certain provinces will also impose their taxes on gains realized on these assets if they are located in their jurisdiction.

Canada has entered into comprehensive tax treaties with various countries (including the U.S.) that serve to reduce or eliminate the double taxation that could result from the rules. This relief is only available for residents of a treaty country. To be such a resident, the entity must be fully subject to taxation on its worldwide income in the country of residence.

A foreign corporation carrying on business in Canada will be subject to an additional 25% (subject to reduction in accordance with relevant tax treaties) branch tax on its profits. This branch tax is similar to its U.S. counterpart and is intended to equal withholding tax that a Canadian corporation would withhold from dividends paid to foreign shareholders. Because a foreign corporation would not be required to withhold Canadian tax on dividends paid to its shareholders, the branch tax ensures that Canada receives its equivalent share of withholding tax.

Foreign persons claiming treaty-based exemptions must file a treaty-based return to avail themselves of the treaty benefit.

Treaty Benefits Available to U.S. Entities

Under the check-the-box regulations, LPs and LLCs are considered by default to be partnerships (flowthrough entities) or in the case of a single-member LLC, a transparent entity, and can elect to be taxed as corporations for U.S. tax purposes. Corporations, by default, are U.S. taxpayers but can elect to be treated as S corporations, with tax characteristics similar to a partnership. This distinction is extremely important in determining whether an entity or its owners can avail themselves of the benefits afforded by the Canadian-U.S. Tax Treaty.

In Canada, notwithstanding a U.S. election to consider an LP to be a corporation, an LP will not be recognized as an entity separate from its owners (a corporation resident in the U.S.) for purposes of the Canada-U.S. Tax Treaty. Instead, Canada will look to the residency of each LP owner to determine whether such members can obtain treaty benefits.

Similar in reasoning, a corporation that has elected S status is still, by default, a corporation and considered to be subject to full comprehensive U.S. taxation. Even though the election allows the corporation to be treated as a partnership (not subject to entity-level tax) under the U.S. tax system, Canada will recognize the S corporation as a U.S. resident for treaty purposes. The justification for this is that, but for a provision in the U.S. tax law, an S corporation would be taxable as a corporation and therefore subject to full comprehensive U.S. taxation.

An LLC, similar to an LP, cannot avail itself of the treaty benefits. Under U.S. tax law, an LLC's default classification is that of a partnership and therefore is not subject to full comprehensive U.S. taxation. However, in Canada an LLC is considered to be a corporation; as such, for purposes of determining treaty benefits, there will not be a lookthrough to the LLC members (unlike the LP). Therefore, an LLC resident in the U.S. that derives revenue from Canada cannot rely on the protection of the treaty to avoid an entity-level tax from a Revenue Canada assessment.

Taxation of a U.S. LLC with Canadian Income

In the U.S., an LLC is by default a partnership or transparent entity for U.S. tax purposes. The LLC will provide a U.S. shareholder with transparency, thus allowing all LLC earnings to be included in the shareholder's income, not in the LLC's. This will ensure that for U.S. tax purposes, no double tax will arise. However, because an LLC is a corporation for Canadian tax purposes, it will be the Canadian taxpayer in respect of Canadian-source income. Any Canadian taxes payable by the LLC in connection with its activities in Canada will be available to the LLC shareholders for FTC purposes (subject to U.S. AMT).

Unfortunately, an LLC, which under the check-the-box regulations is considered a partnership or transparent entity, will place itself outside of the Canada-U.S. Tax Treaty. Therefore, even if the LLC does not have a permanent establishment in Canada, as long as it carries on business in Canada, the LLC will be subject to Canadian tax. As discussed, "carrying on business" is a much lower standard than either "permanent establishment" or "nexus." An entity will be considered to be carrying on business in Canada if it derives income (sales) from Canadian sources, generated by either a dependent or independent agent. In addition, as a foreign corporation, it will also be subject to the branch tax. Without treaty benefits, however, the branch tax rate would increase from 5% under the treaty to 25%. Any income from Canadian property would also be subject to a 25% withholding tax; gains on Canadian assets (other than shares of publicly listed companies when ownership is less than 25%), even if not derived from real estate, will be subject to Canadian tax.

If an LLC acquires shares of a Canadian company to avoid the branch tax, any dividends paid by the Canadian company will be subject to a 25% withholding tax, as opposed to the 5% treaty rate. A lower treaty rate is available when more than 10% of shares of a Canadian corporation are owned by a U.S. corporation.

Without the treaty benefits, the incidence of cross-border taxation increases dramatically. Even though LLC members are afforded lookthrough treatment in the U.S., the Canadian taxes due on the income sourced in Canada are significantly higher than if the treaty provisions had applied. Most members of the U.S. LLC will find themselves in an excess credit situation, due to both the high tax rates and the imposition of the double tax. Additionally, instances may exist in which income sourced to Canada under Canadian tax law is not considered foreign-source income for U.S. tax purposes. Thus, members may be limited further in their ability to offset U.S. taxes imposed on the Canadian-taxed income, a potential triple tax. Clearly, these are not desirable results. As a consequence of the differing positions, treaty negotiators are discussing the merits of dealing with these entities to ensure that they are not used to avoid tax and that they relieve unintended results (such as those occurring with an LLC).

Potential Solutions to the Problem

LP. The use of an LP will eliminate the double tax, but most entrepreneurs prefer the corporate shield (as opposed to the limited liability shield of an LP). The main reason for this is that if one can prove that an LP parter has decision-making abilities or has exercised such abilities, LP protection can be pierced.

Each of the partners carrying on business in Canada or owning Canadian assets will be considered to be carrying on that business or owning those assets and will be required to file Canadian/provincial returns. If the partners are corporations for Canadian tax purposes, they will be subject to Canadian branch tax rules as well. If an LP partner is an LLC, that LLC partner will not be able to avail itself of any treaty benefits, but it will not negatively affect the other LP partners.

