As a general rule, U.S. residents are only subject to Canadian tax on business income to the extent that such income is earned via a permanent establishment (“PE”) in Canada(1).

If a U.S. C corporation earns profits that are taxable in Canada, such profits will be subject to federal corporate taxation under Part I of the Income Tax Act (“the Act”) at a rate of 15%, plus, assuming there is a PE in a province, provincial corporate taxation at varying rates. For example, in Ontario the rate is 11.5% and in Alberta the rate is 10%, thereby resulting in combined corporate tax rates of 26.5% and 25%, respectively(2).

In addition, a U.S. corporation earning income from carrying on business in Canada may also be subject to the “branch tax” that is levied under Part XIV of the Act. This tax is quite similar in its purpose and workings to the U.S. “branch profits tax” that is levied under Section 884 of the Internal Revenue Code.

In general terms, the tax under Part XIV is 25% of the profits taxable in Canada net of normal corporate income taxes. Such after-tax profits are not subject to this tax to the extent that they are still used in the business of the Canadian branch(3).

However, for U.S. resident corporations(4), Article X(6) of the Treaty provides that the rate of this tax is reduced to 5%, and the tax is not levied until cumulative profits subject to the tax exceed $500,000 CDN. In addition, the tax is only applied to profits derived from a Canadian PE(5).

What if the shareholders of the corporation want to use a pass-through entity (S Corporation or LLC), as opposed to a C Corporation for the Canadian operations? This would allow them to personally claim foreign tax credits for the Canadian tax.

Which is better, S Corporation or a LLC?

As a general rule, the federal corporate tax levied under Part I, as well the provincial corporate tax, will be the same, in both cases, as if a C Corporation were used(6).

What about the Part XIV tax (“branch tax”)? This is where there is a very significant difference that would normally point to using an S Corporation, rather than a LLC, if both options are available.

The Canada Revenue Agency (“CRA”) has traditionally viewed S Corporations as being residents of the U.S. for the purposes of the Treaty, and therefore eligible for the benefits of the treaty at the corporate level(7).

Therefore, in the case of an S Corporation, the benefits of Article X(6), being the 5% rate and $500,000 CDN exemption, should apply.

However, an LLC would not be treated by the CRA as being a corporation resident in the U.S. for the purposes of the Treaty(8), and would usually not be entitled to the benefits of Article X(6). The statutory rate of 25% would apply, and there would be no $500,000 CDN exemption. In this regard, although Article IV(6) of the Treaty is intended to provided certain treaty benefits to U.S. residents who earn Canadian-source income via a LLC, the position of the CRA is that the benefits of Article X(6) will only be extended to a LLC to the extent that its income is allocated to a member that is a U.S. resident corporation for the purposes of the Treaty(9). In the far more common situation, where the members are only individuals, the CRA’s position is that Article X(6) does not apply.

One last note: if a LLC elects under the U.S. “check the box” rules to be treated as a corporation, and, then makes an S Corporation election, the CRA has confirmed that the benefits of the treaty should apply(10).

In accordance with Circular 230 Disclosure

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Footnotes:

(1)     Article VII(1) of the Canada-U.S. Tax Convention (“the Treaty”). There are some important exceptions, however: income derived from artistic and athletic activities (see Article XVI) and real estate trading (see Article VI) may be taxed by Canada even if there is no PE in Canada.

(2)     In the event that there is no PE in a province, the federal tax under Part I is increased by 10% to 25%.

(3)     This is achieved by allowing a deduction for an “investment allowance” in computing the amount subject to tax

(4)     Assuming that they are “qualifying persons” for the purposes of the “Limitation of Benefits” in Article XXIX-A of the Treaty. This would generally be the case if all or most of the shareholders are U.S. residents for the purposes of the Treaty. For the purposes of this article, it will be assumed that any U.S. corporation envisioned in a “qualifying person”.

(5)     This latter point is significant in connection with corporations used in connection with artistic and athletic endeavors-because of Article XVI, federal corporate taxes under Part I may be applied even if there is no PE.

(6)     Note that for Canadian tax purposes, a LLC is treated and taxed as a corporation.

(7)     This still the position of the CRA, and was confirmed by various comments in the Technical Explanation to the 2007 Protocol.

(8)     Because the LLC, itself, is not “liable to tax” (federally) in the U.S., as required by Article IV(1)

(9)     See CRA Document 2009-0339951E5

(10)CRA Document 2004-0064761R3