Blog Alert – Repatriating U.S. Earnings to Canada
Repatriating corporate earnings from the U.S. to Canada may involve alternative strategies. These include using U.S. earnings to repay debts payable to its Canadian shareholder, management fees, dividends, and liquidating distributions. Let’s explore the key aspects and considerations when repatriating U.S. earnings to Canada.
Debt Repayment
In general, the repayment of debts including interest incurs no U.S. tax, provided qualifying interest is taxable solely in Canada. However, non-qualifying interest faces a 15% U.S. withholding tax. It’s crucial to adhere to market terms for interest, repayment terms, and other specifics. Absent market terms the IRS may recharacterize debt as equity and subject both the payment of principal and interest payment to a dividend subject to U.S. withholding tax at rates between 5% and 30%.. Repayments of debt are not taxable in Canada, but interest is taxable in Canada. Interest paid by US taxpayers to related non-US persons.
Management Fees
Generally, management fees are deductible in the U.S. but are taxable in Canada. Understanding the federal and state corporate tax rates in the U.S. (averaging around 26% depending on the applicable state) versus Canadian corporate tax rates (ranging from 11% to 27%) is essential for effective financial planning.
Deductible payments to non-U.S. persons must be ordinary and necessary expenses for the benefit of the U.S. business. They are deductible in the U.S. even if rendered outside the U.S. Payments to related non-U.S. persons are only deductible in the year of payment and must reflect “arms-length” terms. Disclosure of payments to or from related non-U.S. related parties using IRS Form 5472 is mandatory. The IRS may assess a $25,000 penalty for non-compliance.
Dividends
Different U.S. withholding tax rates apply to dividends. . Canadian corporations owning at least 10% of U.S. voting shares face a 5% U.S. tax on dividends, while other qualifying Canadian residents are subject to a 15% tax. The statutory U.S. withholding rate of 30% applies to all others.
Canadian corporate tax may not apply to dividends received by it if they are from its U.S. subsidiary’s “exempt surplus”. Generally, exempt surplus arises from an active business in a U.S. The Canadian corporation must own at least 10% of its U.S. subsidiary. Generally, dividends that are not exempt surplus will be taxable when received by a Canadian corporation. When the recipient Canadian corporation pays out the exempt surplus received by it, they will qualify as eligible dividends subject to a preferential Canadian personal tax rate.
Distributions with respect to shareholdings are only dividends for US tax purposes when they are paid out of the U.S. corporation’s current or accumulated earnings and profits. Earnings and profits are neither taxable nor book income, but reflect the U.S. corporation’s economic ability to pay out its earnings.
Corporate distributions are required to follows a specific order. Payments are dividends to the extent of current or accumulated earnings and profits. Then a return of capital to the extent of the recipient’s U.S. tax basis. All amounts over earnings and profits and U.S. tax basis are capital gains for U.S. tax purposes.
Liquidating Distributions
Distributions arising from the complete liquidation of a U.S. corporation are not subject to U.S. Certain exceptions to this rule may apply. While these distributions may not incur U.S. withholding tax, they are taxable in Canada.
Upstream Loans
Loans from a U.S. subsidiary to a Canadian shareholder may be reclassified as dividends, leading to U.S. withholding tax where the payor has earnings and profits. Upstream loans should only be considered for periods of 1 year or less, have market terms including interest, for specific and well-defined purposes and be used with caution.
Conclusion
There are several strategies to repatriating U.S. earnings to Canada. Consideration should be given to these from the moment a U.S. entity is formed. Any plan to repatriate should consider all of these strategies and which best aligns with the corporation’s primary objective.
Please call us for more information, also see our webinar on Repatriating U.S. Earnings to Canada.