U.S. LP partners will, however, be able to claim FTCs to recover part or all of the Canadian tax (subject to U.S. AMT), but the tax compliance can be more complex. Because a Canadian payor to a U.S. partnership has no knowledge of the partners (unless the partners prove their U.S. residency by obtaining proof-of-residency certificates), the partnership will be considered a non-treaty-based entity; partners who have not received residency certificates cannot avail themselves of reduced withholding taxes. They would then have to file refund claims with the Canadian tax authorities.

S corporations. As previously discussed, an S corporation is fundamentally a corporation, which, in the absence of an S election, would be subject to comprehensive U.S. taxation. Accordingly, even if an S corporation elects flowthrough status, it will still be considered a treaty resident for Canadian tax purposes.

Because an S corporation qualifies as treaty-resident, all the concerns faced by LPs and LLCs will be resolved. Therefore, an S corporation will only be subject to full Canadian tax on its business profits if it carries on business in Canada through a permanent establishment. It might still be subject to withholding tax on certain business-income sources, but such taxes would be refundable when the S corporation files its treaty-based income tax return. An S corporation will, however, still be subject to Canadian branch tax on its Canadian operations carried on through a permanent establishment.

Canadian subsidiary. Although Canadian corporate legislation does not allow for LLCs, and Canadian tax legislation does not contemplate corporate transparency, the province of Nova Scotia allows the incorporation of an unlimited liability company (ULC). This Canadian corporate entity will qualify for the U.S. check-the-box regulations, but does not provide limited liability.

Due to this exposure, this entity should always be used in conjunction with an LP or an S corporation (because LLCs cannot avail themselves of treaty benefits, they should not hold shares of a ULC). Generally, ULC shareholders are corporate. ULC use will resolve any branch tax issues, but the ULC will be subject to thin capitalization rules.

As a Canadian subsidiary of an S corporation, a ULC will insulate the S corporation from filing returns in Canada. The ULC's corporate returns will be less complex than that of an S corporation carrying on business through a branch operation. The ULC can return capital invested before returning retained earnings, and any earnings repatriated through dividends to the S corporation will be subject to only a 5% withholding tax.

From a U.S. tax perspective, the earnings and Canadian taxes paid by the ULC will pass through to the S corporation as if the S corporation carried on the operations directly. For FTC purposes, the ULC cannot invest or carry on business in the U.S. Should this occur, it will be subject to Canadian tax on such earnings, reduced by an FTC for U.S. withholding or business taxes payable by it, but not U.S. taxes payable by the S corporation or its shareholders. Because the ULC will not be subject to U.S. tax directly, no FTC will be available to reduce the Canadian taxes on the U.S.-source income earned by the ULC. In the U.S., any Canadian taxes payable on U.S.-source income cannot be credited against U.S. taxes payable by the S shareholders, because for U.S. tax purposes, the ULC is transparent and no FTC is available for foreign taxes payable on U.S-source income. This will result in double taxation on the U.S.-source income earned by a ULC.

If a non-ULC Canadian company was established to carry on the Canadian business, the lack of cross-border consolidation for U.S. tax purposes might increase the U.S. shareholders' overall tax liability, because the Canadian taxes will not be available as FTCs. While some planning may reduce this impact, double taxation will generally occur in the same manner as that in the U.S., when a U.S. taxpayer makes an investment in a C corporation without the benefit of consolidated filings.

Financing. Canada, similar to the U.S., has rules against thin capitalization. The Canadian rules are very specific and deny all interest expense payable to non-arm's-length persons on debt in excess of a two-to-one debt-equity ratio. Therefore, if equity is $100, all interest expenses on related-party debts in excess of $200 will be denied.

Whether Canadian operations are to be carried out through a Canadian branch of an S corporation or through a Canadian subsidiary is an important issue if related-party financing is anticipated.

The current thin-capitalization rules do not apply to branch operations (other than certain financial institutions); therefore, if related-party financing is to be used, the branch is then probably a better alternative than a Canadian subsidiary. The related-party interest will however be subject to Canadian withholding taxes if such interest is deductible against Canadian profits. If the lending entity is an LLC, the withholding rate will be 25%; otherwise, the rate would be only 10% for a U.S resident lender.

If a ULC owned by an S corporation is used to carry on a Canadian business and to avoid the thin-capitalization rules, the debt is borrowed at the S level and the resulting interest will be deductible only in the U.S. In Canada, the ULC would be subject to tax without an interest expense deduction and in the U.S., only the net Canadian income would be subject to tax. This might reduce the ability to claim a full FTC if the interest expense is seen as a direct cost of the foreign income. Instead, the ULC could borrow from an arm's-length lender. Because a ULC is not a limited-liability entity, its shareholders will be exposed to the debt obligations. This is equivalent to the shareholders guaranteeing the ULC debt. Currently, such an arrangement is not subject to the thin-capitalization rules. (The use of guarantees and similar arrangements to avoid thin capitalization has been under study for over two years, without a conclusion.)

Conclusion

The preferred structure for carrying on business or making investments in Canada depends totally on the particular facts (including financing of the operations). Generally, the preferred structure involves an S corporation whose sole activities will be carried on in Canada, operating directly or indirectly through a ULC.

Other considerations in structuring are the different federal and provincial sale and use taxes, provincial tax rates, capital and payroll taxes and ownership of Canadian real estate.

In certain circumstances, trusts or multiple entities and entity types may be the preferred alternative. The most important point is that the use of U.S. LLCs to do business in Canada or own Canadian assets can result in extremely detrimental tax consequences.

From Jerry Wise, CA, Richter, Usher & Vineberg, Montreal, Quebec, Canada