A hybrid entity is an entity that has different tax treatments in different countries. The typical examples of these entities are US Limited Liability Company (LLC), Limited Liability Partnership (LLP) or Limited Liability Limited Partnerships (LLLP).
We have previously published a high-level overview of the taxation of US LLCs in Canada. This post is an attempt to further explain why using LLCs or other hybrid entities results in an abnormally high effective tax rate for Canadian taxpayers. For the purpose of this post, we are going to use the term U.S. LLC interchangeably with hybrid entities.
Disclaimer: Hybrid entities and other cross-border tax issues are complex income tax issues and the readers are recommended to always consult a cross-border tax professional.
A Limited liability company a.k.a. LLC is a business structure available in the U.S., in almost all the states. They are easy to create, very cost-effective to maintain, and flexible enough to best suit the U.S. taxpayers’ needs. By default, an LLC is treated as a disregarded entity or partnership for US income tax purposes. Another advantage is the availability of the option to check the box for it to be taxed as a corporation as well. At the same time, these LLCs offer flexibility to their members to enjoy limited liability at the same time.
LLC is an American creation and works really well for US tax residents. Canadian citizens who have taken residence in the U.S. can enjoy the same benefits of LLCs as long as their LLCs are not subject to Canadian income tax. The real problem comes when an LLC member moves to Canada! Very often, accountants in the U.S. or other professionals recommend that Canadian residents buy real estate using LLCs. This is not uncommon for U.S. accountants to recommend LLCs to the majority of their clients. As a result, we have a lot of Canadian taxpayers who are residents of Canada and run into tax troubles with their hybrid entities.
The key problem: A hybrid entity mismatch – A serious tax issue!
Why Canada treats LLCs as Corporations even if they are flow-through entities in the U.S.?
Subsection 248(1) of the Income Tax Act (ITA) provides the definition of a corporation as an incorporated company. As per the Interpretation Act, a corporation does not include a partnership that is considered a separate legal entity under provincial law. Neither the ITA nor Interpretation Act provides a detailed definition of a corporation. Therefore, Case law over the period of time, through a few cases, provides further information for the Canadian classification of foreign entities.
Canada Revenue Agency applies a two-step approach
The first step is to determine the legal characteristics of the foreign entity under the foreign law and the second step compares the same characteristics as per the Canadian laws.
A hybrid entity mismatch happens when the same entity is a flow-through entity in the U.S. while a corporation is in Canada!
An LLC in the U.S. is not liable for its taxes, its members are. U.S. Canada income tax treaty provides very limited relief to hybrid entities. For a corporation to qualify for the full treaty benefits, it must be a resident of the contracting state i.e. U.S. For a non-tax professional it might look counter-intuitive how come an LLC created under the laws of a state in the U.S. is not a U.S. resident!
In 2017, CRA issued an interpretation and reiterated its position that U.S. LLCs are Corporations under the Income Tax Act in Canada.
Article IV of the Convention Between Canada and the United States of America deals with issues related to “Residence”. A person (corporate entity) must be liable to tax in the U.S. for it to be considered a resident of the United States. Since LLCs are not liable to taxes but their members are, Canada does not consider these entities resident of the U.S.
Tax consequences in Canada
Foreign tax credits help to avoid the double taxation of the same income earned in one country by the resident of another country.
The key to optimizing taxes for LLC members lies in timing earnings and distributions appropriately.
- LLC’s income is taxed at the personal level of its member. The income earned in an LLC flows to its members and the taxpayer is liable to pay taxes at the individual level. There is no U.S. tax applicable when this income is distributed to the shareholder.
- In Canada, LLC is a corporation rather than a fiscally transparent entity. The taxpayer recognizes income only if it is distributed by LLC. That distribution is made from LLC’s pretax income. Such a distribution is recognized as an income at the time of distribution.
- In the case of passive income earned through an LLC, if the LLC is a controlled foreign affiliate, the income is treated as foreign accrual property income (FAPI). FAPI from Controlled foreign affiliates is recognized by a Canadian tax resident in the year when earned. FAPI includes rents, royalties, interests, dividends, etc.
- Income tax act (ITA) section 20(11) allows an individual shareholder to claim a foreign tax deduction for the U.S. taxes paid in excess of 15%. The U.S. taxes paid but not deducted under sec 20(11) can be used as a non-business foreign tax credit under section 126(1).
- As long as an individual has enough non-business income from the U.S. this non-business foreign tax credit can be used. If there is not enough US-sourced non-business income, the unused portion of non-business FTC is lost. Nonbusiness FTCs cannot be carried forward in Canada.
- To best optimize the tax position in Canada to match the distribution from an LLC with the taxable income from the active business of an LLC.
- For LLC income as FAPI in Canada, another mismatch occurs when FAPI calculated as per Canadian income tax rules differs from the income reported in the U.S.
“Check-the-box” for U.S. LLC is not always the best option!
At the outset of reading various management options for adverse tax consequences of U.S. LLCs for Canadians, check-the-box seems to be a great option. Interestingly, many practitioners frequently recommend this option to Canadian tax residents.
It is not always the best option, especially if you have been a tax resident of Canada for a while. The potential for triggering deemed emigration can result in adverse tax consequences. CRA, at a roundtable table, further confirmed this consequence of an often overlooked detail.
As mentioned before, U.S. LLCs face a hybrid mismatch and CRA does not see them as Corporations resident in the United States. In situations where LLCs are controlled by Canadian tax residents, as flow-through entities, these LLCs are Corporations resident in Canada (CRIC). This is due to the fact the ‘central control and management and ‘mind and management’ of these corporations are in Canada.
When a check-the-box election is submitted for an LLC that was previously a CRIC, it triggers the change of residence for this corporation.
The U.S.-Canada tax treaty Article IV provides tie-breaker rules to decide the residency of a corporation, a treaty benefit to avoid double taxation. Please note that previously, in Canada this LLC was not a U.S. tax resident for the purpose of the treaty as it was not liable for taxes in the U.S. For the same reason, it could not get the benefits of the tax treaty. Since it’s a U.S. tax resident now, it can take advantage of the treaty. This change comes with a potentially serious issue. It was a CRIC before and with this change it has become a deemed non-resident of Canada, triggering a deemed emigration. Deemed emigration results in departure tax in Canada.
S-Corporation tax treatment in Canada
Hybrid entities pose a serious challenge for tax residents in Canada. An exception to this is a U.S. S-Corp. S corporations generally cannot be owned by U.S. non-resident aliens. S corps are usually owned by dual citizens living in Canada.
As per the U.S.-Canada tax treaty, CRA sees S-Corporation as an entity resident in the U.S., therefore allowing treaty benefits.
Article XXIX: Miscellaneous Rules, Paragraph 5. provides an option to the shareholder of the S-Corporation to request a Competent Authority Assistant to treat S-Corp income as FAPI. In such a case, FAPI is included in the income of the shareholder in the year when earned and the foreign tax credit is available. SS 20(11) of ITA, in this case, is not applicable.
Such an election does have some challenges! First, the cost associated with this election is high. Second, the FAPI is calculated using the U.S. income tax rules and that may yield adverse results. One such example is Capital gains rules.
For Canadian tax residents, U.S. hybrid entities are not recommended! If you are setting up a separate corporation in Canada, you should be aware of reporting requirements and other sets of rules as well such as GILTI.
Cross-border income tax involves many complex issues and taxpayers should always seek professional tax advice to avoid any surprises! Maroof HS CPA Professional Corporation provides full-scale personal and corporate income tax services for Canada and U.S.
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