A limited liability company (“LLC”) is a common type of business entity used in the United States of America (“US”). However, Americans planning to expand their businesses into Canada need to think twice before involving an LLC in such activities. This posting provides an overview of the Canadian tax issues that arise when LLCs earn income from carrying on business in Canada directly or through a subsidiary.
Tax Consequences of Carrying on Business in Canada
There are two basic ways a non-resident can carry on business in Canada: through a branch or a subsidiary. A branch operation involves expanding an existing business into Canada without incorporating a subsidiary. For example, a US company could simply start carrying on its business in Canada by leasing a Canadian office and hiring Canadian employees. Alternatively, a US company could use a subsidiary for its Canadian business operation.
The default Canadian tax consequences (not considering tax treaty relief) of using a branch operation are as follows. The general active business income attributable to the non-resident’s Canadian branch is subject to income tax. Corporate income tax rates range from 25% to 31% depending on the province or territory in which a permanent establishment is located, if any. A non-resident company will also be subject to branch tax, which is an additional 25% tax on after-tax income not reinvested in Canada.
The default Canadian tax consequences (not considering tax treaty relief) of using a subsidiary are as follows. The worldwide income of the subsidiary is subject to income tax at the rates noted above. As well, dividends paid by the subsidiary to its non-resident parent are subject to 25% withholding tax. If the subsidiary is capitalized in part through debt, the interest payments to the non-resident parent will also be subject to 25% withholding tax.
The Canada-US Income Tax Convention (“Treaty”) significantly reduces Canada’s jurisdiction to tax. Under it, Canada cannot tax the business profits of a branch of a US resident unless the US resident has a permanent establishment in Canada and business profits are attributable to the permanent establishment. Furthermore, a US resident company does not have to pay branch tax unless it has a permanent establishment in Canada. Even if it does have a permanent establishment, Canada cannot apply branch tax to the first CDN $500,000 of the branch earnings derived by a US resident company or an associated company in the same or similar business.
The Treaty also provides benefits to a subsidiary operation. Under the Treaty, dividends paid by a Canadian subsidiary to a US parent company entitled to Treaty benefits will have withholding tax reduced to 5%. There will generally be no withholding tax on interest paid by the Canadian subsidiary to a US parent company entitled toTreaty benefits.
The Treaty provides significant tax reductions for US residents that carry on business in Canada, whether through a branch or subsidiary. Unfortunately, an LLC often does not qualify for Treaty benefits. There can also be issues even if an LLC can access Treaty benefits. Treaty benefits can apply in unexpected ways when an LLC is involved.
For example, consider an LLC that has not elected to be treated as a corporation for US tax purposes. The LLC is carrying on a branch operation in Canada through a permanent establishment, and its earnings have exceeded the CDN $500,000 exemption from branch tax. One might expect that the LLC’s earnings should be subject to the 5% reduced rate of branch tax provided that all of its members are US residents eligible for Treaty benefits. However, the Canada Revenues Agency’s (“CRA”) position is that earnings of the LLC are only eligible for the reduced rate of branch tax to the extent that the members of the LLC are US resident companies eligible for Treaty benefits. Therefore, an LLC with two members – a US resident individual and a US resident company eligible for Treatybenefits – will have 50% of its earnings subject to 25% branch tax and the other 50% subject to 5% branch tax for a combined rate of 15%.
The CRA’s Position on LLCs
The CRA’s long standing position is that an LLC is a corporation for the purposes of the Canada Income Tax Act, and the LLC must, therefore, pay Canadian taxes like any other corporation. The members of the LLC will not pay Canadian income tax on the LLC’s income even if the members are considered to earn the income under US tax law.
The first step in determining entitlement to Treaty benefits is to consider whether the person seeking the benefits is a resident of Canada or the US (i.e., a Contracting State) as only such residents are eligible for Treaty benefits. TheTreaty provides that a person is a resident of a Contracting State if the person is liable to tax in that Contracting State because of that person’s domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.
An LLC is not subject to tax in the US unless it makes an election using Form 8832 “Entity Classification Election” to be treated as a corporation for US tax purposes. In the absence of such an election, an LLC is treated for US tax purposes as either a disregarded entity if it has only one member or a partnership if it has more than one member.
The CRA’s position is that an LLC does not qualify as a US resident for purposes of the Treaty unless it elects to be treated as a corporation for US tax purposes. The CRA’s reasoning is that an LLC treated as a disregarded entity or a partnership for US tax purposes does not fall within the definition of resident of a Contracting State because such an LLC is not itself liable to tax in the US. Based on that reasoning, the CRA denies Treaty benefits to LLCs that have not elected to be treated as a corporation for US tax purposes because only a resident of a Contracting State is entitled to Treaty benefits.
Under recent amendments to the Treaty, an LLC that has not elected to be treated as a corporation for US tax purposes can indirectly access Treaty benefits if its members satisfy the look-through and limitation on benefits rules of the Treaty discussed below.
An LLC Indirectly Accessing Treaty Benefits
Subject to the limitation on benefits rule discussed below, the look-through rule requires Canada to extend Treatybenefits to a US resident where the following conditions are met. First, the US resident must be considered under US tax law to have derived Canadian-source income, profit, or gain through an entity, such as an LLC, that is not resident in Canada. Second, the US tax treatment of such amount is the same as if it had been derived directly by the US resident instead of through a fiscally-transparent entity.
The look-through rule is meant to enable US resident members of a fiscally-transparent entity, such as an LLC, to access Treaty benefits for the amount of Canadian-source income, profit, or gain derived by the entity and proportionally allocated to the US resident members.
