For Canadians looking to invest, not a day goes by without thinking about whether our neighbors in the United States can provide either a better investment yield or an opportunity to purchase a nicely priced vacation home.
Prudent Canadians will seek US tax and legal advice about their proposed US investment well in advance of making a commitment (we have recently written about purchasing US vacation homes and you can access the article here). Too often, however, this advice is dispensed by Wikipedia or Google. In many of these situations the Canadian investor will conclude that the “best” vehicle to facilitate the investment is a United States limited liability company (“US LLC”). Is a US LLC really the “best” choice? This short article will briefly address the issues that Canadians should consider before using US LLCs as a vehicle to any US investments.1
What is a US LLC? It is a limited liability company created by statute and is often described as a hybrid between a corporation and a partnership. To be clear, though, it is not a corporation under US law. All US states that allow LLCs do, however, ensure that limited liability is provided to LLC “members.” This is a feature that is similar to a corporation and its “shareholders”. As a general rule, shareholders of corporations, including Canadian corporations, are not liable for the corporation’s debts (with certain exceptions which the reader is encouraged to seek appropriate legal advice). Accordingly, the limited liability aspect of US LLCs is a familiar concept for most Canadians.
However, a very unique feature of a US LLC is that it may choose the manner by which it is taxed under US federal tax law. Depending on the election it makes, it may be treated as: A) a disregarded entity (with the income of the LLC thus taxed in the single member LLC’s hands); B) a partnership (with the income of the LLC then allocated to its multiple members by virtue of the company’s operating agreement); or C) a corporation. The ability to pass through the income of the LLC to the member level is often called a “pass-through” system of taxation. While not all US states enable LLCs to be pass-through for state tax purposes, the vast majority do. The pass-through system of taxation for a “corporation-like” entity is a concept that most Canadian lawyers and accountants consider, well, foreign (forgive the pun). Conversely, many US lawyers and accountants find it equally foreign (again, forgive the pun) that a US LLC is not taxed as pass-through for Canadian tax purposes as will be explained further below.
The pass-through income tax system is usually optimal because only one level of tax is ultimately paid. Corporations, by their very nature, can result in a heavy taxation burden since the corporation will pay tax on its income and when the after-tax corporate income is ultimately distributed to its individual shareholders via dividends, the shareholders will pay an additional level of personal tax on the dividends received. The result is double taxation to the owners of the entity.
In Canada, the business vehicles that are used to achieve pass-through income taxation results are proprietorships, partnerships and certain trusts. For any reader that is familiar with the proliferation of the Canadian publicly traded “income trust” before 2006, such rampant usage of the income trust was a direct result of the corporation being a high tax burden business vehicle and the desire to have a pass-through income tax result on business profits.
However, none of these business vehicles (proprietorships, partnerships and trusts) offer the owners the same liability protection that corporations do. One exception is the limited partnership (“LP”). Most provinces in Canada have statutes that provide for LPs. Most US jurisdictions do as well. Very generally, there are two types of partners in an LP: general and limited. There is generally a limit on the liability of the limited partner, while the general partner’s liabilities are unlimited. A limited partner’s liability usually depends on the amount the partner contributes to the LP. As mentioned, Canada treats partnerships, including a LP, as a pass-through vehicle for income tax purposes. In the US, it is usual that a LP is also treated as a pass-through although in some cases a partnership can be treated as a corporation but that is beyond the scope of this article.
A simple example may help illustrate the pass-through concept. Let’s assume that we have two US entities – Orange Corporation (“Orange”) and Lime LLC (“Lime”). Orange is a “normal” US “C” corporation and Lime is a US LLC. All of the issued shares of Orange are owned by Mr. Apple, a US citizen and resident. Similarly, all of the member interests of Lime are held by Mr. Apple. Since Orange is a normal corporation, Orange will pay corporate tax on its profits and it will distribute such after-tax profits to Mr. Apple by way of a taxable dividend. In the case of Lime, it will be a disregarded entity and therefore its profits will be taxed directly in the hands of Mr. Apple. Accordingly, Lime will not be subject to corporate tax and Mr. Apple will not pay dividend tax on any amounts received from Lime. To further illustrate, let’s use the following assumed facts:
- US corporate tax rate on business profits – 35%
- US personal dividend tax rate – 20%
- US personal income tax rate on proprietorship or other income – 35%
- Business income of Orange and Lime – US $100
Here is the math:
|Orange Inc.||Lime LLC|
|Profit||US $100.00||US $100.00|
|Available for dividend||$65.00||N/A|
|Personal taxes – dividend||($13.00)||N/A|
|Personal taxes – other||N/A||$35.00|
|Cash to Mr. Apple||$52.00||$65.00|
As you can see, the after-tax result is much better with the use of a US LLC. Hence, the proliferation of the use of LLCs in the US. However, what happens if a Canadian uses a US LLC for US investment purposes?
