In considering a prospective investment in the United States via a partnership, Canadian investors should keep U.S. tax issues in mind, in addition to other relevant U.S. and Canadian legal and tax issues. This article highlights some big-picture U.S. federal income tax issues that Canadian investors would do well to be aware of when considering this type of investment.
The discussion assumes an individual Canadian resident investor that is not also a U.S. citizen or resident and that is considering one or more U.S. investments through one or more partnerships, although many of the same issues would apply to a Canadian corporate investor as well. Each real-life investment opportunity will need to be analysed in detail based on its specific facts and its specific governing legal documents, but knowledge of some of the potential traps for the unwary can help an investor to avoid or mitigate them.
Classification as a Partnership for U.S. Tax Purposes
Most investment opportunities into entities treated as partnerships for U.S. tax purposes will involve a limited partnership (whether organized under U.S. or Canadian law). However, the classification of a legal entity as a partnership (or otherwise) for U.S. tax purposes is largely elective, and therefore at times other types of entities, such as limited liability companies, may also be treated as partnerships for these purposes. Less frequent, but not unheard of, is an entity organized as a limited partnership that is treated as a corporation, rather than as a partnership, for U.S. tax purposes.
Therefore, a preliminary matter to confirm is whether the investment vehicle in question is classified as a partnership for U.S. tax purposes (and if it isn’t, how is it classified?), no matter what label is put on the vehicle for other purposes, such as U.S. state or Canadian provincial law. The remainder of this article uses the term “partnership” to refer to an entity treated as such for U.S. tax purposes, and the relevant principles can be extended to multiple types of entities that are classified as such.[1]
Pass-Through Taxation of Partners
Perhaps the most salient feature of a partnership in this context is that the partnership is a pass-through entity for U.S. tax purposes, which means that the amount and nature of the partnership’s income and deductions generally “pass through” to its partners, including non-U.S. partners, with implications on partners’ tax liabilities and filing obligations. This pass-through treatment applies whether or not the partnership distributes anything to its partners and applies through multiple tiers of partnerships. This principle has different results in different contexts, as discussed below.
U.S. Business
A non-U.S. person deemed for U.S. tax purposes to be engaged in a business[2] within the United States is subject to U.S. federal income taxation on that person’s net income that is treated as being “effectively connected” with that business. A non-U.S. person in this situation is required to file a U.S. federal income tax return and to pay taxes on the “effectively connected” income. Few will be surprised that in the case of, say, a Canadian citizen who travels to the United States for a period of time to engage in business activities will be subject to U.S. on the income earned in the United States. Perhaps less intuitive is that a non-U.S. partner of a partnership (whether that partnership is organized in the United States or elsewhere) is deemed to be engaged in any U.S. business the partnership is engaged in, no matter how small an interest such partner might own in the partnership, and even if such partner is a totally passive investor. This attribution of a partnership’s U.S. business applies through multiple levels of partnerships, so a non-U.S. partner can be treated as engaged in a U.S. business conducted by a partnership in which such person has only indirect ownership through one or more tiers of partnerships.
A partnership with non-U.S. partners that is deemed to be engaged in a U.S. business is required to withhold a portion of the non-U.S. partners’ income and pay it over to the IRS. Additionally, such a partnership may be required to withhold taxes on a redemption of a non-U.S. partner’s interest, and either a purchaser or the partnership itself may be required to withhold on a sale or disposition of that interest. Amounts withheld in respect of a partner may be claimed as a credit against that partner’s substantive U.S. tax liability when the partner files a U.S. tax return.
Some activities that are deemed to be the conduct of a business for these purposes may not strike an investor as a “business.” For example, a partnership that pools capital from its partners and regularly lends money to businesses or individuals in the United States is likely to be treated for U.S. tax purposes as engaged in a U.S. business, alongside more traditional businesses like a hair salon, a sandwich shop or a landscaping concern (not to mention a bank).
Since non-U.S. persons who aren’t already U.S. taxpayers typically do not wish to take on obligations to file U.S. returns and write checks to the U.S. Treasury, a Canadian investor investing in the United States via a partnership should investigate, as part of the diligence process, whether the partnership is expected to engage in a U.S. business, and possibly to seek contractual assurances in this regard, in order to avoid the U.S. tax consequences to a non-U.S. person of being a partner in a partnership engaged in a U.S. business. Such contractual assurances might include a commitment from the partnership not to engage in such activities (for example, in a case where a partnership’s intention is to invest only in publicly traded U.S. securities) or a commitment from the partnership to interpose a corporation between the non-U.S. partners and the U.S. business, as discussed below.
