20 May 1997 Internal T.I. 9713120 - LLC - STATUS FOR CANADA-U.S. INCOME TAX TREATY

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

UNITED STATES LIMITED LIABILITY COMPANIES

Tax Convention Status

Based on legal advice the better view is that generally an entity formed under limited liability laws of a State of the United States (the U.S.) is a corporation for the purpose of Canadian laws including the Income Tax Act (the Act).

On the other hand a limited liability company (LLC) is usually treated as a partnership for the purposes of the Internal Revenue Code (the Code). It is interesting to note that the U.S., in order to eliminate the considerable administrative burden involved in determining whether any entity such as a LLC should be considered a partnership for the purpose of the Code, is proposing to amend the Code effective January 1, 1997 so that U.S. entities not created under U.S. corporate law will be taxed under the Code as partnerships unless they elect to be taxed as corporations.

As you are aware a LLC, as it is not liable to tax in the U.S., cannot be a resident of the U.S. for the purposes of the Canada-U.S. Income Tax Convention (the Convention) even where all the members of the LLC are residents of U.S. for the purposes of the Convention. As a result, the LLC is not entitled to the benefits of the Convention and income of the LLC sourced to Canada is taxed in Canada at the rate of tax provided in the Act. With respect to associations that are partnerships it is our current practice, based on our understanding of the intent of the contracting states and the fact that the partners are the beneficial owners of the income, to look through a partnership and to allow a partner who is resident in the U.S. for the purposes of the Convention to claim the benefits of the Convention on his share of the partnership's income. Whether the members of a LLC should be treated in the same manner is under study by the U.S. and Canada. However, until the study is completed and recommends looking through a LLC, there is no basis on which we can extend the benefits of the Convention to a LLC or its members on the Canadian source income of a LLC.

We have been asked to reconcile our LLC position with our position that treats a Subchapter "S" Corporation (S Corp.) under the Code as a resident of the U.S. for the purposes of the Convention. The Department makes the reconciliation on the basis that a S Corp. is "liable to tax" in the U.S. for the purposes of the "Residence" article of the Convention while an LLC is not so liable. An S Corp. is a U.S. domestic corporation whose shareholders must be U.S. citizens or residents or trusts the beneficiaries of which are U.S. citizens or residents and whose shareholders have elected that they be taxed under the Code as if the S Corp. were a partnership. As a U.S. domestic corporation, an S Corp. that does not elect would be taxed in the U.S. on its worldwide income. Furthermore, notwithstanding the election, an S Corp. will be subject to tax in the U.S. on its worldwide income if certain conditions are not met. It may also otherwise be subject to tax in the U.S. on certain types of income.

For these reasons we feel the S Corp. is distinguishable from the LLC and we can treat a S corp. as resident of the U.S. for the purpose of the Convention. In addition, because the shareholders of a S Corp. must be U.S. citizens or residents who are taxed in the U.S. on world income there is significantly less potential for the entity to be used for tax avoidance. If an S Corp. that elected carried on business in Canada and did not have a permanent establishment in Canada, Canada would not be entitled under the Convention to tax the business income. However, the U.S. would tax such income in the hands of the shareholders of the S. Corp. On the other hand, if a resident of Canada is a member of a LLC, the U.S. would not tax the Canadian resident member on Canadian source income. If an LLC was granted the benefits of the Convention it would be possible for Canadian resident members to avoid both U.S. and Canadian tax on income from a business carried in Canada by the LLC if the LLC did not have a permanent establishment in Canada.

To summarize, an LLC is not a resident of the U.S. for the purposes of the Convention and there may be some question that a S Corp. is. If we saw a need to be consistent in our treatment of both, neither should be treated as resident of the U.S. for the purposes of the Convention.

Foreign Affiliate of a Corporation Resident in Canada

Resident in a Designated Country

Provided the mind, management and control of an LLC is outside Canada, the LLC would be considered a foreign affiliate of a corporation resident in Canada if that corporation is a member of the LLC and its membership interest is not less than 10% of all the membership interests. Prior to the publishing of the proposed amendments to subsection 5907(11) of the Regulations (the proposed amendments), if the LLC was carrying on an active business in a listed country, and its mind, management and control was in that or another listed country, the earnings of the active business would have been included in the computation of the LLC's exempt surplus with respect to the corporation resident in Canada.

