It is common for Canadian corporations when expanding into the United States to conduct their U.S. operations through a Delaware Limited Liability Company (“LLC”) or through a Nevada LLC. This article will discuss the tax consequences of utilizing an LLC.
An LLC is an American hybrid structure inspired by the Limited Liability Partnership structures of Central and South America which are often referred to as “Limitada”. An LLC combines the characteristics of a corporation with that of a limited partnership. The LLC has similarities to a corporation or a limited liability partnership as it provides a shield for a member’s personal assets from creditors of the LLC. Owners of an LLC are referred to as members and can be individuals, corporations or other LLCs. Generally, members do not have to be residents of the U.S. and there is usually no limit on the number of members. Most States also allow for a single member LLC. LLC legislation differs from State to State with the result that each State may impose different eligibility requirements to form an LLC. State taxation of LLCs also differs from State to State.
An LLC with only one member will be treated as a disregarded entity for U.S. income tax purposes unless the LLC elects to be treated as a corporation on I.R.S. Form 8832. An LLC with two or more members is treated as a partnership unless it elects otherwise on Form 8832. A disregarded entity’s activities are treated in the same manner as a sole proprietorship, branch, or division of its owner (IRC Reg. 301-7701-2(a)).
LLC carries on an active business selling widgets manufactured in Canada to arm length customers in the U.S. It also earns royalty income from a licensing agreement with U.S. widget manufacturers. In 2012, LLC earned $100,000 net from selling widgets and LLC also earned $50,000 in royalty income. For purposes of the illustration, it is assumed that Canada considers the LLC to be a U.S. corporation and that the LLC is not deemed to be Canadian Corporation under the mind and management rules.
Canadian Tax Treatment
For Canadian income tax purposes the LLC is deemed to be a U.S. corporation and a controlled foreign affiliate (“CFA”) of Canco.
The characteristic of the income earned by the CFA will determine the tax treatment accorded to the income in Canada. Under the Foreign Affiliate Rules contained in the Income Tax Act a foreign affiliate’s income can be from property, a business other than active business income or from the carrying on of an active business. The first two sources of income are characterized as passive unless there are sufficient employees on the ground earning such income in the foreign jurisdiction to re-characterize the income as active. The classification of passive versus active is important as this determines the treatment of the income in Canada. Dividends from earnings of an active business carried on will be deemed to be from exempt surplus and will not be subject to Canadian income tax on repatriation. Passive income, or as the Income Tax Act titles it, foreign accrual property income (“FAPI”) is taxed in the hands of the shareholder (which can be an individual or a corporation) when earned by the CFA. In other words, one is taxed on FAPI income whether or not such income has been distributed.
In our example, CanCo will only need to include into income for its 2012 year end - $50,000 of the licensing income as this will be deemed FAPI income. There is nothing in the facts that states that the licensing royalties are active business earnings. Should LLC distribute the $100,000 as a dividend then the amount received in Canada will not need to be included into CanCo’s taxable income calculation, as it is traceable to earnings from an active business and is therefore derived from exempt surplus.
U.S. Tax Treatment
In the U.S. a non-U.S. person is subject to U.S. income tax where such person earns:
· Income effectively connected to a U.S. trade or business;
· Fixed or Determinable Annual or Periodical (“FDAP”) income which consists of passive income such as dividends, interest, rents, royalties.
The concept of “effectively connected” income, or ECI, is applicable only to a foreign (a Non-U.S.) corporation or a foreign (a Non-U.S.) individual engaged in a U.S. trade or business. ECI is subject to the progressive tax rates of IRC §11 (corporate tax rates) or IRC §1 (individual tax rates). Non-business income which is typically referred to as FDAP income is taxed at the flat rate of 30% under §881 (corporations) or under §871 where the taxpayer is an individual or at a lower tax treaty rate. Under the Canada – U.S. Income Tax Convention (“Tax Treaty”) the 30% rate will be reduced to the Tax Treaty rate of 5% for dividends, 0% for interest and royalties for payments from a wholly owned subsidiary to its Canadian parent.
LLC as a branch will not only be subject to the graduated rates of IRC §11 on income earned in the US but it will also be subject to the branch profits tax which is imposed on its “dividend equivalent amount (“DEA”). The term DEA is a statutory defined term – see IRC §884(b) – and is intended to be equal to the amount that would have been distributed by the branch had it been a U.S. subsidiary. This article will not discuss the DEA calculation. LLC will be deemed to be remitting a dividend for each of its taxation years equal to the DEA even if it does not actually remit. The DEA is only levied on amounts surpassing $500,000 Canadian dollars (Treas. Reg. §1.884-1(g)(4)(iv)(B). Any amount over Cdn $500,000 will likely be subject to a 30% withholding tax pursuant to Article IV(7) which in essence denies treaty benefits to a Canadian owned LLC.
The royalty payment paid to U.S. LLC will, however, not be able to benefit from the reduced Tax Treaty rate pursuant to IRC §894(c) as such payments are deemed to not be to CanCo, but to a disregarded entity. See IRC Reg. §1.894-1(d)(1) which states:
The tax imposed by sections 871(a), 881(a), 1443, 1461, and 4948(a) on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction. …. An item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction ….
CanCo will therefore be subject to a 30% withholding tax on the $50,000 royalty income earned by LLC.
The purpose of the above illustration is to outline the potential pitfalls when structuring operations through an LLC in the United States. Practitioners often readily assume the LLC is a flow through for U.S. purposes but fail to take into consideration the punitive provision of IRC §894(c) and the CFA rules under the Income Tax Act where such LLC earns passive income.
Sunita can be reached at firstname.lastname@example.org