Cross-Border Partnership With Canadian and U.S. Partners: Section 1446 Withholding, Forms 8804 and 8805, and the Canadian Partner's Return

A partnership with partners in two countries collects tax for the government of one of them on behalf of a partner from the other. The withholding — section 1446(a): a partnership (or an LLC taxed as one) with income effectively connected with a U.S. trade or business must pay a withholding tax on the effectively connected taxable income allocable to its foreign partners — at the highest rate applicable to that partner's type (37 percent for an individual — the top section 1 rate — and 21 percent for a corporation) — whether or not it makes any distribution; the partnership pays quarterly installments (Form 8813) during the year, files Form 8804 (the annual return) and Form 8805 (a statement to each foreign partner showing the partner's share of the income and the tax paid on their behalf) after year-end; the foreign partner claims the tax as a credit on their own U.S. return (Form 1040-NR for an individual, 1120-F for a corporation — attaching the 8805); the partnership is liable for the tax if it fails to withhold; a foreign partner can certify partner-level deductions and losses — loss carryovers and suspended losses from earlier years, not current-year items or charitable deductions — to the partnership on Form 8804-C to reduce the withholding. The treaty doesn't remove it: a Canadian partner in a U.S. partnership engaged in a U.S. business has a U.S. permanent establishment through the partnership (U.S. courts applying this treaty — Donroy and Unger — attribute a partnership's fixed place of business to each partner, limited partners included), so the treaty's business profits protection doesn't apply, and the United States taxes the Canadian partner's share; the withholding is a prepayment of that tax. The sale — section 1446(f): when a foreign partner sells or redeems their interest in a partnership engaged in a U.S. trade or business, the gain is effectively connected income to the extent the partner would have had effectively connected gain had the partnership sold all its assets at fair market value (section 864(c)(8)) and the buyer must withhold 10 percent of the amount realized — and if the buyer fails, the partnership must withhold from its distributions to the buyer (transfers after 2022) — unless an exception applies (a partnership certification that less than 10 percent of its gain on a deemed sale would be effectively connected eliminates it, and the seller's certification of its maximum tax liability can cap it); a redemption or a distribution exceeding the partner's basis is itself a transfer on which the partnership withholds, though a partnership that determines from its books and records that a distribution produces no gain need not withhold. The U.S. side for the Canadian partner: a Form 1040-NR (or 1120-F) every year reporting the effectively connected income from the K-1 (the partnership issues a Schedule K-1 and the K-3 for the international items), claiming the 8805 credit, and reporting any other U.S. income; the state returns for the states where the partnership operates (with the states' own nonresident withholding or composite returns — Florida has no personal income tax, so a Florida partnership's individual partners have no state return there; other states do); the partner needs an ITIN (individual) or EIN (corporation — the Canadian ITN guide's U.S. counterpart). The Canadian side: a Canadian-resident partner is taxed on their share of the partnership's income in Canada — if the entity is a partnership under Canadian law; a U.S. limited partnership or general partnership is a partnership for Canadian tax unless it is a Florida or Delaware LLP or LLLP formed after April 25, 2017, which the CRA treats as a corporation (flowing through — the partner reports the share on T2125 or T776 or as investment income, with the foreign tax credit for the U.S. tax actually paid, which the 8805 withholding and the final 1040-NR establish); a U.S. LLC taxed as a partnership is a corporation for Canadian tax (the Canadian resident owning a U.S. LLC guide's hybrid problem) — the Canadian member is treated as a shareholder of a foreign affiliate: no current Canadian income from the LLC's active business (unless it's FAPI), Canadian tax only on distributions as dividends — while the United States taxes the member's share currently through the partnership rules; the mismatch defers Canadian tax but can strand the U.S. tax as a credit with no matching Canadian income in the year (and an individual's unused foreign non-business income tax credits cannot be carried forward); so a Canadian joining a U.S. venture asks for a limited partnership (or an LLC that elects corporate status, or a Canadian blocker corporation) rather than an LLC. The Canadian partner's foreign reporting: T1135 for the partnership interest if it is specified foreign property costing more than C$100,000 — though a partnership in which Canadian residents hold more than 10 percent of the income files any T1135 itself, and its Canadian partners don't report the interest (the T1135 guide), or T1134 if the LLC is a foreign affiliate (at least 1 percent owned directly and 10 percent with related persons); the Canadian partnership information return (T5013) is required only of a partnership that carries on business in Canada or is a Canadian partnership (all members resident in Canada), so a U.S. partnership operating only in the United States files none. The U.S. partners: their own returns as usual; the partnership's agreement allocates the 1446 tax to the foreign partner's capital account (a deemed distribution to that partner) — the agreement should say so explicitly, because the tax paid for one partner is not a partnership expense shared by all. The bookkeeping: partners' residency and documentation (W-8BEN or W-8BEN-E from foreign partners, W-9 from U.S. partners — the partnership must know who is foreign); the effectively connected income allocable to each foreign partner; Form 8813 quarterly payments; Forms 8804 and 8805; the K-1 and K-3; the 1446(f) analysis on any transfer or redemption; the agreement's allocation of the withholding to the foreign partner's capital account. The errors: no 1446 withholding because the partnership "didn't distribute anything" (the tax is on allocable income, not distributions); the withholding charged to all partners as an expense; a Canadian partner admitted without a W-8 (the partnership doesn't know it's foreign); the Canadian partner never filing a 1040-NR (the credit unclaimed, the U.S. tax overpaid at 37 percent); an LLC used for a Canadian investor without the hybrid analysis; and a buyout of a Canadian partner with no 1446(f) withholding.