The purpose of the proposed amendments was to ensure that only foreign affiliates resident in a country now referred to as a designated treaty country) with which Canada has an income tax convention in force would benefit from the exempt surplus rules. It was felt that even though a corporation may be a resident of a country by virtue of the mind, management and control test, the foreign affiliate should have sufficient nexus with the country in which it was claiming to be resident so that it would be considered resident of that country for the purpose of the income tax convention that Canada had with that country. Residence for the purposes of the Convention means that, generally, the foreign affiliate must be taxable on its worldwide income in that country.

Thus under the proposed amendments a foreign affiliate has to be a resident of a country under the common law test and a resident of that country for the purposes of the income tax convention Canada has in force with that country.

An LLC is not considered to be resident of the U.S. for the purpose of the Convention. In the absence of paragraph 5907(11.2)(b), the Canadian members of an LLC, whose members were subject to tax under the Code on the income of the LLC, would no longer be able to take advantage of exempt surplus rules. Thus an exception was made under proposed paragraph 5907(11.2)(b) of the Regulations as follows:

A foreign affiliate shall be deemed not to be resident in a country with which Canada has a treaty unless "the affiliate would, at that time, be resident of that country for the purposes of the agreement or convention if the affiliate were treated for the purposes of income taxation in that country, as a body corporate,"

This paragraph is too broad. It only achieves the desired result for a LLC whose members are subject to tax under the Code on the income of the LLC. However, if the LLC were treated as a body corporate for the purposes of taxation in the U.S. it would be a domestic corporation that is taxed under the Internal Revenue Code taxes on its worldwide income. If the mind and management of the LLC is in the U.S., the LLC would be considered resident of the U.S., a designated country, for the purpose of the exempt surplus rules. If the LLC is so resident income that is not taxed by the U.S. in the hands of the members of the LLC would form part of the exempt surplus of the LLC. Such a result would be contrary to the purpose of paragraph 5907(11.2)(b) to provide a residency test for a foreign affiliate based on its liability for tax on its total income in the country of residency. An example of this interpretation of the residency test in subsection 5907(11.2) of the Regulations is as follows:

Canco, a corporation resident in Canada, owns two wholly owned foreign affiliates not resident in the U.S. (the tax haven affiliates). These are the members of a LLC that was formed under the laws of one of the United States.

The only activity of the LLC in the U.S. consists of the holding of the annual meeting of the board of directors of the LLC. It is assumed that this would make the LLC resident in the U.S. under common law.

The LLC is financed by contributions from its members. It loans the funds it receives to another foreign affiliate of Canco to which it and Canco are related. The borrower uses the funds in its active business. The borrowing foreign affiliate is not resident in the U.S.

The LLC receives interest income. The Code treats the LLC as a partnership. However, because the interest income it is not sourced to the U.S. it is not taxed under the Code in the hands of the tax haven affiliates.

By virtue of subparagraph 95(2)(a)(ii) of the Act the interest income of the LLC is deemed to be active business income.

If the tax haven affiliates had received the interest income directly, such income would have been included in the taxable surplus of the those affiliates.

Prior to the amendments to subsection 5907(11.2) the tax haven affiliates would have attempted to convert such taxable surplus to exempt surplus by having their annual board of directors meetings in the U.S. As foreign corporations they would not have been subject to tax in the U.S.

If the LLC is considered to be resident in the U.S. under subsection 5907(11.2) for the purposes of the exempt surplus rules, the interest income becomes exempt surplus of the LLC and will retain its identity as exempt surplus when it is paid as a dividend to the tax haven affiliates.

This scheme works only if the LLC is resident in the U.S. under the common law principles. The LLC may not have established residency in the U.S. where the only connection with the U.S. is that the U.S. is the country under whose laws it was formed and the location of the annual meeting of the board of directors. It is possible that the mind, management and control of the LLC resides elsewhere and perhaps in Canada. If the LLC is not otherwise resident of the U.S. under the common law test, paragraph 5907(11.2)(b) of the Regulations does not apply to treat the LLC as a resident of a designated treaty country.

Also where it is reasonable to consider that the member acquired his interest in the LLC to permit the member to avoid, reduce, defer payment of tax or any other amount that would otherwise be payable under the Act (for example by converting taxable surplus to exempt surplus.) subsection 95(6) will apply and the LLC will not be a foreign affiliate. Dividends received from the LLC by a foreign affiliate of a corporation resident in Canada would be FAPI or if received by the Canadian corporation, would be included in income with no deduction under subsection 113(1) of the Act.

