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United States Limited Liability Limited Partnerships – Are you ready for the Canada Revenue Agency’s new hybrid creation?
Canadians who thought they had invested in a partnership when they invested in a US Limited Liability Limited Partnership (LLLP) may be surprised in the coming weeks to find they actually own a “hybrid entity”. No, this isn’t some new genetically modified plant or Frankenstein monster. It’s, for example, an entity which is treated as a partnership in one country, but taxed like a corporation in the other country. Another common hybrid entity Canadians may be familiar with is the US Limited Liability Corporation (LLC). Basically, a hybrid entity is one that is fiscally transparent in one country and not in another. An entity is fiscally transparent if profits are taxable directly in the owners’ hands, regardless of whether any distributions were made to the owners. Based on Canada Revenue Agency (CRA) comments, it appears the CRA is soon going to decree that a US LLLP is a corporation for Canadian tax purposes, thus turning US LLLP interests held by Canadians into investments in hybrid entities. Does our firm agree with the CRA’s comments? No… but we will not debate that conclusion here. Instead, we discuss below the challenge that Canadians will face if the CRA’s position is correct.
As we discussed in a previous blog, the differential tax treatment between Canada and the US can result in significant tax inefficiencies, and this potential classification by the CRA of US LLLPs as corporations is not welcome news for any Canadian invested in, or through, such entities. To date, US LLLPs have been most pervasively used by real estate developers, but increasingly these entities are also being used by onshore hedge funds and private equity funds. And while we understand that a final determination has yet to be made by the CRA, we are already hearing from taxpayers who have been reassessed by the CRA as if their interests in a US LLLP were instead interests in a hybrid entity.
As a refresher, the US LLLP was created in the late 1990s and is a form of limited partnership (LP) that exists under numerous state partnership statutes. US LLLP characteristics are basically the same as the underlying LP, except that unlike an LP, the general partner does not have unlimited liability exposure. Thus, general partners, as well as limited partners involved in the control of the business of the partnership, should have their liability in respect of the US LLLP limited to the amount of their capital investment in the partnership – unless the liability resulted from that partner’s malfeasance. In Florida, a registered LP that wishes to become an LLLP can accomplish this simply by filing a short form and paying a small fee. And, like any other partnership in the US, an LLLP is a flow-through entity where income is taxed in the hands of the partners for US tax purposes.
A US LLLP arguably provides similar liability protection to what a Canadian taxpayer investing in an LP achieves by using a “shell corporation” to hold a nominal general partnership interest. Arguably, the use of this structure makes the additional liability protection flowing from the use of a US LLLP instead of an LP quite trivial. Unfortunately, the use of a US LLLP may come with a high tax cost which wouldn’t exist for Canadian taxpayers invested in a US LP. Interestingly, according to some of the Canadian partners in US LLLPs who have reached out to us for help, their investment in a US LLLP occurred purely by happenstance. Until recently, most Canadians didn’t know what a US LLLP was, and simply asked their US corporate lawyer to set up an LP. For a US taxpayer there is no difference in the taxation of a US LP compared to a US LLLP, so if LLLPs are enabled under the laws of that state, then it may make sense to use an LLLP, and US counsel would more than likely set up a US LLLP. Unfortunately, at the time, neither the investor nor the US corporate lawyer had any knowledge of the potential Canadian tax liabilities that might result from the CRA’s pending classification of the US LLLP as a corporation.
For Canadians who really just wanted the liability protection of an LP, but who may soon find that they have inadvertently invested in a hybrid entity, this inevitably raises the question of what, if anything, can be done? Is there any way to easily fix this? Can you convert from a US LLLP to a US LP without creating a taxable disposition or other tax consequences?
It is a relatively simple matter in the US to convert from a US LLLP to a US LP without creating tax consequences in that country. Even in Canada, the conversion from one type of foreign partnership to another type of partnership within the same country should be possible without tax implications. Unfortunately, if the CRA classifies a US LLLP as a corporation and a US LP as a partnership, then for Canadian taxpayers the change from corporation to partnership would, at least under existing rules, likely create a taxable disposition of the membership units held by the taxpayer, as well as a taxable disposition of the assets of the converting entity for Canadian tax purposes.
