U.S Business Structures for Canadian Parent Corporations Doing Cross-Border Business – Part 1
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Growing Canadian businesses searching for new markets are conducting business on a multinational level. The United States, being Canada's largest trading partner is the country many businesses are seeking first to expand to.
Since more businesses are expanding into the United States, Revenue Canada and the I.R.S. have increased audit activity of cross-border transactions. In order to ensure that companies are taxed on their cross-border activity there has been a vast increase in the cross-border tax compliance requirements for businesses, and large penalties to ensure compliance with the new and existing rules. It is imperative that businesses are aware of these rules in order to minimize tax costs as well as to maximize profits and cash flows. There are a significant number of new rules that require information disclosure only. This is however, not to be taken lightly, because the penalties attached to non-filing of this information can be as much or more than the tax bills that many companies pay.
This third article in our series on Canadian Outbound investment into the U.S analyzes the various structures that can be utilized within the corporate structure, as well as repatriation issues when bringin income back into Canada from the U.S. Another article will analyze the tax implications of these various structures.
Types of Business Entities in the U.S. and How They are Treated from a Canadian Perspective
If a Canadian company concludes that it requires a U.S. legal entity, the next decision is choosing the appropriate entity for its particular business opportunity. The following discussion is not meant to be an exhaustive list of each type of business entity available to Canadian companies; rather, it will focus on the most common business entities encountered in a Canada-U.S. cross-border context.
- Subchapter “C” Corporations
A reference to a corporation in the U.S. is likely a reference to a “C” Corporation. The term “C” Corporation comes from Subchapter C of the IRC which contains IRC sections 301 to 385. Corporations are formed under the laws of the U.S. state in which they are organized however; the reference to “C” dictates how that corporation will be taxed pursuant to the IRC. A “C” Corporation is the only business entity discussed here that is a taxable entity which is to say that the corporation, rather than its shareholders, pays tax on its income. Barring unusual circumstances, shareholders of “C” Corporations are not liable for the debts of the corporation.
The biggest distinction between how “C” Corporations are taxed and how Canadian corporations are taxed is that the corporate profits of “C” Corporations are subject to double-tax. Rather than an integrated tax system where shareholders get a credit for taxes paid by the corporation they own, “C” Corporations first pay a corporate level tax and shareholders then pay tax on after-tax profits distributed to them with no consideration for the corporate level taxes already incurred. This double-tax cost of operating as a “C” Corporation makes the effective tax rate of a “C” Corporation more than that of a fiscally-transparent entity like a partnership.
As noted previously, a “C” Corporation will be subject to tax in the U.S. If it is also a resident of Canada (perhaps because mind and management is in Canada), it will be treated as a resident in the U.S. based on its place of incorporation. If the mind and management is in Canada; however, there may be adverse tax consequences in
respect of the availability of the exempt surplus regime. It will be important to ensure that the mind and management of the “C” Corporation is not in Canada.
2. Subchapter “S” Corporations
In addition to “C” Corporations, a corporation organized under state law can elect to be taxed under Subchapter S of the IRC which contains IRC sections 1361 to 1379. “S” Corporations are fiscally transparent entities unlike “C” Corporations, so the shareholders of an “S” Corporation are responsible for the tax burden of its profits or losses.
Furthermore, unlike “C” Corporations, there are several requirements that need to be met in order for a corporation to elect to be taxed as an “S” Corporation for U.S. federal tax purposes. One such requirement is that all shareholders must be U.S. citizens, lawful permanent residents or U.S. residents for tax purposes. Another requirement is that all shareholders must be natural persons and cannot be other “C” Corporations. Because “S” Corporations are rarely used in a cross-border context, further implications of “S” Corporations will not be addressed.
3. Limited Partnerships
Besides corporations, limited partnerships and similar derivatives of limited partnerships are common business entities in the U.S. Over the last 25 to 30 years, limited partnerships have become less common outside of professional services industries like law firms and accounting firms. Instead, limited liability companies, discussed below, have become ubiquitous. Limited partnerships are created under partnership pursuant to state statutes.
Unlike “C” Corporations, limited partnerships are fiscally transparent and the partnership itself is a conduit to determine the allocation of partnership attributes to its partners. Limited partners generally have limited liability with respect to the debts of the partnership but this comes as a trade-off as limited partners risk losing this cloak of protection if they actively participate in management of the limited partnership. Lastly, every limited partnership is required to have a general partner that has unlimited liability for the debts of the partnership. Typically, where limited partnerships are still found, the general partner is another limited liability entity like a limited liability company or corporation.
In addition to limited partnerships, variants of limited partnerships like limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) have sprout up across the various state partnership acts. These entities are all taxed the same for U.S. federal tax purposes but afford various degrees of limited liability for partners. LLPs are generally reserved for professional service entities and prevent the actions of one limited partner being imputed on the other limited partners and LLLPs provide limited liability protection for general partners.
From a Canadian perspective, Canco would be subject to tax on its shares of the profits of a limited partnership. The CRA has taken the position that both LLPs and LLLPs should be treated as corporations for Canadian tax purposes. The difference in tax treatment for Canadian purposes and U.S. purposes can result in adverse tax consequences.
