Introduction – U.S. Profits Interests
For U.S. federal income-tax purposes, one may hold one of two sorts of interests in a partnership—or any entity that the U.S. taxes as a partnership, such as a limited liability company (LLC): a capital interest or a profits interest.
A capital interest gives its owner the right to a share in the partnership's or LLC's net assets upon the entity's dissolution.
A profits interest, on the other hand, gives its owner the right to receive a percentage of the partnership's or LLC's future profits. It is, in other words, the right to share in the future growth of the business—that is, the amount by which the business's value has increased from the date that the profits interest was granted. So, subject to the terms of the specific profits interest, a profits-interest holder may participate in the entity's profits and capital appreciation from the date of the grant, but the holder is not entitled to receive any capital that existed or any profits that accumulated before the date that the interest was granted.
U.S. business owners, who operate using a partnership or LLC, use profits interests to compensate valued or senior employees. As a part of an employee-compensation package, corporate employers often include employee stock options (ESOs), which gives the employee the right to purchase shares in the employer corporation at a fixed price during a set period.
In that sense, a profits interest is like an employee stock option. But partnerships and LLCs don't issue shares, so a stock option isn't available. In addition, unlike a stock option, a profits interest is by itself an ownership stake in the partnership or LLC. A stock option, by contrast, is the right to acquire an ownership stake in a corporation.
Because a profits interest gives its holder an ownership interest in the issuing partnership or LLC, it also confers upon its holder all the rights and obligations that come with ownership. If you, for example, hold a profits interest in a general partnership, you, like the other partners, are jointly and severally liable for the partnership's debts.
The concept of a profits interest doesn't exist in Canadian law, and the Canada Revenue Agency hasn't given any specific guidance on how the proceeds from a profits interest are taxed. Moreover, parties have some flexibility when structuring the details of any particular profits-interest arrangement. These factors might lead to some uncertainty for Canadians who have been offered profits interests and want to know what Canadian income-tax consequences might arise. Then again, these factors also offer tax-planning opportunities should the parties be open to varying the profits-interest arrangement for tax optimization.
This article discusses how Canada's tax law might characterize the proceeds from a U.S. profits interest and the tax implications arising from those characterizations. This article also discusses foreign-reporting requirements that might result when a Canadian receives a U.S. profits interest. Finally, this article offers some tax tips from our certified tax specialist Canadian tax lawyers relating to U.S. profits interests.
Characterization of a Foreign Arrangement for Canadian Tax Purposes
The rules in Canada's Income Tax Act generally tax transactions or arrangements in accordance with Canada's private law. For example, if an arrangement constitutes a trust under Canadian trust law, then Canada will tax the entity as a trust.
Canada's private law, however, doesn't recognize many foreign entities and arrangements. As a result, the Income Tax Act often contains rules that specifically address certain foreign entities or arrangements by deeming that they be taxed in the same way as an entity or arrangement recognized in Canada.
If the Income Tax Act says nothing about a specific foreign entity or arrangement, then case law governs. In particular, a two-stage test determines the characterization of a foreign arrangement for tax purposes: The first step is to determine the characteristics of the foreign arrangement under the applicable foreign law, and the second step is to establish how these characteristics compare with the recognized characteristics of entities under Canadian law for tax purposes [Blackman v Canada, 2001 SCC 10; Sommerer v the Queen, 2011 TCC 212 at para 60, aff'd. 2012 FCA 207.]
A U.S. profits interest will therefore be taxed in the same way as the most analogous arrangement in Canadian law.
Canadian Income-Tax Implications Stemming from Various Characterizations of a U.S. Profits Interest
Because parties have some flexibility when structuring the details of any particular profits-interest arrangement, the Canadian income-tax implications will depend on the specifics of each arrangement.
