Canadians seeking to make investments in US based private equity funds do face a challenging landscape attributable to the multitude of US taxing authorities, federal, state and local governmental taxing authorities, as well as a somewhat counterintuitive home country tax regime, in reporting their U.S. operations back home in Canada. This is because U.S. private equity funds are frequently organized as limited partnerships which has the consequence that each non-resident U.S. partner is allocated his or its pro rata share of partnership income and is subject to U.S. income tax on such portion. More specifically, with respect to a non-resident investor who is a partner in the fund, its distributive share of partnership income is treated as income attributable to the conduct of a trade or business in the U.S. ("effectively connected income" or "ECI") if the equity fund is so engaged. §875(1). Treas. Reg. §1.875-1. Johnston v. Comm’r, 24 T.C. 920 (1955)(Canada-U.S. Income Tax Treaty: Unger v. U.S. 936 F.2d 1316 (CA-D.C., 1991); Rev. Rul. 90-80, 1990-2 C.B. 170.
The Canadian (or non-resident) partners sale of an interest in the partnership also generates ECI, at least that is the Service’s publicly stated position. See Rev. Rul. 91-32, 1991-1 CB 107 . Where the non-US. Investor in the fund is a foreign corporation, the branch tax is implicated but at a reduced treaty rate. §884 ; Canada-U.S. Tax Treaty, Article X, para. 6. Where the US limited partnership operative a private equity fund has ECI, it must withhold at a 35% rate on each non-resident’s share of ECI. §1446.
In order to mitigate these tax impacts, it is common for a foreign investor to own its interest in a private equity fund in the U.S. through a U.S. corporation. The insertion of such entity, frequently referred to as a "blocker" company , is either a de jure U.S. corporation or a de facto corporation for tax purposes which occurs, in the latter instance, through forming, for example, a single member LLC which makes a reverse default election under the CTB regulations to be treated as a corporation. This results in the blocker corporation being subject to U.S. tax on its share of the fund’s income and is the entity responsible for filing U.S. tax returns and payment of U.S. tax. Profits are distributed to the non-resident owner of the blocker as either dividends or a liquidating distribution. As to dividends, if no treaty is involved the withholding tax is 30% but a Canadian investor may qualify for an exemption or a reduced withholding rate under the Treaty. Canada -U.S. Tax Treaty, Article X, para. 2(b). If the Canadian owner holds 10% or more of the U.S. subsidiary’s voting stock, the rate on dividend withholding is reduced to 5%. A special relief rule applies to liquidating distributions.
A special concern for Canadian investors with use of a "corporate" blocker to hold its interest in a U.S. limited partnership is that that the partnership will still be treated as a pass through entity for Canadian tax purposes. Therefore, for Canadian investors, a problem arises when a U.S. fund uses as a blocker a U.S. limited partnership that elects to be treated as a corporation for U.S. tax purposes. The partnership still will be treated as a pass-through partnership for Canadian tax purposes. See §96 of the Canadian Income Tax Act .
The 2007 Protocol to the Canada-U.S. Tax Treaty, which addressed problems associated with the use of hybrid entities for investing in both Canada and the U.S., also impacts blocker structures for Canadians investing in the U.S. First problem pertains to tax reporting. The U.S. K-1 will go to the U.S. blocker entity (corporation) and not to the Canadian investors who will need the same information provided on a K-1 in order to fulfill their Canadian income tax reporting and tax payment obligations since the blocker is treated as fiscally transparent. More critical is the tax consequences in Canada attributable to the use of the blocker structure itself. Generally a dividend paid to a non-U.S. shareholder is subject to a U.S. 30% withholding tax, subject to applicable treaty reduction. Where a private equity limited partnership makes a distribution to a U.S. blocker taxable as a corporation, the corporation, already subject to income tax on ECI and other U.S. source income includible in taxable income, which them makes a distribution from its earnings and profits to its non-resident partners, is required to withhold 30% of the dividend subject to treaty override. A Canadian resident that otherwise qualifies for benefits under the U.S.-Canadian Treaty can reduce this rate to 15% and 5% if he or it owns 10% or more of the subsidiary’s voting stock. Qualified pensions in Canada are entitled to 0% withholding.
Under the 2007 U.S.-Canadian Treaty Protocol pertaining to hybrid entities, paragraph 7(b), Article IV states:
"An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State [Canada] where ...
"(b) The person is considered under the taxation law of the other Contracting State [U.S.] to have received the amount from an entity that is a resident of that other State [U.S.], but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State [Canada], the treatment of the amount under the taxation law of that State [Canada] is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State [Canada]."
Under this provision, for Canadian income tax purposes, a U.S. "blocker" corporation is still treated as a pass through entity and the income of the U.S. limited partnership is still allocated as ECI to the Canadian owner of shares in the blocker company. The transfer of funds by the "blocker" to Canadian residents is not taxable. (Were the U.S. blocker treated as a corporation for Canadian income tax purposes, then the payments by the blocker would be considered to be a dividend which is the U.S. treatment of the payment). Still, there would seem to be a withholding obligation of 30% by the U.S. blocker on cash funds distributed to the Canadians. In other words, treaty benefits presumably are to be denied to the Canadian investors on the dividends. See Technical Explanation of the 2007 Protocol. As a result, paragraph 7(b) of the 2007 Protocol would apply to provide that the dividends are not considered to be paid to or derived by either the Canadian corporation or the Canadian pension fund.
So direct investment by the Canadian in the U.S. limited partnership (private equity fund) results in ECI on its distributive share of the income and is subject to withholding subject to treaty reduction. Investment in a U.S. blocker corporation doesn’t change the result and perhaps could inspire another level of withholding on dividends paid by the blocker to its non-resident shareholders.
The potential solution to this "whipsaw" situation is the use of a U.S. limited liability company (instead of a limited partnership) to perform the role of the blocker, i.e., the use of a domestic LLC that elects to be treated as a corporation for U.S. income tax purposes. Canada views the LLC as a corporation. See, e.g., CRA Document Nos. 9729780 (11/14/97) and 9713120 (5/20/97); Income Tax Technical News No. 29 (10/30/02); CRA Interpretation Bulletin IT-343R, "Meaning of the Term ‘Corporation’" (9/26/77), at para. This offers the benefits of the U.S. blocker structure and reduction of withholding levels on distributions made by the LLC to Canadian residents.