4. Limited Liability Companies (LLC)
Since the early 1990’s when they started to appear under state statutes LLCs have become one of the most common business entities used to carry on a business. LLCs offer the benefits of flow-through of profits and one layer of tax with benefits of limited liability for all owners including the managing partners.
LLCs with a single-owner are treated as disregarded entities for U.S. federal tax purposes. A disregarded entity is an entity with one owner that passes-through profits and losses and is not the beneficial owner of the assets it owns.
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Rather, the owner of the LLC is treated as owning the assets and income of the disregarded entity. Moreover, disregarded entities do not have separate income tax return filing requirements unlike other fiscally transparent entities like partnerships.
The CRA has stated that where a Canadian resident is the sole member of a disregarded LLC which carries on business in the U.S. and its mind and management is in Canada, there is no relief from double taxation under the Treaty. Moreover, if LLC treated as a resident of Canada, it would generally need to file a Canadian corporate tax return. For this reason the U.S. business should not be carried on by an LLC.
Other issues:
- Check-The-Box
Introduced in 1996, the “Check-the-Box” Regulations allow “eligible entities” to elect their tax treatment for U.S. federal tax purposes. Entities organized as partnerships or disregarded entities may make an election to be taxed as a “C” Corporation for U.S. federal tax purposes while retaining their status as partnerships or LLCs under state law. Once an election is made under these Regulations, it is binding for at least 60 months.
Often when organizing a corporate entity in the U.S., one will find it easier and slightly less expensive to organize an LLC rather than a corporation. Thus, an LLC can be formed under state incorporation/organization statutes but have a different classification for U.S. federal tax purposes. Should an LLC be formed with the intent to elect to be taxed as a “C” Corporation, IRS Form 8832, Entity Classification Election must be filed within certain prescribed time limits in order for the “C” corporation status to be effective from the LLC’s organization date.
2. Disregarded Limited Partnerships
Disregarded limited partnerships are limited partnerships where the limited partner is the sole limited partner and owns 100% of the general partner which is itself an LLC. In this scenario, the general partner usually owns a nominal interest in the limited partnership (1%). Under this arrangement, the same limited partner is treated as owning 100% of the LP units because as discussed above the owner of disregarded entity is treated as owning the disregarded entity’s asset which solely consists of the 1% limited partnership interest. The IRS has ruled that this arrangement will be treated as a disregarded entity for U.S. federal tax purposes which means that the limited partnership is not required to file a U.S. partnership return of income.
Disregarded limited partnerships can be an alternative to using LLCs. The entities are formed as limited partnerships under state law with a general partner. Accordingly, it should be considered to be a partnership for Canadian tax purposes with the result that all of the income will flow through as would be the case if Canco operated as a branch. The CRA should view these as flow-through entities rather than corporations the latter of which causes significant issues in a cross-border context.
3. How to Finance the U.S. Operations
Should USco be funded by debt, equity or a combination of debt and equity? The manner in which Canada and the U.S. deal with debt makes matters complicated.
There is always an incentive to finance USco with debt rather than equity because with the former the principal can be returned to the lender tax-free, interest payments create deductions against taxable income and interest paid by Canco to USco is generally not subject to U.S. federal withholding tax. On the other hand, if a capital contribution or equity is used to finance the U.S. subsidiary, there is no deduction for dividends paid to
shareholders and there is a 5%/15% U.S. federal withholding tax for dividends paid to Canadian resident shareholders.
If the funding with debt, should the loans to USco bear interest? If the loans are non-interest bearing, consideration must be given to the possible application of section 17. If it applies, section 17 will impute interest at the prescribed rate on an amount that is owing for more than a year by the non-resident to a Canadian resident corporation where the interest on the debt is less than a reasonable rate for the period.
In the case of a USco that is owned by Canco, it is possible that the exception in subsection 17(8) would apply. This exception applies where the loan is made to a controlled foreign affiliate and the indebtedness is used for the purpose of earning income from an active business or income that is deemed to be active business income. Attention will have to be paid to the use of the indebtedness to ensure that this test is met.
If to ensure that the shares of Canco meet the test for the LCGE, the shares are held in a Canadian entity that is separate from Canco, it is possible that section 17 will apply because the exception in subsection 17(8) would not be met.
In addition to Canadian tax considerations, further thought should be given to the U.S. tax implications of introducing debt to a U.S. subsidiary. Specifically, the two most common issues associated with financing U.S. operations with debt are: 1) whether the debt might be recast as equity and 2) whether the interest accruing or paid will be deductible for U.S. federal tax purposes.
Conclusion
There are a myriad of Canadian and US tax compliance issues for Canadian businesses expanding into the US A review of at least the items identified in this paper will assist businesses to identify the requirements and to make a calendar of important filing dates. Planning ahead will ensure that proper business structures have been considered, and that all required compliance filings are made to avoid unnecessary and expensive penalties. It will also help to plan for tax compliance issues for Canadian employees spending time or transferring to the US.
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.
