Can a partnership be a corporation? Can a corporation exist without shares? Can an entity be a partnership for one investor and a corporation for another investor? These are the type of questions that taxpayers need to address when investing outside of Canada because the Canadian income tax classification of a foreign entity can dramatically alter the cross-border tax rate and return on investment.
Classifying a foreign entity is a challenging enough exercise by itself, but the constant changes in Canada and abroad makes the analysis even more daunting. The recent U.S. election is a prime example of this phenomenon; predictions in the U.S. indicate that corporate tax rates could fall from 35% to 15% and personal tax rates could fall from 39% to 33%. Tax rate reductions of this magnitude, combined with new Canadian Revenue Agency (CRA) positions on the classification of U.S. entities could significantly change the effective tax rate of a U.S. investment.
The primary reason that foreign entity classification can be so complicated is that the foreign legislation governing foreign corporations, partnerships, joint ventures and more exotic entities is often very different from comparable Canadian legislation. A foreign entity may be referred to as a “partnership” in its country of origin but it may not necessarily be regarded as a “partnership” for Canadian tax purposes. Adding to the confusion is the fact that an entity may be treated differently by the tax authorities in the two countries, resulting in hybrid status. Over the years, the Canadian courts and the CRA have provided a number of guidelines to assist with entity classification. The CRA periodically reviews these guidelines and in recent months have announced a number of changes which affect many popular investment structures. This article discusses some of these rulings and provides guidance as to how the rulings could impact foreign investments.
One of the CRA's more controversial rulings in 2016 was the announcement that it had changed its position on the status of U.S. limited liability partnerships (LLPs) and U.S. limited liability limited partnerships (LLLPs).
Prior to 2015, the CRA had generally regarded U.S. LLPs and LLLPs as partnerships. In 2015, the CRA indicated that it was reviewing its classification of these entities and at the May 2016 International Fiscal Association Tax Conference the CRA announced that it now regards these entities as corporations for Canadian income tax purposes. The CRA indicated that their analysis focused primarily on the following attributes:
- the extent of the liability protection offered by the entity
- whether elements of legal personality exist
- whether state law permits conversion of the entity to a corporation without a change in ownership of assets
There are a number of tax implications for Canadian investors as a result of this ruling including the potential for double taxation and problems with the utilization of foreign tax credits, timing differences in the reporting of income, errors in the computation of surplus, concerns about treaty eligibility and the potential loss of paid-up capital. These issues are exacerbated by the U.S. election results and the potential changes to U.S. corporate and personal income tax rates, both of which may be dramatically reduced and could become lower than comparable Canadian rates for the first time in many years.
To address some of these concerns, the CRA has indicated that it will provide partial administrative relief for LLPs and LLLPs formed before July 2016. The CRA has indicated that it will continue to regard these LLPs and LLLPs as partnerships provided certain conditions are met, including conversion to an entity type the CRA recognizes as a partnership, by no later than 2018.
The CRA's administrative position is not legally binding and Canadian courts may not agree with the CRA. However, any Canadian investor with a direct or indirect investment in a U.S. LLP or LLLP should discuss the tax implications of the CRA's new policy, as well as the impact of potential changes in U.S. tax rates, with a qualified tax advisor. In particular, Canadian investors should consider whether they may be able to convert the LLP or LLLP to an entity that the CRA recognizes as a partnership.
Partnership vs. corporation
Another common U.S. investment vehicle that can cause headaches for Canadian investors are U.S. limited liability companies (LLCs). LLCs generally have the ability to be taxed as either corporations or partnerships/disregarded entities for U.S. tax purposes. The U.S. tax treatment of LLCs, combined with the CRA's position on LLCs (discussed below), can sometimes result in cross-border effective tax rates of 60% to 70% if the wrong structure is implemented.
The CRA's long standing administrative position is that most U.S. LLCs are corporations rather than partnerships, regardless of the U.S. tax treatment of the LLC. However, there was some speculation that the CRA might change its position following the outcome of a recent U.K. court decision. On July 1, 2015 the Supreme Court of England and Wales announced its long awaited judgement in Anson v. HMRC. The taxpayer, Mr. Anson, was resident (but not domiciled) in the U.K. for U.K. tax purposes and subject to U.K. income tax on foreign income remitted to the U.K. Mr. Anson had invested in a Delaware LLC which was classified as a partnership for U.S. tax purposes and, as a result, Mr. Anson was liable for U.S. taxes on his share of the LLC profits.
The Supreme Court ruled in Mr. Anson's favour, finding that Mr. Anson was entitled to the share of the profits allocated to him by the LLC, rather than receiving a transfer of profits ‘previously vested in the LLC'. In effect, the court implicitly found that the LLC was more akin to a partnership than a corporation for U.K. tax purposes.
