One thing is for sure… Canadians continue to invest significant amounts of money in the US. When investing for business or commercial purposes, Canadian residents are often faced with a fundamental question: what legal structure should be used to ensure that an appropriate balance of tax and non-tax objectives are met? Such a question is not easily answered. As my colleague, Roy Berg, says: “… if someone tells you emphatically what the answer is without exploring all of your facts, then politely ask the person to validate your parking and leave”. One of the structures that has recently been recommended by many US and Canadian advisors is the US limited liability limited partnership (“LLLP”). Accordingly, we will explore that alternative in this article.
From a tax perspective, the general objectives when selecting legal structures for US investment by Canadians are to minimize overall taxes after repatriating the funds back to Canada, and to ensure that double tax does not result. Below is a partial list of the more common alternatives that Canadians often utilize when investing in the US. For illustrative purposes we have assumed that a Canadian resident individual wishes to invest commercially in a US rental property.
- Invest personally – the individual invests directly in the US rental property.
This alternative may be tax efficient from an income tax perspective. Both the US and Canada will tax the individual on any rental profits and capital gains. However, the US will have the first right to tax such amounts, with the Canadian tax liability being reduced via the foreign tax credit system. The computation of taxable income for US and Canadian purposes on the rental profits will be different and careful planning should be done to ensure that proper cash flow is adhered to on both sides of the border. Consideration also needs to be given to US withholding tax on rental income and capital gains to ensure proper compliance. The ownership of the US rental property may also require foreign reporting disclosure in Canada pursuant to section 233.3 of the Income Tax Act (satisfied by filing prescribed form T1135 – Foreign Income Verification Statement).
In addition, proper estate planning should be undertaken as the death of the Canadian owner of the US rental property could expose the individual to US estate tax, in addition to Canadian income tax on any accrued capital gain on the fair market value deemed disposition of the US rental property triggered upon death. A mathematical analysis, including any treaty benefits available in the Canada-US tax treaty, should be carried out on a regular basis to ensure that this exposure is manageable.
A direct personal investment in the US rental property will expose the individual to any creditor claim as a result of the direct ownership. Accordingly, creditor proofing should be carried out to mitigate this exposure.
- Invest through a Canadian Corporation – the individual acquires the US rental property indirectly through a Canadian corporation (after properly financing such a corporation).
This alternative is likely not as efficient from a tax perspective as compared to investing personally. The Canadian corporation will pay US federal and state corporate tax on the rental profits and capital gains while also reporting the rental profits and capital gains for Canadian tax purposes (again, the computation of taxable income for US and Canadian purposes will be different and careful planning should be done to ensure that proper cash flow is adhered to on both sides of the border). Similar to alternative #1 above, US income tax paid by the Canadian corporation is often creditable against the Canadian corporate tax. Given that Canadian corporate tax rates are often much lower than US corporate tax rates, the result is often that the US corporate taxes paid exceed the Canadian tax exigible. While there may be no additional Canadian tax owing, a higher overall effective tax rate may result when compared to alternative #1 where the US rental property is owned directly by the individual.
When dealing with business investments, we often find that this type of investment structure results in significant “business-income” foreign tax credits that are being carried forward and ultimately trapped in the Canadian corporation… not good. We note in the context of “non-business-income” (which may include real estate investments) such “non-business-income” foreign tax credits are not available for carry-forward in Canada. Consideration should also be given to US branch tax in this type of structure which can be triggered when funds are repatriated back to Canada from the US; further increasing the overall effective tax rate.
On a positive note, the exposure to the US estate tax can be avoided (since US estate tax only applies to US situs assets that are held by an individual and in this structure, an individual does not own the US commercial property… a Canadian corporation does). In addition, subject to confirming legal advice, creditor protection may be improved for the Canadian resident individual.
- Invest through a US Corporation
This alternative is also not very tax efficient. Assuming that a US C corporation is utilized (since non-US citizens generally cannot own shares of a US S corporation), then such rental profits and capital gains will be taxed at high US corporate tax rates. The after-tax amounts will be repatriated to the Canadian shareholder by way of dividends. Such dividends will be subject to US withholding tax, which should be recoverable in whole or in part in Canada via the foreign tax credit system. If the shareholder is an individual then the Canada – US tax treaty will reduce the withholding to 15% of the gross dividend. If the shareholder is a Canadian corporation and owns 10% or more of the voting stock of the US corporation that is paying the dividend, then the withholding rate is reduced to 5%. If the dividend recipient is the Canadian resident individual, then such dividend is taxed as ordinary income. If the dividend is received by a Canadian corporation, then additional analysis would need to be done to see how such amount is taxed.