As a matter of interest the U.S. Treasury is considering a proposal to curb the use of LLCs by Canadian investors. This proposal involves substituting of Canada's tax principles, for U.S. tax principles to determine who for the purposes of the Convention is the "beneficial owner" of dividends, interest or royalties paid by a resident of the U.S. to a resident of a U.S. treaty country. If a country such as Canada treats an LLC as a corporation and the "beneficial owner" of such payments, the U.S. proposes to follow that treatment. This means even though the U.S. considers the LLC to be partnership it would no longer follow its policy to look through the LLC and treat the Canadian members of the LLC as the "beneficial owner" of such payments for the purpose of the Convention. Therefore, Canadian members of LLCs would not receive the benefits of the Convention with respect to such payments. U.S. Treasury defends such a result by arguing that it would be inappropriate to provide the benefits of the Convention when the income is not being taxed in Canada, because the LLC is treated under Canadian law as a foreign affiliate of Canadian resident corporation. Canadian taxpayers object to the proposal on the grounds that it incorrectly denies the benefits of the Convention to members (partners for U.S. tax purposes) of an LLC who are bona fide residents of Canada and it violates the non-discrimination clause in paragraph 2 of Article 25 of the Convention.

If Canadian taxpayers do not win their argument against the IRS, where dividend, interest and royalty income of an LLC arises in the U.S. Canadian taxpayers will likely rearrange existing corporate structures. They will avoid the use U.S. LLCs in the future. Canada's problems with LLCs with U.S. source income may simply become problems with similar entities found in other jurisdictions. In any case, it should be noted that U.S. LLCs may still be used for non-U.S. source income in schemes similar to the one in the example illustrating the residency test in subsection 5907(11.2) of the Regulations. Foreign Tax Credits and Subsection 20(12)

Where a LLC is treated as a partnership under the Code, the members of the LLC are liable for U.S. income tax on their share of the LLC's profits, whether distributed to the members or not. Where such a member is a Canadian resident corporation (Canco), the U.S. income tax paid will qualify as an "income or profits tax" and, subject to the other requirements of the definition in subsection 126(7) of the Act, qualify as a "non-business-income tax" ("NBIT"). The income to be reported for Canadian tax purposes by a Canadian resident corporate shareholder of the LLC (in respect of its investment in the LLC) are the distributions by the LLC which will be taxed as dividends.

The dividends paid by the LLC will most likely be dividends out of exempt surplus of a foreign affiliate of the recipient and deductible in computing taxable income of a Canadian resident corporate shareholder by virtue of paragraph 113(1)(a) of the Act.

Foreign withholding tax paid by a corporation on dividends or distributions treated as dividends from a share of a foreign affiliate is excluded from subsections 20(12) and 126(1) of the Act, and an exemption (rather than a credit) is provided under the foreign affiliate regime to mitigate the effect of double taxation on income from such shares.

We are concerned that Canco may argue that any NBIT paid by it on profits earned by the LLC is in relation to the income of the LLC and therefore may not reasonably be regarded as having been paid by Canco in respect of income from the share of the capital stock of a foreign affiliate of Canco. Canco could then claim this NBIT to reduce Canadian tax under subsection 126(1) of the Act on other U.S. source income. If Canco does not use the NBIT as a foreign tax credit, Canco may argue that subsection 20(12) of the Act allows it to deduct the NBIT in computing a loss from property which is its shares in the LLC. Canco may argue that subsection 20(12) of the Act allows for such a deduction and that such deduction does not make the NBIT a tax paid which may reasonably be regarded as having been paid in respect of income from the share of the capital stock of a foreign affiliate of Canco.

The following example illustrates the inappropriateness of allowing the NBIT paid by Canco on its share of the income from a U.S. LLC as a tax credit pursuant to subsection 126(1) of the Act or as deduction from income under subsection 20(12)of the Act.

-Assume Canco has $1,000 Canadian source income and $100 U.S. source interest income on which it has paid $10 U.S. tax.

-Canco pays Canadian tax at a rate of 50%.

-Canco has a Dec 31 year end.

-Canco has a 50% interest in a U.S. LLC.

-The LLC has $200 income from carrying on an active business and Canco's U.S. tax on its share of that income is $40.

-LLC's year end is Oct. 31 and LLC pays a dividend to Canco on Nov. 30 of $100.

Computation of Canco's Canadian Tax
Canadian source income $1000

U.S. source income Interest $ 100
LLC Dividend 100
200
Net income 1200
Deduct dividend from exempt surplus of LLC 100
Taxable Income $1100
Tax otherwise payable 50% $ 550
U.S. Tax paid ($10 + $40) $50
Canadian tax paid on U.S. source income
of $100 ($200 - $100 ((clause 126(1)(b)(i)(D))) $50 Foreign tax credit 50
Canadian taxes paid $500

There was no income from the LLC included in taxable income for Canadian tax purposes. The result is that the U.S. tax paid with respect to the income earned in the LLC reduces Canadian taxes on other U.S. source income from $40 to nil.