An LLC may have both US and non-US resident members. In such circumstances, the proportion of the LLC’s Canadian-source income, profit, or gain that is allocable to non-US resident members will not be eligible for Treatybenefits. For example, consider an LLC with two members. One member is a US resident individual, and he has a 45% interest in the LLC. The other member is a non-US resident individual, and she has a 55% interest in the LLC. In these circumstances, only 45% of the LLC’s Canadian-source income, profit, or gain will be eligible for Treatybenefits. In a corporate structure where there are one or more tiers of LLCs, the tiers of LLCs are looked through to determine the proportion of the Canadian-source income, profit, or gain allocable to non-US resident members and thus not eligible for Treaty benefits. For example, if Holdco LLC is a member of Subco LLC, the proportion of Holdco LLC’s members that are non-US residents affects the amount of Subco LLC’s Canadian-source income, profit, or gain that is eligible for Treaty benefits.
Limitation on Benefits Rule
Under the limitation on benefits rule, a person cannot access Treaty benefits unless the person is a “qualifying person” or meets certain other criteria described below.
The basic rule is that only a qualifying person is entitled to all Treaty benefits. In the context of an LLC, it is the members of the LLC that must be qualifying persons. A qualifying person is a resident of Canada or the US that falls within one of the following categories:
- natural persons;
- certain Canadian and US government entities;
- certain publicly traded companies and trusts as well as their subsidiaries;
- certain companies and trusts that satisfy the ownership and base erosion tests;
- estates; and
- certain not-for-profit organizations and other types of tax-exempt organizations.
Under the above rule, a US resident company that is a member of an LLC will be a qualifying person if it falls within the category of publicly traded company and their subsidiaries or if it satisfies the ownership and base erosion tests.
The ownership and base erosion tests are as follows. The ownership test requires that 50% or more of the aggregate vote and value of the shares of the company and each disproportionate class of shares of the company (in neither case including debt substitute shares) not be owned directly or indirectly by persons other than qualifying persons. The base erosion test requires that expenses deductible from gross income that are paid or payable by the company in its preceding fiscal period (or, in the case of its first fiscal period, that period) directly or indirectly to persons that are not qualifying persons are less than 50% of the company’s gross income for that period.
Active Trade or Business
If the qualifying person requirement cannot be satisfied, the Treaty provides that a resident of one Contracting State is entitled to Treaty benefits with respect to income derived from the other Contracting State if three requirements are satisfied. First, the Canadian or US resident, or a person related thereto, must be engaged in an active trade or business in the state of residence. Second, the income derived from the other Contracting State must be in connection with or incidental to the active trade or business carried on in the state of residence. Third, the active trade or business carried on in the state of residence must be substantial in relation to the activity carried on in the other Contracting State giving rise to the income for which Treaty benefits are being claimed.
The CRA does not consider a member of an LLC to carry on the business of the LLC. This means that the active trade or business test will be difficult to meet. However, the test will be met by reference to the business activities of the LLC where a member of an LLC is related to that LLC, and the LLC’s business satisfies the above test.
A US company that is not a qualifying person and that does not meet the active trade or business test may still obtainTreaty benefits for dividends, interest, and royalties if a derivative benefits test is satisfied. Basically, derivative benefits enable a company resident in a Contracting State to access certain Treaty benefits if shareholders owning substantially all of its stock are either qualifying persons under the Treaty or would have been entitled to equally favourable tax treaty benefits from the other Contracting State had the amounts in question been earned directly by those shareholders. The actual test is similar to the ownership and base erosion tests described above.
An LLC that has not elected to be treated as a corporation for US tax purposes cannot access derivative benefits under the Treaty. However, a company that is a member of the LLC that meets the tests noted above will be entitled to limited Treaty benefits under the derivative benefits test. Note, Canadian withholding tax on interest is reduced to 0% when Treaty benefits apply to such interest. As a result, a member of an LLC that is not a qualifying person can never receive reduced withholding on interest through derivative benefits because no other Canadian tax treaty offers equally favourable treatment of interest.
A person resident in a Contracting State who does not otherwise satisfy the limitation on benefits rules may request relief from a competent authority. The person must make the request to the competent authority of the state from which Treaty benefits are sought. The competent authority in Canada is the Minister of National Revenue or her authorized representative which is the CRA. An LLC that has not elected to be treated as a corporation for US tax purposes cannot apply to the competent authority for relief. However, this type of relief is theoretically available to the members of an LLC.
The LLC is the Only Visible Taxpayer
Canada does not grant Treaty benefits directly to the members of an LLC despite the fact that it is the members who must satisfy the look-through and limitation on benefits rules. Instead, the LLC is treated as the only visible taxpayer, and it must comply with all filing requirements related to Canadian-source income and pay Canadian tax on that income. This means Canada will not require the members of an LLC to file Canadian tax returns for Canadian-source income earned by the LLC. Instead, the LLC must file a Canadian tax return in which the LLC itself claims theTreaty benefits on behalf of its members.
Anyone using an LLC should be aware that they may be required to fill out and file a Form NR303 “Declaration of Eligibility for Benefits Under a Tax Treaty for a Hybrid Entity”. An LLC filing a Canadian income tax return and claiming Treaty benefits must submit a Form NR303 along with its tax return. An LLC seeking a refund or waiver of various Canadian withholding taxes must also fill out and file a Form NR303.
Determining the tax consequences of using an LLC for a business carried on directly or indirectly through a subsidiary in Canada can be complex. This posting has not even touched on the adverse tax consequences that may arise if an LLC incorporates a Canadian subsidiary that is an unlimited liability company. Furthermore, any Canadian resident thinking of taking a membership interest in an LLC needs to be cautious because double taxation and other adverse results may arise. The bottom line is that before using an LLC in Canada think twice and consult a Canadian tax expert.