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Investing in Foreign Businesses – A Canadian Perspective – Part 2
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International competitiveness is a rather ill-defined term since it could have a variety of meanings. It might mean how competitive a country might be as a place of location for investments and production compared to other jurisdictions. It could also imply how competitive a home-based multinational resident is relative to other multinationals operating at a worldwide scale. These concepts are not the same.
An important element in attempting to maintain Canada as a desirable country to attract foreign investment from is the efficiency of it’s tax structure. Efficiency implies that the tax system should distort economic decisions as minimally as possible so that individuals and businesses make choices based on economic gains that are not influenced by tax considerations.
To this end the Department of Finance strives to maintain a foreign affiliate tax regime that facilitates tax-efficiency. If a Canadian resident earns income abroad, Canada has a tax credit and deduction system that, in theory, offsets the foreign tax paid so that the ending tax obligation of that resident is consistent with Canadian personal tax rates. Perfect integration of course is not always realized, but the intention remains.
The foreign affiliate regime is designed to ensure Canadian companies are not at a disadvantage when expanding their active business abroad through foreign subsidiaries by permitting, in general terms, earnings of an active business of a "foreign affiliate" ("FA") to not suffer Canadian tax when earned, or when distributed as a dividend to its Canadian corporate (not individual) shareholder provided certain conditions are met. Further, it permits planning to reduce foreign tax applicable to active income by shifting income from one FA to an FA in a lower-tax jurisdiction.
Nature of Income to be Earned in the Foreign Jurisdiction
The nature of income from foreign activities, and the form in which it is earned, dictates its taxation. In general, income from property is not taxed as favourably as income from an active business, whether earned directly through a branch or partnership or indirectly through a CFA of a CCPC. Where foreign income is earned directly, the main question is whether the income constitutes income from an active business[1] ("ABI"), which excludes Aggregate Investment Income (“AII”). AII is defined to be, in part, income from a source that is property, which includes income from a "specified investment business" ("SIB") carried on in Canada. AII is subject to refundable surtax, increasing the tax payable until distribution to individual shareholders. Where foreign income is earned through a CFA, again, the question is whether it constitutes income from an active business ("FA ABI"), but such income is defined differently.
The FA ABI definition excludes income from an "investment business", which is similar but not identical to a SIB. Although similar in concept, AII under the CCPC rules differs from FAPI under the CFA regime; in short, the latter is broader than the former. For instance, the definition of SIB is narrower than
[1] Structuring Outbound Foreign Expansion for Owner Managed Businesses, Canadian Tax Foundation, Andrew Morreale, Andrew Somerville.
"investment business" under the CFA regime. Although both are defined to include, in part, a business the principal purpose of which is to earn income from property (unless the prescribed number of employees are actively engaged in the business), the domestic definition is restricted to such income from property, whereas the FAPI related definition is broader in two respects.
First, in the case of the "investment business" definition, the principal purpose of the business is not limited to earning business income in the form of income from property, but rather its principal purpose can be to earn income from other sources, including profits from the disposition of an "investment property" (which includes real property). Second, the SIB definition excludes income from a source outside Canada that is property. Business income earned by a CCPC that takes the form of income from property from carrying on business activities through a foreign branch (directly or through a partnership) should be treated as ABI under the CCPC rules (even if its income is from a source outside Canada that is property); but if business income in the form of income from property is earned by a CFA, it should constitute FAPI, which in turn should be included in AII (on the basis that such activity should be considered to be an investment business unless it has the requisite number of employees or equivalent employees).
Therefore, it is possible to be in a situation whereby the income earned by an FA is FAPI where, if earned by a CCPC in the domestic context it would be considered to be income from an active business.
Residency
A very common issue with respect to OMBs that expand abroad is maintaining the residency of the FAs in the country in which the FA is carrying on its activities. Residency must be considered under 1) the common law test for Canadian purposes, 2) the domestic law of the foreign jurisdiction, and 3) a relevant tax treaty, if any.
Under the common law test, a foreign incorporated company will be considered to be a tax resident of Canada where its central management and control is exercised in Canada.62 In very general terms, central management and control is considered to reside where strategic decisions are made, as distinct from day-to-day management decisions. The strategic decisions of a corporation are typically made by the board of directors and, therefore, central management and control of a corporation is generally considered to be where the directors reside and meet to make strategic decisions in respect of the business. It is often best practice for a majority of the board of directors to be residents of the country in which the FA conducts its business so that it is considered a resident there under the common law test.
Common Indicia of Residency
There is no bright-line test for establishing where central management and control of a corporation is exercised. All relevant facts and circumstances have to be considered over the entire time period of the corporation's existence such as:
1) Where do the majority of the directors reside? While not determinative, it will likely be factually easier to evidence central management and control in being exercised the country the directors live. Should the board have Canadian resident directors, they should
physically attend board meetings in the foreign country, and not remotely via phone or video conference.
2) Is there documentation to support board meetings? Board meetings should be documented, and during such meetings, the board of directors, should exercise its control and make decisions relating to the company's operations and general policies such as investment, financing and dividend payments.
Being able to form a functioning board in the country where the FA carries on business can be very challenging for OMBs, especially those that may be in the early stages of expanding and do not have the financial resources nor the need to engage foreign directors. Further, most entrepreneurs and business owners are very heavily involved in the strategic management of their businesses and consider the decision to expand abroad to be significant and are often hesitant to give up any control of their foreign operations (to either employees in the local jurisdiction or independent directors who reside there).
