Foreign Entity Classifications

“The actual process of classifying an entity for Canadian tax purposes is difficult.”

Canadian resident taxpayers often invest in foreign entities that are not easily comparable to Canadian legal entities or relationships.  Accordingly, Canadian tax advisors may be left scratching their heads, wondering how to deal with the foreign entity.  Should the investment in the foreign entity be reported under Canada’s foreign reporting regime?  If the foreign entity is earning income, should the Canadian resident investors be directly reporting such income on their tax returns?  If the foreign entity is earning passive income (such as interest or rental income) do Canada’s foreign affiliate passive income (“FAPI”) rules apply?  If a tax treaty between Canada and the foreign country exists, how does it deal with the type of entity (if at all)?

For example, how does Canada view a United States Limited Liability Company (“LLC”)?  A United States Limited Liability Limited Partnership (“LLLP”)?  A Chinese Foreign Contractual Joint Venture? Austrian Foundations? An Italian Società cooperativa a responsabilità limitata? There is no shortage of other examples.

The Canada Revenue Agency has outlined, in Income Tax Technical News No. 38 (Sept. 22, 2008), its approach to classifying entities:

  “… to determine the status of an entity for Canadian tax purposes, we generally follow the two-step approach described below:

  1.  Determine the characteristics of the foreign business association under foreign commercial law;
  2. Compare these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories.

Even if we consider all the characteristics of an entity, the most important attributes are the nature of the relationship between the various parties and the rights and obligations of the parties under the applicable laws and agreements.”

One can view the above as a “one size fits all” approach, and ultimately, it is.  After applying the above two-step approach (which is easier said than done), the analysis will need to conclude whether or not the foreign entity is similar to a corporation, a partnership or a trust or some “other” legal relationship under Canadian law.  For example, using the above-noted approach, the CRA has concluded that U.S. Limited Liability Companies should be treated as corporations in Canada even though they are disregarded or considered partnerships by the IRS.

Once the entity has been classified, then the Canadian tax consequences of holding such a foreign entity can be determined.  The actual process of classifying an entity for Canadian tax purposes is difficult for tax practitioners and the CRA.  In fact, there are many types of entities that the CRA has declined to classify.  This difficulty in classification makes planning harder for practitioners but should not be ignored, as it is critically important.

If you are investing in or currently own foreign entities, you should contact your TSG advisor to assist you with the question of foreign entity classification.

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