Canadian taxpayers who may have been hoping that the CRA would change their classification of LLCs based on the Anson decision were disappointed. In November 2015 at a CRA Roundtable the CRA stated that the Anson decision has not changed their position with respect to LLCs and that they will continue to treat most LLCs as corporations for Canadian income tax purposes.
Canadians who have invested in a U.S. LLC should carefully review their investment structure with a tax advisor to determine the impact of potential changes in U.S. tax rates and to ensure that they have the optimal cross-border structure. In some cases it may be prudent to use a Canadian holding company, a U.S. holding company, or a combination of both a Canadian holding company and a U.S. holding company to invest in an LLC.
Surplus computation
The CRA introduced even more confusion for LLC investors last year by changing the surplus computation rules for disregarded LLCs1. The CRA's new position is that most disregarded LLCs must apply Canadian tax rules to compute surplus, instead of using U.S. tax rules, for taxation years ending after August 19, 2011. Further, the CRA stated that they will now treat deductions previously claimed using U.S. tax rules as if they had been claimed using Canadian tax rules.
Amongst other concerns, the administrative change could result in surplus differences if Canadian tax principles result in larger deductions than U.S. tax principles; in this scenario, it's possible that previously paid dividends may have exceeded the re-computed surplus pools. In addition, Canadian tax laws may trigger the early recognition of income by the LLC, which could result in future U.S. tax payments being ignored for surplus purposes.
One of the more peculiar aspects of the CRA's new position is that it suggests that disregarded U.S. LLCs are more akin to a “branch” of the Canadian corporate investor, as opposed to a foreign corporation. This logic seems inconsistent with the CRA's treatment of LLCs as corporations for Canadian tax purposes, as discussed above.
Canadians who have invested in a disregarded LLC through a Canadian corporation should discuss the surplus implications of the CRA's new policy with their tax advisor. In many cases it may be necessary to re-compute the surplus in the LLC.
Cooperatives (“co-ops”) are commonly used investment vehicles in the Netherlands due to their legal and tax flexibility. Cooperatives have the ability to provide limited liability protection without actually issuing shares, investors in the co-op are usually referred to as “members” and the co-op is generally viewed as an extension of its “members.” These features can be challenging from a Canadian tax perspective in terms of classifying a co-op as a corporation, a partnership or something else.
The CRA has issued a limited number of rulings on Dutch co-ops over the last decade. In 2015 the CRA was asked to provide its interpretation of the status of another Dutch co-op and this ruling was released in 20162. Consistent with most previous rulings, the CRA concluded that the provisions of the foreign legislation and the articles creating the co-op supported the conclusion that the entity should be treated as a corporation for Canadian income tax purposes. In addition, the CRA confirmed that certain conditions required for a tax-deferred rollover in paragraph 95(2)(c) of the Income Tax Act were satisfied, potentially facilitating a tax-deferred corporate reorganization.
Canadian corporations with an investment in a Dutch co-op can take some comfort in the knowledge that many of these entities will be treated as corporations for Canadian income tax purposes and that certain tax-deferred rollover provisions may be available.
The question of “what makes a dividend a dividend?” was at the heart of a recent CRA ruling3 dealing with Canadian investment into Germany. German tax legislation can allow a German parent company to form an “Organschaft” with one or more of its German subsidiaries. The group of companies in the Organschaft elect to be treated as an integrated fiscal unit for tax purposes, allowing the companies to offset profits of one legal entity with losses of another entity. The Organschaft regime can also require compensatory payments to be made between companies within the group as compensation for the use of losses.
In 2016, the CRA was asked to opine on the treatment of a compensatory payment from a German subsidiary to its German parent to compensate the parent for the use of its losses. Upon reviewing the facts of the case, the CRA stated that the compensatory payment from the German subsidiary to its parent should generally be regarded as a dividend, provided that the payment was a pro-rata distribution to the parent. Further, the CRA indicated that the payment should not be regarded as foreign accrual property income to any direct or indirect Canadian parent of the German organization.
Investors should welcome the CRA's clarification of the treatment of compensatory payments within an Organschaft regime, particularly the clarification that payments generally should not be regarded as foreign accrual property income.
Closing thoughts
Tax administration is never static. Court cases, tax rulings and legislative changes in both Canada and in foreign countries can quickly change the tax consequences of foreign investments and investors should periodically review their foreign investments with a qualified tax advisor. In particular, any Canadian who has invested in the U.S. should review the impact of potential changes in U.S. tax rates resulting from the election, as well as the changes in the CRA's administrative positions with respect to U.S. partnerships.
1) CRA Roundtable at the 2016 CTF Annual Tax Conference
2) CRA Document #2015-0571441R3
3) CRA Document #2016-0642081C6
The information in this publication is current as of March 17, 2017.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.