As a result, consideration must be given to whether or not residency of the FA can be properly maintained outside of Canada, as this will impact the appropriate structure. For example, if there is concern that the US subsidiary will be considered to be a resident of Canada under the common law test (because the sole director is the Canadian resident owner-manager who makes most of the strategic decisions in respect of the US corporation while in Canada), consideration should be given to forming a US C-corporation (or regarded LLC) so that the corporate tie-breaker rule in the Treaty can be invoked. The Treaty tie-breaker rule provides that where a company is considered a resident of Canada and also a resident of the US, it is treated as resident only of the US based upon its place of incorporation.
It is important to note that not all of Canada's tax treaties contain a place of incorporation "treaty-tie breaker rule." One such example is Canada's tax treaty with the UK, where the CRA could take the position that a UK subsidiary that is incorporated under the laws of the UK and operates solely in the UK is a resident of Canada because its central management and control is exercised in Canada. Absent Competent Authority resolution concluding on UK residency only , the UK subsidiary could be subject to Canadian income tax on its worldwide income together with the requisite Canadian income tax filing and reporting obligations.
Disregarded US LLC: Impact of the Canadian Residency Rules
As outlined above, subject to the application of an applicable tax treaty with a corporate residency tie-breaker rule, a foreign incorporated company will be considered to be a tax resident of Canada under the common law test where its central management and control is exercised in Canada. However, this is not always the case, particularly in the context of disregarded LLCs as they are not eligible to claim the benefits of the Treaty, so the corporate tie-breaker rule does not apply. Conversely should the central management and control of an LLC be exercised in the US, the issues below should not apply and the Canadian FA rules will continue to govern the Canadian tax treatment.
A disregarded LLC is unable to access treaty benefits in respect of its residency because treaty residency requires the entity to be fully liable to tax and, for US tax purposes, LLCs are fiscally transparent with their members being taxable on LLCs profits for US tax purposes. Accordingly, both Canada and the US have taxing rights over the income of an LLC where it is a resident of Canada under common law principles, thus giving rise to the potential for double taxation to apply. To avoid the potential for double taxation where a disregarded LLC is owned by a Canadian taxpayer, care should be taken to ensure that if there are Canadian resident individuals in a position to exercise central management and control of
the LLC that they are in the minority of those that are able to do so and that they consistently do so from outside Canada (likely in the US) at documented meetings.
Consider the following example: assume a Canadian corporation ("Canco") owns a Canadian tax resident LLC ("Can LLC") that carries on business in the US and such business generates taxable income. Canco, as the single member of Can LLC, elects a Canadian resident director or owner-manager of Canco to also act as the manager of Can LLC. If this manager is responsible for making major decisions on behalf of Can LLC the location where these decisions were undertaken will be relevant to the determination of where Can LLC is resident. This is a factual inquiry that may be challenging for a single manager (similar to a corporate director) resident in Canada to establish a sufficient factual record that sustains a determination that the LLC they manage is not resident in Canada.
For US tax purposes, Can LLC is disregarded and the sole member, Canco, is considered to be carrying on the business in the US and is, thus, taxable on the income of Can LLC as having a permanent establishment in the US. Assuming that the central management and control of Can LLC is in Canada, it will also be a resident of Canada for Canadian for tax purposes on the basis of its central management and control being exercised in Canada, it will be taxable in Canada on its global income, and required to report that same income as taxable income for Canadian tax purposes. If this is the case, adverse consequences, including the potential for double taxable may arise; Appendix 5 offers an overview of potential restructuring options available to mitigate the inefficient taxation of Can LLC for future taxation years.
Canadian-resident LLC: Inability to Claim a Foreign Tax Credit
Compounding the adverse tax consequences of the potential double taxation arising where a disregarded LLC is resident in both the US and Canada is the inability of a Canadian corporation to claim a Canadian FTC in respect of the US tax paid by Canco in computing its Canadian tax liability. This is because as a disregarded entity Canco is considered the taxpayer in respect of Can LLCs income for US tax purposes and, thus, Can LLC itself is not subject to foreign tax. Therefore, in computing Can LLCs potential Canadian FTC, it is unable to claim the US tax paid by Canco in respect of its income earning activities in the US.
Canadian-resident LLC: Inability to Enjoy Relief under the Competent Authority Process
Under the Treaty, competent authority may provide relief where taxation, not in accordance with the tax objectives of the Treaty, such as double taxation resulting from dual residency arises. However, since Can LLC is not a resident of the US for the purposes of the Treaty, it is the position of the CRA that it will not be entitled to benefits under the Treaty that are based upon it being a resident of the US, including competent authority relief. Although relief provided under the competent authority process is not subject to published disclosure, in informal discussions the CRA has indicated that it was not aware of any instances involving a US LLC resident in Canada, in a scenario similar to that outlined above, being granted relief under the competent authority process.
Practical Tips for Acquisitions of a Disregarded LLC
The easiest manner to address the residency issues of disregarded US entities upon acquisition is to elect to have them be taxable, regarded entities for US tax purposes. If the LLC forms part of a larger corporate group in the US, consolidated tax filing with the rest of the corporate group will remain possible.
Where a less than a whole interest in a US LLC is acquired, the US based members of the LLC may not wish to have the LLC regarded for US tax purposes as doing so would produce less than ideal tax results for them. In such instances, the corporate governance of the entity may be such that maintaining a majority of non-US resident directors, and ensuring that central management and control takes place in the US may be significantly easier. However, in such an instance, the LLC is still not subject to the Treaty vis-à-vis the Canadian member, and a mismatch between the taxpayer and the LLC may still exist for Canadian tax purposes. It may in such instances be beneficial to acquire or structure the taxpayer's holding of such an interest through a regarded US corporation.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com.
