CRA’s Bad News for Canadians Investing in US Real Estate

Two popular vehicles for investments in US real estate are limited liability limited partnerships (LLLPs) and limited liability partnerships (LLPs). However, the CRA’s announcement at the May 26, 2016 International Fiscal Association (IFA) round table that it will consider many of these entities corporations for Canadian tax purposes has sharply increased their effective tax rate. As a result, restructuring that requires forgoing limited liability may be necessary. The restructuring will have to be done by 2018 in order to take advantage of administrative relief provided by the CRA.

For investments in US real estate, US legal counsel often recommend the use of disregarded limited liability corporations (LLCs), which offer both legal liability protection and flowthrough treatment for US tax purposes. However, for the reasons discussed below, LLCs are not tax-efficient for Canadian investors, because LLCs are treated as corporations from a Canadian tax perspective. As an alternative, Canadian investors have historically preferred to make use of US LLLPs or LLPs, which have typically been viewed as partnerships for Canadian purposes but still offer legal liability protection akin to that of an LLC.

The CRA had previously provided little specific guidance on how LLPs or LLLPs should be characterized for Canadian tax purposes. However, in addressing the tax treatment of Delaware limited partnerships and general partnerships, the CRA had stated that the attributes of entities formed under the Delaware Revised Uniform Partnership Act (DRUPA) or under the Delaware Revised Uniform Limited Partnership Act (DRULPA) more closely resemble those of a partnership under Canada’s common law than those of a Canadian corporation. Accordingly, the CRA indicated that entities governed by DRUPA or DRULPA would generally be treated as partnerships for Canadian tax purposes (see CRA document nos. 2000-0056715, November 28, 2000, and 2004-0104691E5, August 14, 2008, and Income Tax Technical News no. 34). Because the CRA’s statement was broad enough to encompass both LLPs and LLLPs, Canadian taxpayers proceeded on this basis.

All structuring that uses LLPs and LLLPs is now disrupted by the CRA’s announcement that, after much deliberation, it has concluded that Florida and Delaware LLPs and LLLPs should be treated as corporations for Canadian purposes—due in large part to the limited liability protection that they afford their members. This statement effectively puts Canadian investors in the same situation that they would have been in had they originally used disregarded LLCs instead. Unfortunately, the double taxation resulting from the use of LLCs or similar vehicles is substantial for individual and corporate Canadian investors.

Consider the effect on a Canadian individual earning rental income through an LLC (or an LLP or LLLP). For US tax purposes, he or she would be taxed at rates of up to 43.4 percent (including the 3.8 percent net investment income tax) on the rental income. Further, in Canada the entity is considered to be a corporation and a foreign affiliate pursuant to subsection 95(1) of the Act. Thus, the Canadian individual will be taxed in Canada on the income either as a dividend when the cash is ultimately distributed by the LLC or, if the LLC is also considered a controlled foreign affiliate, as FAPI under subsection 91(1) in the year in which the income is earned. In the latter case, no offsetting deduction for US taxes will be available under subsection 91(4) (because the definition of foreign accrual tax [FAT] in subsection 95(1) encompasses only taxes paid by the affiliate itself; the US tax does not qualify, since it is paid by the individual). Furthermore, the CRA takes the view that although a foreign tax credit (FTC) would be available under subsection 126(1) (see CRA document no. 2013-0480321C6, June 11, 2013), it would be limited to 15 percent. A deduction under subsection 20(11) would be available for the US tax in excess of 15 percent. For a taxpayer resident in Ontario, the effect of these rules is an overall effective tax rate in excess of 66 percent (before state tax implications, if any, are considered).

For a Canadian corporate investor, the results are far worse. In addition to US federal corporate tax at rates up to 34 percent, US branch tax could apply at a rate of 30 percent on after-tax profits (owing to the lack of treaty benefits available for the Canadian corporation pursuant to article IV(6)(b) of the Canada-US treaty). Furthermore, no FTC would be granted in Canada under subsection 126(1), because the tax is considered to be paid in respect of income from a share of a foreign affiliate. In addition, no FAT deduction would be available. Therefore, when one factors in refundable part I taxes levied on CCPCs, the overall effective tax rate on the rental income could exceed 100 percent.

The CRA has orally indicated an intention to provide partnership treatment for existing LLPs and LLLPs if, among other things, the LLP or LLLP is converted before 2018 into an entity recognized as a partnership for Canadian tax purposes—that is, an ordinary limited partnership. Such a step, while fairly straightforward, would force Canadian investors to forgo the legal liability protection that they had originally sought in the first place with the LLPs and LLLPs.

Karina Shahani
Deloitte LLP, Ottawa
kshahani@deloitte.ca

Canadian Tax Focus
Volume 6, Number 3, August 2016
©2016, Canadian Tax Foundation