In the past 15 years, direct investment in Canada has more than tripled in value; more than 65% of that investment has come from the U.S. It is anticipated that this figure will continue to grow as U.S. corporations seek to expand their markets. This item discusses the basic Canadian tax issues facing U.S. corporations seeking to expand their businesses into Canada and the use of limited liability companies (LLCs) and unlimited liability companies (ULCs).
Taxation of Nonresident Corporations
Under Canadian law, nonresident corporations are subject to income taxes in Canada when they carry on a business there or dispose of taxable Canadian property (generally real estate, property used in a Canadian business and private company shares). These corporations will be subject to tax at ordinary rates, which range from 31% to 39% depending on the province to which the income is allocated.
In addition to income taxes, nonresident corporations are subject to a branch tax of 25% of the profits deemed to have been repatriated to the U.S. The amount is determined by formula and is designed to replicate the withholding tax that would have been imposed had those corporations carried on their Canadian business indirectly through a Canadian corporation that distributed its after-tax business earnings via dividends
Defining “Carrying on Business”
A question often asked is, “what level of Canadian business activity can a nonresident corporation engage in before being deemed to be carrying on business in Canada?” The term “carrying on business” is not specifically defined in the Canadian Income Tax Act (Act); rather, a common-law definition has evolved from the U.K. and Canadian courts. In addition, Act Section 253 provides an extended meaning of the term that deems a nonresident to be carrying on business in Canada if it:
1. Produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs anything in Canada;
2. Solicits orders or offers anything for sale there through an agent or servant, whether the contract or transaction is completed inside or outside of Canada; or
3. Disposes of certain resource properties or Canadian real estate.
Accordingly, the level of Canadian activity required to be deemed to be carrying on business there is very low. U.S. resident corporations can usually find relief in the Convention between the United States of America and Canada with respect to Taxes on Income and on Capital, signed September 26, 1980 (Treaty).
The Treaty generally provides relief for U.S. residents via Article VII, Business Profits. This Article states that a U.S. resident will not be taxable in Canada on business profits unless it carries on a business there via a permanent establishment (PE) situated in Canada. When there is a Canadian PE, all business profits allocable to it may be taxed there.
Article V, Permanent Establishment, defines a PE to include:
1. Place of management, a branch, an office, a factory, a workshop and a mine or oil and gas well;
2. Building site or construction or installation project that lasts more than 12 months;
3. Person acting in Canada on behalf of a U.S. resident if that person has, and habitually exercises in Canada, the authority to conclude contracts.
A PE is deemed not to include a fixed place of business used solely for storage, display or delivery of goods or for the purchase of goods. In addition, the fact that a U.S. corporation has a Canadian subsidiary that carries on business there via a PE will not result in the U.S. parent having a PE in Canada.
Accordingly, when treaty protection is available, it is possible to carry on business in Canada, within these limits, without being subject to Canadian income taxes. Note: Canada requires a nonresident carrying on business in Canada, but exempt from Canadian tax because of Treaty provisions, to file an annual information return; see Act Section 150(1)(a).
Article 10, Dividends, also reduces (and in some case eliminates) various withholding taxes and exempts the first C$500,000 of branch profits from Canadian branch tax.
The LLC Trap
The popularity of U.S. LLCs in the last few years has led these entities to establish Canadian branches or subsidiaries. While an LLC may be disregarded or treated as a partnership for U.S. tax purposes, it will be treated as a corporation for Canadian tax purposes. This differing treatment generally does not cause any problems in inbound-to-Canada planning, and can provide some significant opportunities in the area of cross-border financing structures.
The LLC trap is caused by the fact that Canada does not consider a disregarded LLC, or an LLC treated as a partnership, to be a U.S. resident for Treaty purposes; thus, it does not afford treaty benefits to such an LLC. This is became Article IV, Residence, defines a resident of a contracting state as a person that is subject to tax in that state. Because a disregarded LLC or an LLC treated as a partnership is not subject to tax in the U.S., it is not deemed to be a U.S. resident. Thus, an LLC carrying on business in Canada:
* Will be taxable in Canada, whether or not it is operating through a PE;
* Will be subject to 25% withholding tax, if it receives interest, dividends and royalties from a Canadian resident;
* Will not be eligible for the C$500,000 branch tax exemption; further, the branch tax will be imposed at 25%, rather than the 5% Treaty rate.
There are also negative consequences for an LLC that forms a Canadian subsidiary. While the subsidiary will still be taxed at regular Canadian rates, the withholding tax on dividend distributions will be 25%.
It is widely anticipated that the next protocol to the Treaty will resolve the LLC trap; however, it is not known when it will be completed. Accordingly, if an LLC is considering expansion into the Canadian market, it is vital that a Canadian tax adviser be consulted before commencing operations there.
A special type of Canadian corporation, the ULC, has become very popular with cross-border planners over the last few years, due to the opportunities presented by its hybrid classification. It is treated as a corporation for Canadian tax purposes and may be treated as a disregarded or flowthrough entity for U.S. tax purposes. In the past, this type of corporation could only be formed in the province of Nova Scotia; very recently, the province of Alberta passed legislation allowing ULC formation there, too; compare the Nova Scotia Companies Act to the Alberta Business Corporations Amendment Act (Bill 16, 5/17/05). Some of the advantages “of using a Canadian ULC include:
1. When an S corporation carries on business in Canada through a PE, the use of a ULC can reduce the effective tax rate, by allowing the S shareholders access to foreign tax credits that would not be available if the S corporation had used a regular Canadian corporation. A qualified subchapter S subsidiary is often used to shield the parent S corporation from liabilities arising from the Canadian operations, as a ULC does not provide liability protection.
2. The use of a ULC allows losses to flow through to the U.S. parent.
3. When a ULC is disregarded for U.S. purposes, transfer pricing issues are simplified; only the Canadian authorities must be satisfied, as the transfer price does not affect U.S. taxation.
4. A ULC instead of a Canadian branch also simplifies Canadian transfer pricing issues, as there is more guidance available on establishing transfer prices between two corporations than on determining the profits that should be allocated to a PE under the Treaty.
5. The use of a ULC instead of a regular Canadian corporation avoids the complexities of the U.S. controlled foreign corporation and passive foreign investment company rules.
6. The ULC can be very useful in developing cross-border financing structures that can significantly reduce the effective cost of capital.
7. In an acquisition, it may be possible to step up the basis of the assets of a Canadian target corporation by “converting” it to a ULC.
The cost of incorporating and maintaining a ULC has risen over the past several years, due to increased fees being charged by Nova Scotia; however, with the competition provided by Alberta’s ULC legislation, it is anticipated that these costs will now decrease.
While this item has discussed some of the basics of Canadian taxation of nonresidents and some issues surrounding the use of LLCs and ULCs, there are many more considerations for a U.S. corporation seeking to expand into the Canadian marketplace; it will be vital for U.S. and Canadian tax planners to work together to find the most effective structure for both sides of the border