We will examine some possibilities based on terms that often appear in profits-interest arrangements. In broad strokes, though, the proceeds from a profits interest might be characterized as either capital or income—specifically, employment income
On the one hand, some features of a profits interest support a capital characterization. A profits interest is a right. So, it's a "property" under the Income Tax Act. Moreover, a profits interest is an interest in a partnership or an LLC, and Canada's tax law views a partnership interest as a capital property. And profits interests are often structured so that the company essentially repurchases the interest upon paying proceeds to the holder. This arrangement resembles a buyout of a partner's interest by the other members in a partnership. And this transaction would attract capital treatment under Canadian tax law. That is, the retiring partner disposes of a recognized capital property. So, this characterization implies that, when a taxpayer receives proceeds upon disposing a profits interest, the income is a capital gain, and thus only half-taxable.
Other features support an employment-income characterization. First, as mentioned above, a profits interest is often tied to the recipient's employment—that is, you receive it solely because you're an employee. In addition, other common features of profits interest also support the employment-income characterization. For example, profits interests sometimes come with time-based and performance-based vesting, which resemble bonuses for seniority and performance respectively. These features favour an employment-income characterization, which would mean that the income is fully taxable as employment income under subsection 5(1) of the Income Tax Act.
While the ambiguity may seem off-putting, it—along with the flexibility that these arrangements typically offer—presents a tax-planning opportunity. The terms of the profits interest may be drafted so that the arrangement displays the features of the desired tax characterization. The terms, for instance, may resemble those of a security, which typically draws capital treatment. Or they may resemble those of a promise to distribute future earnings, thus drawing income treatment.
Foreign-Reporting Requirements for U.S. Profits Interests
A U.S. profits interest may trigger foreign-reporting obligations for Canadians who receive them. For instance, under section 233.3 of the Income Tax Act, if a Canadian taxpayer owns a "specified foreign property" with a total cost exceeding $100,000, the Canadian taxpayer must file a T1135 form reporting the existence of the foreign property.
The Income Tax Act gives a broad definition of the term "specified foreign property." In particular, the definition includes "an interest in, or for civil law a right in, or a right—under a contract in equity or otherwise either immediately or in the future and either absolutely or contingently—to any property." This will very likely include a profits interest in a U.S. partnership or LLC. So, a Canadian resident with a profits interest in a U.S. entity may need to file a T1135 or risk incurring steep financial penalties.
Granted, when employers offer a profits interest as employee compensation, they often don't require the employee to purchase the interest. So, the employee's cost to acquire the profits interest may be nominal.
Still, certain Canadian tax rules might deem a taxpayer to have a higher tax cost for the profits interest. For example, when a taxpayer becomes a tax resident in Canada, the tax cost of the taxpayer's property is bumped up to its fair market value as of the time that the taxpayer became a resident. (This rule ensures that Canada taxes only the foreign gain that accrued during the time that the taxpayer was a tax resident in Canada. For Canada has no jurisdiction to tax the foreign income of a non-resident.)
This rule means that a U.S. national, who owns a profits interest and later moves to Canada, may need to start filing T1135 forms—even though his or her actual cost to acquire the profits interest was nominal
Tax Tips – U.S. Profits Interests
As you have probably guessed, if you own a profits interest in a U.S. partnership or LLC, your Canadian tax obligations are not entirely straightforward. Not only is it uncertain as how Canadian law will characterize the profits interest for tax purposes, but also the various characterizations themselves may invoke complex income-tax rules.
That said, the ambiguity and the flexibility that these arrangements typically offer may present a tax-planning opportunity. If you anticipate receiving U.S. profits interest and you want to optimize the Canadian tax effects, or if you're a U.S. employer planning on granting a profits interest to employees in Canada, consult with one of our experienced Canadian tax lawyers. We can review the terms of your profits interest and provide advice about the resulting Canadian tax obligations. In addition, we can suggest drafting revisions so that the arrangement displays the features of the desired tax characterization
In addition, if you were required but failed to report your income from a profits interest or your ownership of a profits interest, meet with one of our Canadian tax lawyers today. The Voluntary Disclosures Program may be a viable option for avoiding penalties or prosecution.
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.