Additionally, the ownership of the US corporation shares can invoke the application of Canada’s foreign anti-deferral regime; affectionately called “FAPI” (which is short for “foreign accrual property income”). FAPI can result in an imputed income inclusion for the Canadian resident shareholder of a “controlled foreign affiliate” that earns property income, such as rental income. The application of FAPI can result in significant complexities. Canadian foreign reporting requirements would also need to be reviewed, including prescribed form T1134 – Information Return Relating to Controlled and Not-Controlled Foreign Affiliates.
Finally, if a Canadian resident individual shareholder owns shares of a US corporation, the possible application of the US estate tax needs to again be considered. If the shares of the US corporation are owned personally, then such shares constitute US situs assets and could expose the Canadian resident shareholder to US estate tax upon death.
Subject to confirming legal advice, creditor protection may be improved where a Canadian resident individual utilizes a US corporation to hold the US rental property.
- Invest through a US Limited Partnership (“LP”)
Partnerships are one of the only vehicles that are considered “flow through” vehicles for both Canadian and US tax purposes. Accordingly, the idea with this type of structure is that the US rental profits and gains will flow through to the ultimate partner both for Canadian and US income tax purposes. However, the fundamental question with the use of a LP structure is who will the partners of the LP be? A Canadian corporation? A Canadian resident individual? Once understood, then the tax analysis can begin which will encompass elements of alternatives #1 and #2 above, including any exposure to the US estate tax.
From a non-tax perspective, the LP is typically structured so that a General Partner – who will generally accept all liability for the debts of the partnership – will acquire a nominal interest and the limited partners acquire the balance. The general idea is that the limited partners have limited liability equal to the amount of their investment, subject to various rules set out by the province or state that may alter that liability dependent on the limited partner’s behavior with respect to the partnership.
- Invest through a US Limited Liability Company (“LLC”)
Our firm has spilled ink on this alternative before and it can be read here. Suffice it to say that the use of a US LLC is usually not a great idea for Canadian residents.
- Invest through a US Limited Liability Limited Partnership
What if one could achieve the flow through character of a limited partnership but access improved creditor protection for the general partner? Well, welcome to the LLLP, a relatively new creature of statute introduced by a number of US states. Wikipedia, the font of all wisdom, has a general explanation of what an LLLP is in plain English here.
Some Canadian advisors have jumped on the LLLP bandwagon and recommended that Canadians use US LLLPs to invest in US commercial property or businesses.
However, how does the Canada Revenue Agency (“CRA”) view a US LLLP? The answer to that question is important to ensure that the intended flow through character for tax purposes results. How the CRA views foreign entities is a very interesting subject. I wrote an article on how the CRA classifies foreign entities for one of our affiliated associations and it can be viewed here. One of the questions that our Firm has had about US LLLPs is whether the additional liability protection afforded the general partner would cause the CRA to view a US LLLP as a foreign corporation. If so, then significant tax problems, similar to those that arise with a US LLC, could arise. In our view, there are compelling arguments that a US LLLP should be viewed as a foreign partnership for Canadian tax purposes. However, there are also interesting arguments that could be raised to suggest that such an animal could be viewed as a foreign corporation from a Canadian tax perspective.
Given the uncertainty and the relative newness of US LLLPs, my friends and I who are responsible for the STEP Canada CRA Roundtable submitted this question as part of the recent STEP National Conference. You can view the questions and answers here but take a look at question number four. It appears that the CRA gave little consideration to the issue and ultimately said:
The CRA has not previously had to consider whether an LLLP formed under US state legislation is a partnership, a corporation or some other entity for purposes of the Income Tax Act… The CRA would consider the classification of an LLLP in the context of an advance income tax ruling.
As a quick aside, there is Canadian tax commentary that suggests that the CRA has in fact had to consider whether a US LLLP is treated as a foreign partnership for Canadian tax purposes (see TI 2010-0386201R3). However, respectfully, I would suggest that the CRA did not explicitly rule that a US LLLP was a partnership for Canadian tax purposes and seems, in the context of the subject Ruling Request, to have given short shrift to this issue.
So what does this mean for Canadian residents using a US LLLP for US commercial investment? Well, one better be confident that it would be considered a foreign partnership from a Canadian tax perspective. If not, significant tax complexities, some adverse, could arise. Our Firm is aware of certain parties who may take the CRA’s invitation and ask for an Advance Income Tax Ruling involving a proposed investment into the US using a LLLP. Stay tuned for further developments in this area.
Are US LLLPs the Holy Grail for cross-border investment? Not yet.