Canadians
Investing in Limited Liability Companies
A limited liability company (LLC) is a popular investment
vehicle for carrying on business in the United States and
making a joint investment with other investors. An LLC provides
its members with liability protection and avoids some of
the limitations found in other US investment vehicles. For
example, an LLC avoids the necessity of identifying a general
partner for a limited partnership, the ownership limitations
that apply to an S corporation (e.g., a regular US corporation
that elects to be treated as flow-through entity for US tax
purposes), and the double-tax inefficiencies that can arise
in a C corporation (e.g., a regular US corporation). For
these reasons, Canadian corporations and individuals will
often find themselves presented with opportunities to invest
in a US business through an LLC. However, before making such
an important decision, Canadian investors need to be aware
of the potential tax issues and pitfalls that can result
from such investments.
Classification of a Limited Liability Company
The
tax issues with respect to an LLC arise from the divergent
treatment of an LLC under US tax law and Canadian tax law.
For US tax purposes, an LLC is generally treated as a flow-through
entity. An LLC with a single member is disregarded altogether,
whereas an LLC with more than one member is treated as a
partnership1. As a result, where the LLC is treated as a
flow-through
entity, the LLC’s members are required to include the
LLC’s income, gain, loss and expense in computing their
taxable income for US tax purposes. Thus, the LLC members
are subject to any US tax on their allocable share of the
LLC’s income, rather than the LLC being taxed itself.
For Canadian tax purposes, an LLC is treated as a corporation.
This hybrid tax treatment of an LLC can be problematic for
a Canadian member of an LLC because the Canadian member may
subject itself to double-taxation in certain situations and
on certain types of income allocated from the LLC. In such
cases, without proper tax planning, the Canadian investor
can suffer an extremely high effective tax rate on income
earned through an LLC.
Denial of Treaty Benefits
Residents
of Canada and the United States may rely on the Canada-US
tax treaty to avoid double tax on certain types
of income. The treaty allows a resident to avoid double taxation
by determining which taxing jurisdiction has the right to
tax that income. A company is only considered resident for
treaty purposes if it is subject to taxation on its worldwide
income. The use of LLCs is problematic in that Canada does
not view an LLC as being a resident for treaty purposes because
the LLC is not subject to US taxation on its income. Instead,
the LLC’s members are subject to US taxation on the
LLC’s income. As a consequence, Canada does not grant
treaty benefits to an LLC.
Under
Canadian tax law, if an LLC is a resident of Canada under
common law, the LLC is subject to Canadian tax on its
worldwide income. An LLC is a common-law resident of Canada
if it is managed and controlled in Canada (e.g., through
its Canadian members). Since the LLC’s members, including
its Canadian members, would also be subject to US taxation
on the LLC’s income, the Canadian tax imposed on the
LLC would result in a second level of taxation. The treaty,
which would normally limit worldwide taxation of a company’s
income to the jurisdiction under which the company is incorporated
or established, would not protect the LLC from Canadian taxation
on its worldwide income since Canada does not grant treaty
benefits to the LLC.2
Investment Income Earned through an LLC
A Canadian member of an LLC that earns US-source investment
income, such as interest income, may also be subject to
double tax on that income. Under Canadian tax law, Canadian
shareholders of certain non-resident corporations that
earn certain investment income are required to include
their share of the non-resident corporation’s investment
income in their Canadian taxable incomes in the year that
the non-resident corporation earns the income. The rules
effectively prevent Canadian shareholders from deferring
Canadian taxation on investment income earned through a
non-resident corporation.
However,
where the non-resident corporation has paid foreign tax
on its investment income, the Canadian shareholders can
claim a grossed-up deduction for their share of the foreign
tax. This grossed-up deduction allows the Canadian shareholders
to avoid any additional Canadian tax on the investment income
where the foreign tax paid on the investment income is no
less than the Canadian tax that would otherwise be payable
on that income. A Canadian member that earns investment income
through an LLC cannot claim the grossed-up deduction due
the hybrid nature of an LLC. While the LLC is considered
to be a non-resident corporation for Canadian tax purposes,
it will not be considered to have paid foreign (e.g., US)
tax on its income since the LLC members would be subject
to tax on the LLC’s income. As a result, the Canadian
shareholders will not have any relief from Canadian tax.
A Canadian
resident will also be at a disadvantage by earning US source
investment income through an LLC as opposed to
earning the income directly. Investment income earned directly
by a Canadian resident is ordinarily subject to US withholding
tax, which may be reduced or eliminated under the treaty.
However, a Canadian member of an LLC is ineligible for otherwise
treaty-reduced US withholding tax rates on its share of the
LLC’s income. Under US tax law, a member of an LLC
must be considered to derive its share of income earned by
the LLC. A member is considered to derive its share of an
LLC’s income where the LLC is treated as a flow-through
entity under the laws of the member’s country. Since
an LLC is not considered to be a flow-through entity under
Canadian tax law (because the LLC is treated as a non-resident
corporation), a Canadian member will not be treated as deriving
its share of the LLC’s income. As a consequence, the
US withholding tax rate on the Canadian member’s share
of the LLC’s income will not be reduced under the treaty
from the US statutory rate of thirty percent.
Summary
Due to these and other issues and pitfalls that can arise
with an LLC, a Canadian corporation or individual thinking
about investing in an LLC should consult with a tax advisor
before making the investment.
1 Although not discussed here, an LLC may also be eligible
to elect
to be treated as a regular
US corporation for US tax purposes.
2 US investors will also want to avoid owning Canadian investments through an
LLC since Canada denies treaty benefits to the LLC. For example, an LLC which
receives
Canadian-source dividends and interest income, or earns income through a Canadian
branch, will not be eligible for treaty-reduced Canadian withholding tax and
Canadian branch profits tax rates.
Disclaimer
|
"The
information contained herein is of a general nature and
is not intended to address the circumstances of any particular individual
or entity. Although we endeavor to provide accurate and
timely information, there can be no guarantee that such information
is accurate as of the date it is received or that it
will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough
examination
of the particular situation.
KPMG and the KPMG logo are registered trademarks of KPMG
International, a Swiss cooperative.
© 2006 KPMG LLP, the
Canadian member firm of KPMG International,
a Swiss cooperative. All rights
reserved."
|
|
|
