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Canadian individuals who choose to utilize US Limited Liability Companies (LLCs) for earning rental income or conducting business in the United States encounter a host of challenges due to the distinct tax treatment by the Canada Revenue Agency (CRA).
Despite the possibility of making a check-the-box election to designate the LLC as a flow-through entity for US tax purposes, the CRA categorically treats such entities as corporations, undermining the flow-through benefits. This dichotomy in tax treatment gives rise to significant complications, one of the foremost being the issue of double taxation.
The LLC generates income and both the US and Canada tax it separately at different intervals. Potentially exposing Canadian taxpayers to taxation on the same income in both jurisdictions.
Moreover, the Canadian tax system exacerbates the situation by denying the application of foreign tax credits for taxes paid in the US. This means that even if a Canadian taxpayer pays taxes on the income generated through the US LLC to the Internal Revenue Service, the CRA does not recognize these payments as eligible for offsetting Canadian tax liabilities.
Consequently, Canadians utilizing US LLCs may find themselves in a challenging position where they are unable to fully mitigate the tax impact of their cross-border activities, leading to potential financial strain and a complex compliance burden.
Individuals often seek professional advice to optimize their tax strategies and minimize the adverse consequences of the disparate tax treatment between the two countries. In navigating these intricacies, they are often compelled to take proactive steps.
The Canadian Tax World
In Canada, the tax system operates on a residency-based principle. Meaning that residents are subject to Canadian taxation on their worldwide income. Non-residents, on the other hand, are typically subject to tax only on income derived from Canadian sources. This fundamental difference sets the stage for potential conflicts when US LLCs enter the picture.
Canadians who use US LLCs to earn rental income or carry on business in the US face many issues. The CRA treats them as corporations and not as flow-through entities even if they make a check-the-box election.
This creates several problems including double taxation since income is taxed in the US and Canada at different times. In addition, the CRA will not allow foreign tax credits for the US taxes paid.
Double Taxation
The US LLC is a popular vehicle for investing in the United States, particularly US real estate. However, there are potentially significant tax consequences for Canadians using US LLCs that invest in Canada.
The issue arises because the CRA treats LLCs as corporations, despite being considered disregarded entities or partnerships for US tax purposes.
Consequently, the Canadian member does not report the profits of a US LLC in their individual income tax return. Unlike if they owned it directly. In addition, the CRA does not allow members to claim foreign tax credits for taxes paid on LLC profits.
This divergence in the treatment of the same business entity prevents Canadians from benefiting from the flow-through treatment of the LLC and may lead to double taxation unless steps are taken to avoid it. As a result, investors in US LLCs need to obtain expert cross-border tax advice.
Treaty Shopping
Hybrid entities, taxed as a corporation in one country and as a partnership in another, are susceptible to conflicting treatment between the two jurisdictions.
For example, a US LLC that distributes dividends to its non-resident Canadian members would trigger a 25 percent withholding tax on the amount distributed. The Treaty cannot exclude this taxation because the CRA deems an LLC to be a corporation for Canadian income tax purposes.
This result is the result of a practice called “treaty shopping.” This involves attempting to access benefits that a tax treaty provides through a strategy that exploits mismatches in the way an entity is classified under both domestic and international law. This type of planning undermines the integrity of tax treaties and deprives jurisdictions of tax revenue.
Other parts of the world have successfully combated treaty shopping by interpreting treaty wording in a manner consistent with its designed purpose, rather than by reference to domestic law.
They have achieved this success by actively interpreting treaty wording in line with its intended purpose.
The approach to combating treaty shopping involves interpreting treaty language actively, rather than relying on reference to domestic law.
Successful efforts in other regions have centred around interpreting treaty wording actively to align with its intended purpose.
Foreign Reporting Requirements
When a US LLC is taxed as a flow-through entity, its earned income is passed through to its owners. This can cause serious Canadian tax problems for Canadians who invest in US businesses or real estate.
In Canada, however, an LLC is taxable as a corporation. The CRA’s long-standing position is that a US LLC is not fiscally transparent in Canada and that a foreign branch profits tax of 25% applies (with an exemption for the first CAD 500,000).
Since an LLC cannot claim treaty benefits in this situation. It can result in a significant amount of Canadian tax on Canadian-source earnings. In addition, withholding taxes can apply in this circumstance. Consequently, careful planning is necessary to ensure that the direct member, rather than a non-resident Canadian shareholder, pays the LLC’s US tax liability. Opting for a US limited partnership (LP) is a better structure for investments in US business or real estate. As it is not taxed on a flow-through basis.