Tax Consequences of Carrying on Business through a Disregarded Entity in the United States

Reproduced from the April edition "Private Companies and Taxes"

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)).

Illustration

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 Doobay

TaxChambers, Toronto

Sunita can be reached at sunita.doobay@taxchambers.ca

Interest Deduction Denied: Swirsky

In Swirsky (2013 TCC 73) the TCC concluded that interest paid on a loan incurred for the purpose of a share purchase was not deductible under subparagraph 20(1)(c)(i). The decision touches upon the issue of whether the gross expected dividend return on shares places a limit on the deductibility of interest expense related to their purchase.

Mr. Swirsky, the taxpayer, held shares in Torgan Construction Limited, a corporation actively engaged in real estate development. The taxpayer incorporated Torgan in 1974 and his wife became an equal shareholder a few years after their marriage. The 1989 decline in the real estate market created the very real possibility of bankruptcy to the taxpayer. Just before the market peaked, the taxpayer and Mr. Cohen embarked on an ambitious development and each provided joint and several personal guarantees to a bank. The project was cancelled and when the taxpayer learned from Mr. Cohen that he was creditor proof, he had reasonable concerns that the bank would seek to collect the entire loan amount under his personal guarantee. The taxpayer sought to place the Torgan shares out of the lender’s reach by selling them to his wife and by using the sale proceeds to pay down shareholder loans that he owed to Torgan.

Torgan had not made a practice of paying dividends and instead paid bonuses and extended significant shareholder loans to the taxpayer to achieve the deductibility of amounts paid out of its income. Arguably on the facts a preference existed, because Mr. Swirsky knew that he was potentially facing bankruptcy, his wife believed that bankruptcy was imminent, and the transaction was entered into to preserve family income, but the court concluded that the transaction was an effective creditor-proofing measure.

In Shell ([1999] 3 SCR 622) the SCC concluded that four requirements support an interest deduction under paragraph 20(1)(c): (1) the amount must be paid in the year or be payable in respect of the year of deduction; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable in light of the first three requirements. 

The TCC in Swirsky focused on the third requirement: whether the borrowed money was used for the purposes of earning non-exempt income. Based on Ludco, although personal intention is not determinative, the TCC in Swirsky said that clearly the wife  purchased the shares without any understanding of their potential for income. And there was little objective history of the payment of dividends on those shares before their transfer to the wife. Interestingly, dividends were paid on the shares after their transfer. The TCC largely ignored the post-transfer conduct, but pointed out that the first dividend paid was a non-taxable capital dividend, and the first taxable income after the shares’ transfer occurred in 2003, over seven years after the transfer’s final stage. (The accountants advised to transfer the shares in three tranches in order to match the shareholder loans outstanding.) According to the TCC, Ludco required that there must be a reasonable expectation of income at the time that the investment was made.

On the facts presented, there is a strong implication that the wife agreed to purchase the shares in order to facilitate a creditor-proofing transaction, independent of any desire to earn income. The TCC also concluded that the spouses agreed between themselves that the wife would not be responsible for the loan costs. The court concluded that thus it was more likely than not that the wife was not concerned with the shares’ income-earning potential at the time of their purchase.

The TCC appears to be correct in concluding that based on a lack of dividend history, a reasonable buyer could not anticipate income, and thus the wife had no reasonable expectation of earning income from the shares acquired with the loan. The wife’s lack of understanding of the economic consequences augments the conclusion that there was no reasonable expectation of earning income from the shares. Arguably a history of dividend payments prior to the transfer might have resulted in a different conclusion because it would justify an objectively supported and reasonable belief that the shares would earn income. However, the focus on dividend payments as the predominant source of income from shares may seem too narrow in the context or a personally held corporation, because many taxpayers earn different types of income from a corporation, such as salary, bonuses, loans, and dividends. Salary and bonuses are generally used to entice employees to reach their top performance.

In our view the TCC in Swirsky was correct to focus on dividends. The CBCA provides two economic rights that must be allotted to classes of shares: the right to receive any dividend declared by the corporation and to receive the remaining property of the corporation on dissolution. Other rights, such as a conversion right or a right of redemption, attach to the share, not the shareholder (Bowater Canada Ltd v RL Crain Inc (1987), 62 O.R. (2d) 752, 46 D.L.R. (4th) 161, 26 O.A.C. 348, 39 BLR 34). Thus while most other forms of compensation, such as salary and bonuses, are tied to acts done on the corporation’s behalf, dividends are the product of two factors. First, the directors must decide to declare a dividend, further to their obligation to manage the business and affairs of the corporation. Second, the shareholder must own a share that has the right to participate in the dividend declared. If both elements are present, the principle of equality demands that the share receive the dividend (McClurg, [1990] 3 SCR 1020) and no further acts by the shareholder on the corporation’s behalf are required to justify the payment of the dividend (Neuman, [1998] 1 SCR 770).

Sunita Doobay

TaxChambers, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba