US LLC Double Taxation in Canada

Contact Neufeld Legal for Canadian incorporation legal work at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The fundamental cause of double taxation for a US Limited Liability Company (LLC) owned by a Canadian resident (or forming part of certain cross-border tax structures) lies in a "hybrid mismatch" of entity classification. To the United States Internal Revenue Service (IRS), an LLC is typically treated as a "pass-through" or "disregarded" entity, meaning the business itself is not taxed; instead, its income flows directly to the owners. However, the Canada Revenue Agency (CRA) does not recognize this flow-through status. Under Canadian tax law, a US LLC is viewed as a distinct legal entity separate from its owners, essentially a foreign corporation. This divergence creates a situation where the two countries are taxing two different "taxpayers" on the same income at different times and under different classifications.

US Tax Obligations: Current Year Income From the US perspective, the Canadian owner is taxed immediately when the income is earned by the LLC. Because the US views the LLC as a partnership (or a disregarded entity if single-member), the income retains its character (e.g., active business income) and is allocated to the individual member in the year it is generated. The Canadian owner must file a US non-resident tax return (Form 1040-NR) and pay US federal and state income taxes on their share of the LLC's profits. Crucially, the US considers this tax to be paid by the individual on business income.

Canadian Tax Obligations: Taxation on Distributions From the Canadian perspective, the LLC is a corporation. Consequently, the CRA does not tax the Canadian resident on the LLC’s income as it is earned. Instead, Canada waits until the LLC distributes that money to the owner. When the owner moves the money from the US LLC to their personal account, the CRA views this transaction as a receipt of a foreign dividend. This dividend is fully taxable at the individual’s marginal tax rate in Canada. The problem is compounded because the CRA does not view the underlying US tax paid by the individual as a tax on this dividend; they view it as a tax on the LLC's business income.

The Failure of Foreign Tax Credits The mechanism that usually prevents double taxation, the Foreign Tax Credit (FTC), often fails in this specific scenario. To claim a foreign tax credit in Canada, the foreign tax must typically be of the same nature (e.g., income tax on dividends) and paid by the same taxpayer. However, because Canada treats the income as a "dividend" and the US tax was paid on "business income" (and often in a different tax year if profits weren't distributed immediately), the CRA often denies the credit. The Canadian resident cannot use the US taxes paid to offset the Canadian taxes owed on the dividend.

Resulting Effective Tax Rates and Treaty Limitations The cumulative effect of this mismatch is true double taxation. The income is taxed once by the US (up to 37% federal + state tax) and then again by Canada (up to 53% marginal rate) with little to no relief, potentially leading to an effective tax rate exceeding 70%. While the Canada-US Tax Treaty was updated (Fifth Protocol) to help US residents claim benefits on Canadian LLCs, it offers little protection for Canadian residents owning US LLCs. The treaty benefits generally apply to the US taxes, but they do not force Canada to change its domestic classification of the entity, leaving the Canadian owner fully exposed to the double tax trap.

So if your United States-based business enterprise is looking to undertake business in Canada, or is currently engaged in business in Canada, and requires incorporation-related legal services, contact our law firm at 403-400-4092 / 905-616-8864 or via email at Chris@NeufeldLegal.com.

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