One of the current trends in the world of tax is the increased use of rectification as a remedy for errors that created unintended tax consequences. It is interesting to consider whether this might be a tool to remedy the “unfairness” created by a CRA pronouncement that US LLLPs are considered foreign corporations for Canadian tax purposes. Alternatively, it is not out of the question that the CRA might provide some form of grandfathering, or other relief, to help taxpayers avoid the unintended and potentially retroactive negative consequences resulting from the classification of a US LLLP as a corporation.
It would seem reasonable that if the CRA determines that US LLLPs will be classified as corporations, the CRA may wish to provide taxpayers relief from historical penalties and interest. For example, this could result from a failure to report foreign accrual property income, or to file T-1134 forms for an entity which retroactively becomes a foreign affiliate. Potential timing differences in respect to the taxation of income in the US versus in Canada, and the differential application of foreign tax credits to what would now be non-business income instead of business income may also create additional taxes that will be owing by the taxpayer.
The relief that the CRA provided when they changed their administrative treatment of single-purpose corporations a number of years ago could potentially be a precedent with respect to relief for Canadian partners in LLLPs. Historically, single-purpose corporations were used by Canadians to hold residential real property in the US in a fashion that mitigates the application of US estate taxes on death. The CRA had historically indicated they would not assess a taxable shareholder benefit in respect of the holdings of single-purpose corporations, provided the Canadian corporation had certain specific characteristics. However, this all changed relatively quickly with an announcement by the CRA in 2004 in Technical News No. 31R2. The CRA reversed their administrative position and indicated that going forward a taxable benefit would be assessed in these situations. Fortunately for taxpayers, however, with this reversal the CRA also announced that they would grandfather existing single-purpose corporations until either the corporation disposed of the US real property or the taxpayer disposed of their shareholdings in the corporation.
Arguably, the situation in respect of single-purpose corporations is materially different from the situation now with US LLLPs. With single-purpose corporations, the CRA had a stated administrative position which they then reversed. In contrast, the CRA does not currently have a position in respect of the entity characterization of US LLLPs. However, if we apply this precedent to the current situation, it is possible that the CRA could administratively grandfather Canadian partners of US LLLPs where they have been consistently filing as partners in a US partnership. It is unclear what this might look like in practice.
In addition to grandfathering the Canadian resident partners of these entities, we would encourage the CRA and the Department of Finance to consider providing additional relief in the form of a one-time rollover in respect of a disposition of the interests in a US LLLP to an entity that will be treated as a US partnership. These relieving measures would allow taxpayers to evaluate and choose the correct entity form for their needs. Again, what this would look like in practice is unclear.
If the CRA does not extend specific administrative relief at the time their pronouncement is made, then it may be possible for taxpayers to use the taxpayer relief provisions in the Income Tax Act (the Act) to reduce the retroactive impact. The taxpayer relief measures provide the Minister with discretionary powers to waive or cancel penalties and interest that would otherwise be payable where a taxpayer was unable to comply with the Act due to circumstances beyond the taxpayer’s control. This could be as a result of extraordinary circumstances, actions of the CRA, or financial hardship. These provisions can be broadly applied and could be used to provide relief to Canadian-US LLLP partners if the CRA chooses to do so.
In the absence of CRA provided relief, rectification may be an attractive option. Rectification is an equitable remedy granted by provincial courts instead of by the Tax Court of Canada. In Canada, the use of rectification has evolved to include changing the terms of a transaction, or even to adding steps to a series of transactions, in order to eliminate unintended tax results.
In the case of US LLLPs that were formed under the mistaken belief that they would be partnerships, from a Canadian perspective, clearly a Canadian court would not have the jurisdiction to change the form of these entities in the US. Therefore, some form of rectification would need to take place in the US. Assuming this is possible, it is not immediately obvious what should be done procedurally from a Canadian perspective in order to ensure recognition of that remedy by Canadian tax authorities.
Rescission is an equitable remedy available in the US which can be used to void a transaction that has already occurred, but the mistake which requires correction must either be a mistake of fact or of law. If successful, a rescission may be used to return the parties to their original rights and property. A US rescission order would partially solve the jurisdictional problems highlighted above, however, the US rescission doctrine is generally only available for tax purposes where the transaction is rescinded in the same taxation year in which the transaction in question occurred.
