LLC trap for the unwary in Canada.

• Author: Bakale, Anthony
• Position: Limited liability companies

As a place to invest or expand, Canada provides vast opportunities, an undervalued currency, a stable economy and easy access. Once the decision to move is made, how should a business or investment be structured?

In the U.S., there is a lack of integration between corporate earnings and the repatriation thereof to the shareholders. As such, most entrepreneurs carrying on business through regular corporations may face double taxation. Assuming both a corporate and personal combined Federal and state tax rate of 40%, the overall taxes payable on $100 of corporate earnings distributed to an individual shareholder would be $64 ($40 corporately ($100 x 40%) and $24 personally ($60 x 40%)). To avoid this result, many entrepreneurial businesses in the U.S. are carried on through limited partnerships (LPs), S corporations or limited liability companies (LLCs).

Each of these alternatives allows individuals to include the business entity's income on their personal returns, thereby eliminating the double-tax potential, while at the same time shielding the entrepreneur from business risk through limited liability.

Canada has enough similarities with the U.S. to be considered the 51st state (or the U.S. the eleventh province), with the perception that what works as a business structure model in the U.S. must also apply to Canada. This may not always be the case.

Canadian tax legislation and jurisprudence have held steady the notion that a corporation is a corporation and a partnership is a partnership. No S elections or check-the-box regulations exist to breach the gap. From a U.S. tax perspective, this is onerous, because an investment in a Canadian company by an individual taxpayer will result in double taxation. The corporation will be subject to Canadian corporate tax and the individual investor will be subject to a U.S. personal tax on the dividend distributions received from the Canadian corporation on repatriation of profits. Even though the payment of this dividend will result in a 15% Canadian withholding tax for a shareholder who is a U.S. resident individual, the U.S. will grant such shareholder a foreign tax credit (FTC) (subject to any U.S. alternative minimum tax (AMT) adjustments), which effectively eliminates most of the additional tax cost of the withholding tax. However, there is no corresponding FTC to a U.S. individual investor for Canadian tax paid at the corporate level. Hence, double taxation exists.

Overview of Canadian Tax Legislation

Canadian tax rules, while similar to U.S. concepts, have enough differences that professional advice is a must.

In general, anyone employed in Canada, carrying on business in Canada, earning pension or investment income in Canada or disposing of Canadian assets is subject to tax on such revenue.

Carrying on business in Canada includes soliciting sales in Canada (whether through a dependent or independent agent) or providing services in Canada, regardless of whether the individual or business has nexus or a permanent establishment in Canada. This type of income will be subject to full comprehensive Canadian taxation.

If a taxpayer (individual or corporation) meets the Canadian residency criteria, the taxpayer will be subject to tax on worldwide income, rather than just Canadian-source income. Canadian-source income (other than property income that qualifies as business income or management, administration and service income) will not be subject to Canadian withholding tax. Property income will be subject to a 25% Canadian withholding tax on gross income, but if earned as part of a business, such withholding tax will be considered as an installment against the regular tax liability.

Management and administrative income, if paid to related parties, will be subject to a 25% withholding tax, whether or not these activities are performed in Canada. All other income from services performed in Canada will be subject to a...