An answer to Question 16 of the “CRA Roundtable”, that was part of the 20th Annual STEP Canada Conference held earlier this year, may lead taxpayers and their advisors to make a dangerously uninformed decision. The question and answer are produced below “Given recent changes to the tax system in the US, Canadian resident persons who carried on business in the US through US LLCs may now prefer to alter this choice of entity for US tax purposes. An election is permitted in this case, the check-the-box election, whereby the US LLC may be designated to be a corporation for US tax purposes. In such a circumstance, where a check-the-box election is made, does CRA agree, generally speaking, that the making of the check-the-box election has no implications for Canadian tax purposes? It is noted that the Canadian tax treatment of the US LLC would be that it is a foreign corporation, and the check-the-box election would not alter this treatment for Canadian tax purposes.
CRA Response: Our understanding is that checking the box doesn’t change US law with respect to the classification of the entity and that it remains the same legal entity after checking the box as it was before. Therefore checking the box would not result in a disposition of either the LLC’s units or its assets for Canadian purposes. Checking the box could have an impact on Canadian residents though. There are previous written Roundtable answers where we talk about the impact on Canadians and now that the tax shifts to the LLC that could change those answers.”
Although, on the face of it, this seems correct and reasonable, it fails to fully consider a potentially important fact.
That is, I submit that, in most cases where Canadian residents control a US LLC, the LLC is actually a corporation that is resident in Canada. This is based on the fact that its “mind and management” or “central management and control” is in Canada. The shareholders (or “members”) normally act as managers and are the equivalent of Directors in a normal corporation. Given that, it would be hard to argue that it is not resident in Canada based on common law rules, regardless of the fact that it is formed in a US state.
The LLC, assuming it is treated as a partnership or disregarded entity for US tax purposes, is not a resident of the US for the purposes of the Canada-US Tax Convention (“the Treaty”). That is because it is not “liable for tax therein” as required by Article IV(1). Therefore, it cannot claim the benefit of the “tie breaker” rule in Article IV(3) of the treaty to avoid Canadian residency.
Hence, contrary to what is suggested in the question, in the typical situation, it is not actually a “foreign corporation” for Canadian tax purposes, but a Canadian resident corporation.
Often, out of ignorance on the part of the LLCs shareholders or advisors, they do not own-up to this fact in their Canadian tax planning and filings, but that is the reality.
Now, what happens if and when the “check the box” election is made? The LLC then becomes a US taxpayer and, by virtue of Article IV(3), it becomes a US resident for the purposes of the Treaty. Under subsection 250(5) of the ITA, it would then be deemed to be a non-resident of Canada. In effect, checking the box means that it emigrates from Canada.
Because of that, it will be subject to the application of the “departure tax” regime under subsection 128.1(4) of the ITA. This would entail, amongst other things, a deemed disposition of assets at fair market value.
In addition, a secondary level tax under section 219.1 will also apply. This tax would generally be equal to 5% of the fair market value of assets, minus liabilities and paid-up capital of shares at the date of emigration.
Accordingly, Canadians should not use the US “check the box” regime in connection with a US LLC without carefully considering the implications of a deemed emigration.