Foreign entity classification for Canadian income tax purposes: Canada Revenue Agency’s recent comments

Since Canada taxes a “person,” it is important to determine whether a foreign entity is classified by Canada Revenue Agency (“CRA”) as a corporation (and therefore a “person”) or something else, such as a partnership or a trust. The classification of a foreign entity by CRA will determine how Canadian tax laws, when applicable, apply to that particular entity. Misclassifying a foreign entity may lead to significant Canadian tax liability, including penalties, and interest.

At a conference earlier this year, when commenting on the classification of Luxembourg common limited partnerships (“Lux CLP”) and Luxembourg special limited partnerships (“Lux SLP” and together with Lux CLP, “Lux LPs”), CRA confirmed the approach it takes when classifying foreign entities.[1]

Two-step approach

First, CRA determines the characteristics of the foreign entity under the applicable foreign law. This first step requires a review of the foreign entity’s constating documents, contracts and other relevant documents applicable to the foreign entity.

The second step is a comparison of the foreign entity’s characteristics with comparable Canadian entities.

Lux LPs and reverse hybrid rules

An interesting aspect of Lux LPs is that their tax treatment is dependent on how they are treated in other jurisdictions. Generally speaking, for Luxembourg purposes, it is the author’s understanding that Lux LPs are fiscally transparent under Luxembourg laws, unless investors of the applicable Lux LP are located in a jurisdiction that treats them as fiscally opaque. In such circumstances, Luxembourg’s reverse hybrid rules may apply, resulting in the Lux LP no longer being fiscally transparent in Luxembourg. As mentioned in CRA’s response, under Luxembourg laws, Lux CLPs have a legal personality but Lux SLPs do not.

Additional entity classification guidance

CRA declined to comment specifically on how it classifies Lux LPs but said it would if the question was in the form of an advance income tax ruling request. Notwithstanding, CRA offered some general comments on the topic of foreign entity classification and the classification of the Lux LPs. These general comments are as follows:

1. The fact that the Lux CLP has separate legal personality under Luxembourg laws is not on its own determinative of how CRA will classify a Lux CLP.
2. The classification of an entity for foreign tax purposes is not generally relevant to the classification of the entity in Canada under the two-step approach. In other words, how an entity is treated for tax purposes in a foreign jurisdiction is generally not relevant to the classification of the entity in Canada by CRA. In that regard, the Canadian classification of the entity for purposes of applying the provisions of the Income Tax Act (Canada) (the “Act”) only informs the application of Luxembourg’s reverse hybrid rules where Canada views a Lux LP as being taxable in Luxembourg for Canadian income tax purposes.
3. The existence and potential application of Luxembourg’s reverse hybrid rules would generally not determine the characterization of the entity or arrangement for purposes of the Act under the two-step approach.

If you have any questions regarding foreign entity classifications for Canadian income tax purposes, please contact a member of the Miller Thomson LLP Corporate Tax group.

[1] Canada Revenue Agency, Views 2024-1007541C6: IFA 2024 Q2 – Foreign Entity Classification — Section 248(1) « corporation », online: https://v3.taxnetpro.com/.