Article by Kenneth Snider, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Cross-Border Taxation - March 2005
The administrative position of Canada Revenue Agency (CRA) with respect to U.S. limited liability companies (LLCs) has created considerable consternation. CRA consistently repeated its position that LLCs that are treated as fiscally transparent for U.S. tax purposes will not be entitled to the benefits of the Canada-U.S. Tax Convention (the Convention) on the basis that they do not qualify as residents of the U.S. for purposes of the Convention even where all the members are U.S. residents. This position is in contrast to CRA’s "favourable" administrative position with respect to extending benefits to S corporations and generally looking through partnerships to the residency of the partners for purposes of applying a tax convention.
The denial of benefits under the Convention to an LLC will result in adverse tax consequences to U.S. residents in a number of situations including (i) loss of the protection of the business profits provision of the Convention which restricts Canada’s right to tax business profit except to the extent they are attributable to a permanent establishment in Canada, (ii) the imposition of the Canadian statutory rate of withholding tax at 25% (assuming a statutory exemption to the payment does not apply) on certain payments rather than the reduced rates under the Convention and (iii) loss of protection against Canadian tax on certain capital gains from the disposition of "taxable Canadian property".
Unless and until the Convention is amended to resolve this issue, the preferred approach is clearly to avoid investing in Canada using an LLC. In some circumstances, however, an LLC already holds the Canadian property and a Canadian taxable event, based on CRA’s position, is anticipated. It is necessary to consider what tax planning opportunities may be effective to obtain benefits under the Convention without creating adverse U.S. tax consequences.
There are two approaches to be considered in these circumstances. One approach which has been taken is the subject of an advance tax ruling by CRA dated June 4, 2004. In summary, the facts were that an LLC was created under the laws of the U.S., and all the members were individuals who were resident in the U.S. for purposes of the Convention. Pursuant to an election made by the LLC with the members of the LLC pursuant to section 1362 of the Internal Revenue Code (the Code), the LLC was subject to tax under the Code as an S corporation. Consequently, the income of the LLC is taxed in the hands of its members for purposes of the Code. The LLC had filed U.S. returns as an S corporation.
It was proposed in the ruling that the LLC would begin to "carry on business" in Canada for Canadian tax purposes. While the ruling did not deal with whether the LLC had a permanent establishment in Canada, presumably the objective of the LLC was to obtain the benefits of the business profits provision in the Convention. The tax ruling was given that the LLC was a corporation for purposes of the Income Tax Act, and a resident of the U.S. for purposes of the Convention. It is interesting that the ruling did not address the question of whether the general anti-avoidance rule applied presumably on the basis that no ruling was requested in this respect.
This approach would only be viable if the U.S. taxpayer was entitled to elect to be taxed as an S corporation and there were no adverse U.S. tax implications.
Another approach is to convert the LLC into a limited partnership under the Delaware Limited Partnership Act. In a technical interpretation dated March 29, 2004, CRA specifically set out the analytical framework for determining whether a statutory conversion from a Delaware limited liability company to Delaware limited partnership (LP) results in a disposition for Canadian tax purposes. If there was a disposition of "taxable Canadian property" as a result of the conversion, the benefit of Article XIII of the Convention would not be available and the capital gain would be taxable. CRA identified the following considerations:
(a) whether the converting entity is required to wind up its affairs or pay its liabilities and distribute its assets;
(b) whether the conversion is deemed to constitute a dissolution of the converting entity;
(c) whether the assets of the LLC become the assets of the partners as a result of the conversion;
(d) whether the LP is considered to have been in existence since the creation of the LLC; and
(e) whether there is any restriction on the LP’s conversion back to an LLC.
The CRA stated that these considerations are to be answered on a case-by-case basis with reference to the applicable partnership agreements and the provisions of Delaware law. CRA has not yet made public its position in respect of this matter. Consequently, it is very important for an LLC owning taxable Canadian property to consult with Canadian tax counsel prior to a conversion to an LP.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.