Published: March 4, 2020
Last Updated: October 21, 2022
Introduction – Lowering Your Tax Burden when Investing in the United States
Various tax efficient vehicles are available to Canadians who purchase and hold assets, or carry out business in the United States. Generally, it is best for Canadians to avoid using a Limited Liability Corporation (LLC), a popular investment vehicle that is only available south of the border. The Canadian and the United States tax authorities classify an LLC differently, and this difference often leads to double taxation of a Canadian taxpayer who is a member of an LLC. Consequently, it is generally advisable for Canadian taxpayers to avoid using LLCs to structure their affairs. In light of the recently lowered U.S. Federal corporate tax rates, there are more tax efficient investment structure for those conducting business or looking to invest in the United States.
What is a Limited Liability Corporation?
A Limited Liability Corporation (LLC) is a hybrid structure with characteristics of both a corporation and a partnership. Like a corporation, LLC offers legal liability protection to its members, and similar to a partnership, this investment entity offers flow through treatment for tax purposes.
Uniquely, an LLC can elect the manner in which it is taxed under the United States tax laws. It may be treated as a disregarded entity, a partnership, or a corporation. As a disregarded entity, the income of the LLC is taxed in the hands of the single LLC member. When designated as a partnership, the LLC income is distributed amongst partner LLC members in accordance with their partnership agreement, and taxed in the hands of each partner. As a corporation, the income of the LLC is subject to the corporate tax rates, and its distributions are taxed in the hands of LLC members similar to corporate dividends in the hands of a corporation’s shareholders.
Problem of Double Taxation: How is a Limited Liability Corporation Taxed in Canada?
The Canada Revenue Agency (CRA) classifies LLCs as a corporation for tax purposes. This means that many of the intended tax efficiencies of the LLC resulting from its “pass-through” treatments under the United States tax laws are unavailable to Canadian taxpayers.
The classification of the LLC as a corporation by the CRA has a number consequences for Canadian taxpayers who are members of an LLC. First, if Canadian residents control the LLC, the CRA is likely to treat this entity as a Canadian resident corporation. The common law rules dictate that the residence of the “controlling mind” of a corporation, in this case the Canadian taxpayers who are LLC members, determines the residence of the corporation. If the LLC has elected to be treated as either a disregarded entity or a partnership under the United States tax laws, there is a mismatch in its classification under the Canadian and United States tax laws.
The mismatch in the classification of LLC under the Canadian and United States tax laws leads to double taxation. The LLC has to report its income to the United States Internal Revenue Service (IRS). As a disregarded entity or partnership the IRS taxes the LLC income in the hands of the entity’s members, subject to individual personal tax rates. The LLC, as a Canadian resident Corporation, also has an obligation to report its income to the CRA, and is therefore subject to the Canadian corporate tax rates. The same income is therefore taxed twice. There is no remedy to this double taxation.
The Canada-US Tax Convention tiebreaker rules cannot be applied to remedy the double taxation. The tiebreaker rules of the Convention are set out in Article IV(1), and apply when an entity is subject to tax in both Canada and United States. As a disregarded entity or partnership, the LCC is only subject to the taxation in Canada, and therefore the tiebreaker rules are not triggered.
It is important to note that not only is the same income taxed twice, but also the tax credits that would otherwise be available to the shareholders of a foreign corporation are unavailable to LLC members. The same income is taxed once more when the LLC distributes the income to its Canadian resident members. Because the CRA treats the LLC as a corporation, its income is taxed once at the corporation level, and once dividend are distributed, the income is taxed once more at the hands of the shareholders, in this case, the LLC members. As the LLC is likely deemed a Canadian resident corporation, the LLC member cannot apply the Foreign Dividend Tax Credit to count for the tax already paid to the IRS. As a result, the income is taxed once more at the hands of the Canadian taxpayer who is the LLC member.
Tax Tips from a Canadian Tax Lawyer For Limited Liability Corporation
As a general rule, using LLC as an investment vehicle is not only tax-inefficient, but a burdensome choice for Canadian taxpayers. There are exceptions to this rule. Given the newly reduced Federal tax rates in the United States, there are circumstances where using an LLC offers Canadians an optimal choice in arranging their affairs. The suitability of the LLC depends on a particular taxpayer’s individual circumstances. Speak to one of our experienced Toronto Tax Lawyers about your tax planning options when investing in real estate or other assets in United States. Planning a tax-efficient structure has the potential to significantly reduce your tax burden and in turn free up more capital for investment and business purposes.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."