The answer to the above question depends on how Canada classifies (and therefore taxes) US LLCs. The Canada Revenue Agency’s (“CRA”) long-standing position is that a US LLC is a non-resident corporation for Canadian tax purposes notwithstanding the US does not treat a US LLC as a corporation.2 A recent case, TD Securities (US) LLC,3 has not altered the CRA’s views on this matter.
Given the above, if Lime LLC’s member interests were wholly owned by Mr. Banana, a Canadian resident and non-US person, then an awkward mis-match could result. This is because the US would treat Mr. Banana as being the recipient of Lime LLC’s profits for US tax purposes since Lime is a disregarded entity for US tax purposes. Mr. Banana would pay US personal tax on such profits, say $35. However, given that Canada treats Lime LLC as a non-resident corporation, Mr. Banana would not be able claim a foreign tax credit against his other Canadian income for the payment of the US tax. When the income from Lime LLC is paid to Mr. Banana, the CRA will treat the receipt of such as a foreign dividend and thus taxable to him for Canadian purposes. If the “foreign dividends” are received in the same year, then it may be possible to utilize some of the US tax paid by Mr. Banana to reduce the resulting Canadian tax. However, if received in a different year, this may not be possible.
Canadians need to consider several other issues before deciding to use US LLCs to hold their investment interests. These issues include the following:
- If the US LLC holds passive assets – such as US real estate or portfolio assets – then Canada’s Foreign Accrual Property Income (“FAPI”) rules might apply to impute income to be received by the Canadian member(s) notwithstanding such income might not have been received. Careful planning is necessary to avoid nasty surprises with US LLCs and the application of Canada’s FAPI rules.
- The latest protocol to the Canada-US tax treaty does extend treaty benefits to US LLCs but the application of such benefits is tricky. Very careful planning is necessary to ensure that treaty benefits are available whenever a Canadian owns an interest in a US LLC.
- Since Canada treats a US LLC as a non-resident corporation, it is usually not a good idea to own personal property – such as vacation property – through such a vehicle. Canada will take the view that the US LLC will have conferred a shareholder benefit on the ultimate individual “shareholder(s)” of the LLC. The computation of such taxable benefits can be onerous and result in income tax liability when no cash has been actually distributed.
- Canadian individuals who hold interests in US LLCs may be subject to the US estate tax depending on their specific facts.
- In situations like Mr. Banana as described above, careful planning has to occur in order to ensure that the payment of the US tax liability is paid by the direct member and not, say, a Canadian corporation. If a Canadian corporation pays Mr. Banana’s US tax liability, a Canadian taxable benefit could result.
- In most cases, the transfer of property by a Canadian resident to a US LLC cannot occur on a tax deferred basis in Canada. In other words, such a transfer will occur at fair market value if the transferor individual is related to the US LLC.
- Depending on the state in which the US LLC is formed or does business, there may be additional state or local tax liability.
- If the US LLC holds US real estate, US withholding tax on rental income and on a disposition of the property will need to be considered.
- US tax compliance and registration issues will need to be considered.
- Possible Canadian foreign reporting requirements such as the need to file prescribed forms T1135 or T1134A/B will need to be considered.
While careful planning may be able to mitigate some of the above negative consequences, suffice it to say that the use of US LLCs as a vehicle for investment in the US by Canadians can be very tricky to navigate.
A future article will discuss the use of US LLCs as a vehicle by Americans for investment into Canada. These issues can be equally difficult to navigate. More on that to follow…
1. This article does not constitute legal, accounting, or other professional advice. It is intended as a general discussion of the issues presented and neither a definitive analysis of the law nor a substitute for professional advice.
2. See CRA TI 2010-0369311E5 as a recent example where the CRA confirms this view.
3. 2010 TCC 186