Key takeaways

• A U.S. partnership with effectively connected income withholds tax on its foreign partners' allocable share — distributions or not — at the highest rate for the partner's type, paid quarterly (Form 8813) and reported on Forms 8804 and 8805.
• The treaty doesn't remove it: a partnership's U.S. business gives its Canadian partner a U.S. permanent establishment.
• A sale or redemption of a foreign partner's interest triggers section 1446(f) withholding of 10 percent of the amount realized.
• The Canadian partner files a U.S. nonresident return to claim the 8805 credit — and reports the share in Canada with a foreign tax credit, if the entity is a partnership for Canadian purposes.
• A U.S. LLC is a corporation for Canadian tax — the Canadian member's mismatch can strand the U.S. tax; use a limited partnership, an LLC electing corporate status, or a Canadian blocker.
• The partnership agreement must charge the 1446 tax to the foreign partner's capital account, not share it as an expense.

The cross-border partnership file

Partner documentation (W-8 or W-9). Effectively connected income by foreign partner. Form 8813 quarterly; Forms 8804 and 8805; K-1 and K-3. Partner-level deduction certifications (8804-C). 1446(f) on transfers and redemptions. Agreement: withholding charged to the foreign partner. Canadian partner: 1040-NR with the 8805; Canadian reporting and foreign tax credit; T1135 or T1134; entity classification in Canada. The W-8 at admission is the item the partnership needs first.

Worked example

Three partners form a Florida limited partnership to own and operate a self-storage facility in Orlando: two U.S. residents and a Calgary investor with a 40 percent interest (the entity chosen as a limited partnership, not an LLC, after the Canadian investor's adviser flagged the hybrid problem). Year three: US$500,000 of effectively connected taxable income; US$200,000 allocable to the Canadian partner — 37 percent withholding of US$74,000, paid quarterly on Form 8813 by the partnership, reported on Forms 8804 and 8805, and charged to her capital account under the agreement; the partnership distributed only US$80,000 to her that year (the withholding was owed on the allocable income regardless). Her Form 1040-NR reports the US$200,000 and claims the US$74,000 credit — her actual U.S. tax at graduated rates is about US$41,000, and the excess (about US$33,000) is refunded (she later certifies deductions on Form 8804-C to reduce future withholding). In Canada, the limited partnership is a partnership — she reports her share on her T1 (rental income on T776, or business income on T2125 if the facility provides services beyond the space itself) with a foreign tax credit for the US$41,000 of final U.S. tax; because Canadian residents hold more than 10 percent of the partnership's income, the partnership itself files any T1135 required for its U.S. property, and she doesn't report her interest. Five years later, the U.S. partners buy her out: her certification of her maximum tax liability (her effectively connected gain, from the partnership's figures, times the applicable rate) limits the section 1446(f) withholding, and her gain is reported on her 1040-NR and in Canada. A similar venture structured as a Florida LLC left its Canadian member with U.S. tax on income Canada didn't see until distributed.

Official sources

The IRS explains: “Under section 1446(a), a partnership (foreign or domestic) that has income effectively connected with a U.S. trade or business (or income treated as effectively connected) must pay a withholding tax on the effectively connected taxable income (ECTI) that is allocable to its foreign partners.” — Internal Revenue Service, Partnership withholding, https://www.irs.gov/individuals/international-taxpayers/partnership-withholding

Publication 597 explains: “This publication provides information on the income tax treaty between the United States and Canada. It discusses a number of treaty provisions that most often apply to U.S. citizens or residents who may be liable for Canadian tax.” — Internal Revenue Service, Publication 597 (10/2015), Information on the United States–Canada Income Tax Treaty, https://www.irs.gov/publications/p597

Practitioner note

A U.S. partnership with a Canadian partner collects U.S. tax on that partner's share of the business income every quarter, whether it distributes a dollar or not — and the treaty doesn't stop it, because the partnership's U.S. business is the partner's permanent establishment. Our desks document every partner at admission, run the section 1446 withholding through Forms 8813, 8804, and 8805 with the tax charged to the Canadian partner's capital account, file the partner's Form 1040-NR to recover the excess, and choose a limited partnership over an LLC at formation — because the LLC that Canada treats as a corporation can leave the U.S. tax with no Canadian income to credit it against.

See also: For related guidance, see owning U.S. S corporation or partnership interests from Canada; and browse every cross-border tax topic guide, organized by situation.

Next step

Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk and Canadian Tax Desk handle cross-border partnerships — partner documentation, section 1446(a) withholding with Forms 8813, 8804, and 8805, partner-level deduction certifications, section 1446(f) on transfers and redemptions, partnership agreement allocations, Canadian partners' U.S. nonresident returns and Canadian reporting, and entity classification at formation. See pricing or book a call.