In a situation where engaging in a U.S. business cannot be avoided (for example, where the investment opportunity itself necessarily involves a U.S. business), the impact on a Canadian investor of investing through a partnership frequently can be mitigated by interposing one or more (often, though not necessarily exclusively) U.S. corporations between the Canadian investor and the U.S. business. The corporation itself would be subject to U.S. tax on its net income, but if structured properly, it can prevent the Canadian investor from being personally subject to U.S. net income tax and return filing obligations. The business of a corporation generally is not attributed to its shareholders in the way that a partnership’s business is attributed to its partners, so a Canadian investor generally would not be subject to U.S. tax on the operating income of the business and (with certain exceptions, notably with respect to “U.S. real property holding corporations,” as noted below), the Canadian investor would not be subject to U.S. tax on gain from a sale of such investor’s stock in the public or private markets. Interposing a corporation can be a simple and effective strategy when the investor’s goal is not to receive periodic distributions of operating income from the U.S. business, but rather to reap the benefit of the business’s growth via a future sale. In other cases, it may be more complex but can still be effective.
Investments in U.S. Real Property
Special rules (the statutory basis for which is often referred to as “FIRPTA”) require the gain or loss of a non-U.S. person from disposition of a “U.S. real property interest” to be taken into account as though the gain or loss were “effectively connected” with a U.S. business, resulting in similar obligations to pay U.S. taxes and file U.S. tax returns as described above. A partnership interest in a partnership that owns one or more U.S. real property interests is considered itself to be a U.S. real property interest on a look-through basis, and withholding of taxes in respect of a non-U.S. partner may be required in the event of the partnership’s disposition of a U.S. real property interest or a redemption or other disposition of the non-U.S. partner’s interest in the partnership. Again, amounts withheld in respect of a partner may be claimed as a credit against that partner’s substantive U.S. tax liability when the partner files a U.S. tax return.
For example, imagine a Canadian partner in a partnership that purchases and passively holds for investment a vacant lot located somewhere in the United States, and the partnership later sells the vacant lot at a gain. Although passively holding a vacant lot may not itself be a business for U.S. tax purposes, FIRPTA would treat the Canadian partner’s share of the gain as effectively connected with a U.S. business simply because it is U.S. real estate. The definition of a U.S. real property interest is not always obvious. In addition to land and buildings in the United States, other categories of U.S. real property interests can include mineral interests, certain items that would ordinarily be considered personal property but that are incorporated into real property such as a building, and “any interest other than an interest solely as a creditor” (such as stock or convertible debt) in a U.S. corporation that cannot be determined not to be a “U.S. real property holding corporation,” which means interests such as stock or convertible debt in a corporation 50% or more of the assets of which (measured using prescribed rules) consist of U.S. real property interests. An important exception to the imposition of U.S. tax on the disposition of stock in a U.S. real property holding corporation exists for a non-U.S. person that owns (after the application of certain constructive ownership rules regarding related party ownership) no more than 5% of a publicly traded class of shares. This exception can allow an investment in shares of a private U.S. real property holding corporation that later goes public to be disposed of without imposition of U.S. tax on a non-U.S. investor.
Investments Not Involving a U.S. Business or U.S. Real Property
Many investment partnerships, such as those whose assets consist of corporate stock and/or bonds, generally would not be treated as engaged in a U.S. business. However, a Canadian partner in such a partnership would be subject to U.S. withholding tax on certain types of U.S.-source income of the partnership. This withholding tax is applied on a gross basis (i.e., without any deductions for expenses) at a rate of 30% (which rate may be reduced, including in certain circumstances to zero, by the U.S.-Canada Income Tax Treaty). Dividends of U.S. corporations and royalties that are deemed to have a U.S. source are examples of payments subject to this withholding tax, subject to possible treaty-based reduction. Most interest is exempt from this tax under the U.S. tax law’s “portfolio interest” exemption, and even interest that does not qualify for this exemption (such as interest paid by a U.S. corporation to a Canadian investor that, either alone or along with certain related parties, owns 10% or more of the voting stock of the corporation) may be exempted from U.S. withholding tax for a Canadian investor that qualifies for benefits under the U.S.-Canada Income Tax Treaty.
Importantly, this withholding tax is not imposed on capital gains from the sale of stocks and bonds. Therefore, a Canadian partner in a partnership that sells securities of U.S. issuers generally (subject to the FIRPTA rules regarding U.S. real property holding corporations discussed above) would not be subject to U.S. withholding or other taxes on the gain from disposition of those securities.
[1] Limited liability companies require special consideration in the case of cross-border U.S.-Canada investments because of a possible mismatch between the treatment of these entities under the U.S. and Canadian tax systems. Although an investor should always consider the application of both countries’ laws, investments involving limited liability companies are an excellent example of the importance of thinking about both U.S. and Canadian rules and of advisors on both sides of the border working together.
[2] The U.S. tax law uses the term “trade or business,” but since it does not differentiate between a trade and a business, the term “business” is used herein for simplicity.