Reformation is effectively the US version of rectification. It is an equitable remedy that may be available in US state courts to correct or change a legal document. Reformation may be ordered if the parties to a binding agreement find that a related document does not conform to their agreement, either because of an error or fraud, however, clear and convincing evidence of the parties’ true intentions is required in order for this doctrine to apply. Reformation is frequently sought where one or both parties realize the effect of the document as written does not conform to what the parties understood or agreed, but it has already been recorded or filed with a governmental agency. Unlike rescission, reformation does not need to be completed in the same taxation year as the agreement was executed, however it is generally not retroactive with respect to its effect for federal tax purposes in the US unless the matter was purely clerical. For example, if a zero was left off a number in a contract, or something of that nature.  In this situation, where reformation would be respected and granted by the state judiciary but not recognized as retroactive for purposes of the US federal taxation authorities, it seems unlikely that a Canadian court would allow retroactive effect for a US reformation order.
Additionally, a US court generally does not have the right to impose a contract on parties who did not agree to the terms of the “reformed” contract; instead, the court can only impose upon the parties that which they already agreed upon (but which is not accurately expressed in the parties’ written agreement). In this case, it is unclear whether the application for a certain form of partnership to a state constitutes a contract that both parties have agreed to so that the doctrine of reformation could be applied.
Interestingly, it appears that some states, including Florida and Delaware, have statutory provisions which allow a “statement of correction” to be filed to correct any LP or LLLP document filed with the state, and which make the correction retroactively effective to the date of the document it corrects. Effectively, these states appear to allow for a form of statutory rectification which could be used to correct the situation where a US LLLP was mistakenly formed instead of a US LP. While it is not certain that corrections filed under these circumstances will be universally accepted by the state, particularly given the potentially large time delay between the formation of the partnership and the request for correction, it is our understanding that a request for correction should generally be accepted as a matter of course by the state, provided an error occurred. Further, because the change from LLLP to LP is not a taxable event in the US, there should be no taxable disposition for US tax purposes as a result of the correction.
Procedurally, the course of action to ensure that this form of statutory rectification granted by a US state is respected by the CRA is far from clear. The CRA generally likes to review every change with retroactive effect impacting taxes payable, and they seem determined to use the judiciary as the vehicle to do this. Recently, in the Canadian Forest decision, the Tax Court of Canada ruled on whether the Minister was required to respect foreign rectification orders. The court found that foreign rectification orders are not binding on the Canadian tax court, but will be considered. Effectively, the CRA would not be bound by the foreign rectification order unless it was first sanctioned by a domestic court to ensure the order did not conflict with the law of rectification in Canada. As previously mentioned, equitable remedies like rectification are the purvey of the provincial courts; however, it is unclear whether a provincial court would rule in respect of the characterization of a US entity, even if it is predominately or in fact entirely, held by Canadian investors.
In light of the recent decision in Canadian Forest, it is doubtful that merely obtaining statutory rectification in the US, and updating the partnership documents accordingly, would be sufficient for the change to be respected by the CRA. Canadian Forest suggests that where foreign rectification takes place a taxpayer should inform CRA, provide the CRA with an opportunity to have input into the foreign rectification order, and then have the order affirmed in a Canadian court. In this case, if a correction was made pursuant to US state statute there is no judicial order, however, the effect is similar. Therefore, we believe that it would be prudent to at least inform the CRA of the pending correction. Note that if the taxpayers attempt to correct the form of their partnership retroactively was not respected by the CRA then, as previously discussed, it is very likely that the conversion from a US LLLP to a US LP would result in a taxable disposition.
Additionally, while it appears that statutory rectification allowed by US states could be used to retroactively reform a US LLLP into an LP, this will not be a universally applicable solution. As a practical matter, if the Canadian taxpayer was merely a minority investor in a US LLLP this solution may not be welcomed by US majority partners who will be unaffected by the CRA’s classification of a US LLLP as a corporation. Other more complex transactional solutions may be necessary in these cases.
In 2018, the novel Frankenstein will be 200 years old. For those of you who haven’t read this classic novel, it tells the story of a young science student Victor Frankenstein who creates a grotesque but sentient creature in an unorthodox scientific experiment. Could the CRA’s treatment of US LLLPs fall into a similar storyline? Will the Canadian tax treatment of US LLLPs be a sentient but grotesque creature? It certainly might be. Let’s hope that this story doesn’t last as long, though. In the meantime, Canadian investors in US LLLPs should prepare and plan accordingly.
