The Unusual Tax Treatment of U.S. LLCs in Canada
Colleen Mathews, Tax Manager
A U.S. partnership is treated as a partnership in Canada and a U.S. corporation is treated as a corporation in Canada, how do our neighbors to the north view a U.S. Limited Liability Company (LLC)? The answer is that while the United States allows this amorphous American business entity to choose the more advantageous flow-through tax form, in Canada the authorities assign the entity a corporate form. These divergent classifications can prevent U.S. members of an LLC from receiving the benefits of the Canada-U.S. Income Tax Convention (the “Treaty”).
The LLC is a distinctly American creation that provides members with legal protection and the ability to choose how to be taxed by the U.S. federal government. Although an LLC can be taxed as a corporation, which means income is taxed at the entity level and members are taxed again on distributions from the company, the entity can also be taxed as a partnership or classified as a disregarded entity. When an LLC is taxed as a partnership or disregarded, it serves as a conduit for passing income, deductions, losses, and credits to its members, who then report the income on their individual tax returns. This fiscally transparent entity is taxed by the U.S. federal government only at the individual level, not at the corporate level.
As U.S. LLCs expand their businesses northward into the Canadian provinces, their members are finding that the fiscal transparency does not travel with their business across the Canadian border. The Canadian Revenue Agency (CRA) treats the U.S. LLC, regardless of its U.S. tax treatment, as a corporation. The CRA has long held that the LLC and not its members are subject to the Canadian corporate tax.
This conflicting treatment of LLCs collides when the entity’s members seek to access the tax relief provisions contained in the Treaty. The Treaty’s benefits are extended to U.S. residents, but the CRA does not consider an LLC a U.S. resident because the entity itself is not subject to U.S. federal income tax.
The Treaty has been revised five times since it was signed in 1983. The most recent revision, the 2008 Protocol, added a new paragraph that was designed to afford treaty benefits to LLC members. The new language of Paragraph 6, Article IV provides a limited look-through to LLC members, such that the U.S. members are treated as deriving income directly, and therefore are able to obtain treaty benefits on income earned by the entity in Canada. This paragraph restores limited fiscal transparency so that LLC members can use their U.S. residency status to claim treaty benefits. However, if the member cannot qualify for treaty benefits on his or her own merits, the CRA would continue to assess the corporate income tax on the LLC.
- Example: Suppose a U.S. LLC is taxed as a partnership in the U.S. and it has two members, one is an individual U.S. interest holder and the other is a non-U.S. resident member. It has operations in Canada, but it does not have a permanent establishment in the country.* The income allocated to the U.S. resident would qualify for the Treaty exclusion because Canada considers the individual a resident of the U.S. and treats the individual as earning the income directly. The income allocated to that individual would not be subject to Canadian tax. However, the non-U.S. resident would not qualify for Treaty benefits. The income to be allocated to the non-resident would remain taxable to the LLC in Canada and would be subject to corporate-level income tax.
In addition to the income tax, the CRA assesses a branch profits tax of 25% on operations of U.S. LLCs, if the entity has a permanent establishment in Canada. LLC members have attempted to use the Paragraph 6 look-through rule to access the Treaty in this situation, because the Treaty reduces the default 25% branch tax rate to 5% and it provides an exemption for the first CAD 500,000 of the branch earnings. In this instance, the CRA will only grant Treaty benefits to members who are U.S. corporations.
As discussed above, paragraph 6 allows the LLC to claim treaty benefits for its U.S. members if the member would qualify for the benefits on their own merit. If the income was earned directly by an individual, it would not be subject to the branch tax and no treaty relief would be required. Because the branch tax is only charged against corporations, corporations are the only members who can qualify for relief.
- Example: The members of a U.S. LLC owned 50% by a U.S. resident individual and 50% by a U.S. resident corporation would receive the following tax treatment: Profits allocated to the individual would be subject to the Canadian branch tax at the full rate of 25%, while the U.S. corporation would be subject to the branch tax at a reduced rate of 5%, which is applicable only on profits exceeding $500,000.
Determining the tax consequences for U.S. LLCs operating in Canada is complex because an LLC does not qualify for treaty benefits and even when it members do, the CRA can apply the provision in unpredictable ways. If you would like more information about Canada’s treatment of U.S. LLCs and its members, please contact Stuart Lyons or your BNN tax advisor at 1-800-244-7444.
*As we discussed in a previous article, a permanent establishment (PE) is generally a fixed place of business, but it can also occur when a company carries on business through an employee who has the general authority to contract on behalf of the employer.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.
IRS CIRCULAR 230 DISCLOSURE:
Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachment) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.