If the LLC had been a U.S. domestic corporation it would have paid the U.S. taxes of $40, leaving $60 to be paid to Canco in the form of a dividend. There would be U.S. withholding tax of $6 (10% rate assumed). The dividend would not be included in taxable income of Canco and under subsection 126(1) of the Act there would be no foreign tax credit for the $6 tax paid to the U.S. by Canco. The $40 of taxes paid by the foreign affiliate do not qualify as non-business-income tax of Canco for foreign tax credit purposes. Canadian taxes paid would have been $540. In other words with respect to dividends received out of exempt surplus of a foreign affiliate the Act provides for an exemption system, rather than a credit system, to eliminate double tax. To allow the credit as set out above allows a combination of exemptions and credits and, as illustrated above, unduly reduces Canadian tax on the U.S. interest income by $40.

Assume the same facts as described in the above example but without U.S. interest income. If subsection 20(12) of the Act applies, the $40 paid in respect of the LLC income could be deducted from income and reduce the Canadian taxes paid to $480. As subsection 20(12) of the Act is a part of the tax credit system the result of the application of both the exemption system and the credit system is an undue reduction of $20 in Canadian taxes on Canadian source income.

In our opinion, any NBIT paid by Canco on the profits of the LLC may reasonably be regarded as having been paid by Canco in respect of income from the share of the capital stock of a foreign affiliate of Canco for the purposes of subsection 126(1) and 20(12) of the Act. As the subsection 20(12) of the Act deduction can only be made in computing income from property, in this case the share in the LLC, it is arguable that the NBIT can reasonably be regarded as having been paid in respect of income from the share of the capital stock of a foreign affiliate of Canco. This argument does not seem to be available to deny the deduction of the NBIT under subsection 126(1) of the Act. However, if Canco had chosen to invest in a U.S. corporation other than a LLC it would not have had a NBIT. In such cases the foreign taxes paid by the affiliate on active business income are not taken into account in computing Canco's Canadian income tax and any foreign taxes paid on dividends received from such affiliates can not be used to obtain a foreign tax credit or a subsection 20(12) of the Act deduction. There is no tax policy reason why investing in a LLC in these circumstances should result in a tax advantage to Canco as compared to an investment in a U.S. domestic Corporation. Exemption from Canadian tax on the income from such an investment should be sufficient in each case.

Our position is that the tax paid to the U.S. by a Canadian resident corporation of which the LLC is a foreign affiliate is NBIT paid in respect of income from a share of the capital stock of a foreign affiliate of the corporation and can not be used for the purpose of obtaining a tax credit under subsection 126(1) of the Act or a deduction from income under subsection 20(12) of the Act. This position also applies if the income pays the tax to the U.S. there is no foreign accrual tax to be deducted from the FAPI. The result, which may be considered anomalous, is that the Canadian resident corporation gets no credit for foreign taxes paid and is taxed on the full amount of FAPI. While FAPI is the income of the LLC, it is considered to be income from the share of a foreign affiliate for the Canadian resident corporation and there appears to be a stronger argument that the U.S. tax paid by Canadian corporate member of the LLC is in respect of that FAPI income. In fact, if the tax had been paid by the affiliate, it would have been foreign accrual tax because it would have been reasonable to consider that it was applicable to the amount included in FAPI. In addition it should be remembered that a LLC is generally used for tax planning purposes and it would be unusual for an LLC to have FAPI.

Even if a LLC was a resident of the U.S. for the purposes of the Convention, the above position would not result in taxation that is contrary to the Convention. As set out in subparagraph 2(b) of Article XXIV of the Convention the Canadian resident corporation is allowed to deduct in computing its taxable income any dividend received by it out the exempt surplus of a LLC of which it is a member. Furthermore, as the income of the LLC does not represent U.S source income of the Canadian resident corporation, Canada does not have to provide a tax credit under subparagraph 2(a) of Article XXIV of the Convention for the taxes paid to the U.S. by such corporation on the income of the LLC.

These issues continue to develop. Recently we have been asked to consider, if an LLC had FAPI and the resulting taxable surplus was distributed so that section 113 of the Act applied, could the U.S. tax that was paid by the Canadian resident shareholder on the FAPI of the LLC be considered to be a tax paid for the purpose of a deduction under paragraph 113(1)(c) of the Act. While the argument may have some merit, we have not had time to fully consider it and have not taken a position to date.