 There are a number of CRA rulings suggesting that provided there is no change in the rights of the owners, or to the underlying entity classification, for example the conversion from one type of corporation to another type of corporation, then it is likely there should be no taxable disposition of the membership units in the converting entity held by the taxpayer, or of the property and assets owned by the entity. See for example 2005-0109741R3 – Conversion of a French societé anonime into a French societé par actions similifiée and 2008-0272141R3 – Conversion of Delaware Corporation into a Limited Liability Corporation.
 For example, CRA document 2004–0104691E5 – Conversion of a Limited Liability Corporation to a Limited Partnership, where the CRA concluded that the conversion resulted both in a disposition by the shareholders of their interest in the LLC, and a disposition by the LLC of its underlying assets when the LLC converted to a Delaware Limited Partnership.
 For example in subsection 220(3.1) Waiver of penalty or interest — The Minister may, on or before the day that is ten calendar years after the end of a taxation year of a taxpayer (or in the case of a partnership, a fiscal period of the partnership) or on application by the taxpayer or partnership on or before that day, waive or cancel all or any portion of any penalty or interest otherwise payable under this Act by the taxpayer or partnership in respect of that taxation year or fiscal period, and notwithstanding subsections 152(4) to (5), any assessment of the interest and penalties payable by the taxpayer or partnership shall be made that is necessary to take into account the cancellation of the penalty or interest.
 CRA Information Circular IC07-1 Taxpayer Relief Provisions explains the situations where the relief that from penalty and interest that may be granted by this provision may be warranted. For example, as set out in paragraphs 23 and 24, The Minister may grant relief from the application of penalty and interest where the following types of situations exist and justify a taxpayer’s inability to satisfy a tax obligation or requirement at issue: (a) extraordinary circumstances (b) actions of the CRA (c) inability to pay or financial hardship. The Minister may also grant relief if a taxpayer’s circumstances do not fall within the situations stated in 23.
 Zhang v. Canada (Attorney General) provides a useful summary of the current state of the law in Canada in respect of rectification in tax cases. In this case, the court focuses on the parties’ intention at the time they entered the transaction. In order to grant rectification, there must be evidence that the taxpayer had a plan to avoid a specific tax issue, and had the intention to proceed with that plan, but made a mistake in drawing up the documents to implement the plan. Effectively, by having evidence to support their intent as described above, a taxpayer should be able to illustrate that they are not attempting to engage in rectification for the purpose of retroactive tax planning.
 See Rev. Rul. 80-58. Additionally, for a good description of current IRS practice in respect of rescission see “To Err Is Human; to Rescind, Devine”, Philip B. Wright, March 2012, Taxes – The Tax Magazine P.B. Wright.
 In Rev. Rul. 71-416 the IRS found that a nunc pro tunc order correcting a mathematical error was given retroactive effect for federal tax purposes, but that this was permissible only where there is a factual finding of an error of a clerical nature in a written nunc pro tunc decree.
 As examples of where the US Federal tax authorities have allowed retroactivity and where they have not, Rev. Rul. 71-416, 1971-2 CB 83, IRC Sec(s).71 details a nunc pro tunc amendment correcting a mathematical error in a divorce decree where the change was given retroactive effect for Federal tax purposes. In contrast, Rev. Rul. 74-582,1974-2 CB 34, IRC Sec(s). 104 includes two examples one whereof retirees whose status changed. Where the retiree who was eligible to retire based on physical disability chose to retire on the length of service, and then retroactively changed his designation to be retirement on physical disability, there was no retroactive applicability for the change for Federal tax purposes. For the other retiree, they also had a change in their status. They initially retired for length of service, rather than service connected disability, but then their situation was re-evaluated by their employer – the Armed Forces, and their retirement status was changed to service-connected disability. Effectively where the change was as a result of a re-evaluation by the employer, rather than personal choice, the associated Federal tax changes were applied retroactively.
 With respect to how the CRA might generally treat a rectification or reformation order granted by a state court in the US, it is interesting to consider the decision in Dale et al. v. The Queen. [In this case, the court discussed the role that the laws in other jurisdictions may play in the consideration of the application of the Act and found that the determination as to whether a legal transaction should be recognized for tax purposes depends on the law in the jurisdiction in which the transaction occurred. In Dale, the court was commenting on the applicability of provincial laws, but a similar analysis could likely also be applied to the foreign laws under which rectification or reformation was granted.
 Canadian Forest Navigation Co. Ltd. v. The Queen, 2016 TCC 43