In this article, the authors consider the effect the U.S. Tax Cuts and Jobs Act may have on Canada regarding both U.S. inbound and outbound investments.
According to the Office of the United States Trade Representative, U.S. goods and services trade with Canada totaled an estimated $673.9 billion in 2017. In 2016 U.S. foreign direct investment into Canada was $363.9 billion, and Canada's foreign direct investment in the United States was $371.5 billion. With bilateral trade of more than $1.8 billion daily, Canada and the United States clearly have an important trading relationship and a high level of economic integration.
Given that relationship, it is unsurprising that anything that affects Americans could also affect Canadians, and the recent U.S. Tax Cuts and Jobs Act (P.L. 115-97) is no exception. Therefore, it is necessary to consider the effects those changes could have on both inbound and outbound U.S. investment. Much has already been written about what impact the reform will have on more aggressive tower and repo structures designed to create advantageous tax outcomes, but relatively little has been said about some of the more common cross-border investment and business vehicles.
While refinements are coming out almost daily as regulations are drafted, it is still useful to take stock of what we know so far about the tax reform. Of benefit to taxpayers is the 21 percent corporate tax rate, the ability to immediately expense new and used business assets, and special deductions based on a company's foreign-derived intangible income (FDII). Those changes would seem to make the United States an attractive place for both Americans and Canadians to grow their businesses. On the flip side, the reform introduced several detriments for U.S. persons who have investments on the other side of the border — for example, the global intangible low-taxed income tax and expanded subpart F.
Because of those changes, cross-border structures that until now have been tried and true must be reconsidered. Cross-border businesses and investors who might previously have considered holding investments through a Canadian corporation might lean heavily toward holding investments, particularly in intangibles, through U.S. corporate structures instead. Several changes have made U.S. C corporations more attractive, which is good news for both Americans wanting to do business in Canada and Canadians wanting to do business in the United States.
Historically, many U.S. taxpayers who do business in Canada — and vice versa — have used hybrid entities like limited liability companies that have not elected to be classified as corporations, limited liability partnerships, and limited liability limited partnerships (LLLP). The use of those hybrid entities in a cross-border capacity frequently results in surprisingly high effective tax rates, so it is useful to consider the changes affecting U.S. corporations and the result that has on the equation for those hybrid entities.
The History of Hybrids
Pre-reform, it was common to see investments from Canada into the United States take place either through a U.S. LLC, LLLP, or limited partnership (LP). Given the restrictions on the use of S corporations, those entities were generally not an option, and the high U.S. corporate tax rates paid by C corporations meant those entities also were rarely used. The use of an LLC or LLLP often has unfortunate tax consequences in a cross- border context, however. For a Canadian investing into the United States — even before tax reform — the use of a C corporation (or in some cases, a trust) at times would arguably have resulted in better preservation of after-tax capital than an LLC, LLLP, or LLP; however, rarely were those structures used. And even for a U.S. resident investing into Canada, again, an LLC really didn't produce great results, as discussed below.
For a U.S. tax adviser, unless those hybrid entities file a Form 8832 and elect to be treated as a corporation, they are all substantively the same thing — a partnership or a disregarded entity. But from a Canadian perspective, a U.S. LLC or LLLP is substantively different from an LP, with substantively different Canadian tax results.
Foreign entity classification in Canada is based on comparing the legal nature of a foreign entity with the types of entities recognized in Canada. Occasionally an entity being classified will become a hot topic for Canadians, particularly if it is a domestic U.S. entity — and sometimes the process has unexpected results. That is the case regarding the classification of LLCs, LLLPs, and LLPs that have not elected to be treated as a corporation for U.S. purposes. In the United States, all those entities are effectively partnerships or disregarded entities, but the presence of legal personality and broad limited liability for all members caused Canadian tax authorities to consider them corporations.
Unfortunately, because of that classification, the use of a U.S. LLC, LLLP, or LLP could come with a high tax cost that wouldn't exist for Canadian taxpayers investing or doing business in the United States through a U.S. LP or C corporation. Many Canadians find themselves partners in U.S. LLLPs purely by happenstance. To a U.S. corporate lawyer, an LLLP, LLP, and LP are all partnerships, so if a client asks to form a partnership and is in a state that provides for LLLPs, that is often the entity provided.
Pre-Reform Canadians Investing Into the U.S.
So what causes the problem? The root of the issue is that an LLC, LLLP, or LLP is not itself liable for U.S. tax, but Canada sees it as a distinct legal entity. That results in a mismatch in the treatment of those entities from one side of the border to the other, leading to serious tax problems, including double taxation for Canadians who invest into the United States through one of those entities.
As a starting point, consider the question of tax residency. Under the Canada-U.S. income tax treaty, just being formed in the United States is not enough for an LLC, LLLP, or LLP to be recognized as U.S. resident. Under treaty Article IV on residence, to be "found resident of a contracting state" under the laws of that state, a corporate entity or flow-through entity (FTE) must be "liable to tax" there. Because an LLC, LLLP, or LLP that has not elected to be treated as a corporation is not itself taxable, Canada takes the position that those entities are not U.S. resident entities entitled to full treaty benefits.1 Article IV(6) of the treaty provides some limited relief from Canadian withholding tax on payments made to an LLC, LLLP, or LLP, but if one of those entities has its central management and control in Canada, Canada might deem it Canadian resident and impose Canadian corporate tax on its worldwide income. In most cases, there will be no foreign tax credit relief for that additional tax.
That differential treatment between Canada and the United States can create several challenges because tax is imposed by Canada at the partnership level, rather than at the partner level like in the United States. While the full impact on a Canadian resident taxpayer of its investment in a U.S. LLC, LLLP, or LLP will depend to some degree on what it has invested in, because those entities are foreign corporations and thus foreign affiliates, Canada might impose a reporting obligation regarding the entity.
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Reprinted from Tax Notes International, July 30, 2018, p. 465
1 The Canadian tax authorities have, however, made an administrative concession, saying an S corporation will be deemed U.S. resident under the treaty.
Moodys Gartner Tax Law is only about tax. It is not an add-on service, it is our singular focus. Our Canadian and US lawyers and Chartered Accountants work together to develop effective tax strategies that get results, for individuals and corporate clients with interests in Canada, the US or both. Our strengths lie in Canadian and US cross-border tax advisory services, estateplanning, and tax litigation/dispute resolution. We identify areas of risk and opportunity, and create plans that yield the right balance of protection, optimization and compliance for each of our clients' special circumstances.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.