Written by Enzo Morini | Williams and Antonio Calabria
The use of an Unlimited Liability Company (“ULC”) continues to be a unique and favoured vehicle by U.S. acquirors of Canadian businesses or of U.S. businesses expanding into Canada.
Currently, a ULC can be formed under legislation in Alberta, Nova Scotia, Prince Edward Island or British Columbia. Shareholders of a ULC are generally insulated from liability for the debts and activities of the company. However, shareholders are liable for the ULC’s debts and liabilities if the ULC liquidates or dissolves and cannot pay such accounts.
Under the Income Tax Act (the “Act”), a ULC is treated like any other corporation. Like any other corporation, a ULC is eligible for protection under the Canada-U.S. Tax convention.
U.S. Tax Treatment of a ULC
For U.S. tax purposes, a ULC is classified as a branch if there is only one shareholder or a partnership if there is more than one shareholder. If it is classified as a branch or a partnership, then the ULC is treated as a flow through entity.
As a result, a ULC is called a hybrid entity whereby it is recognized as a corporation for Canadian tax purposes and a flow through entity for U.S. tax purposes.
Individual Investor in a Canadian ULC
A U.S. individual can consider a direct investment in a Canadian ULC. However, in order to provide for asset protection and further tax efficiency, a U.S. individual investor should consider using an “S” corporation in the U.S. as an intermediary.
The use of an “S” corporation in the U.S. results in the flow through of income or losses of the “S” corporation to the shareholder rather than being taxed at the entity level. The individual shareholder will benefit from flow through treatment from the ULC while also being insulated from the liabilities of the ULC. In addition, the U.S. investor will benefit from a lower withholding tax rate on dividends of 5% rather than 15%.
Although the use of a Limited Liability Company (“LLC”) is a favoured vehicle for U.S. investors in U.S. businesses, the use of an LLC should be avoided as the Canada Revenue Agency (“CRA”) does not consider an LLC to be a resident of the U.S. for treaty purposes. As a result, treaty benefits such as the reduced rate of withholding tax are not available to an LLC.
In addition to allowing for the flow through of income or losses of an ULC to an individual via an “S” corporation, an individual will be able to claim a foreign tax credit on their individual U.S. tax return for Canadian taxes paid by the ULC.
U.S. Corporate Investor in a Canadian ULC
Where a U.S. corporation is the sole shareholder of a ULC, the ULC will be disregarded as an entity separate from its shareholder, unless it elects otherwise. As a result, the ULC’s income or losses will be consolidated with that of its U.S. parent. The consolidation of income generally enables the U.S. parent to claim foreign tax credits in the U.S. to offset Canadian tax paid by the ULC. This structure will allow for a U.S. parent with a ULC subsidiary to pay less total tax than if the U.S. parent used a regular corporation as a subsidiary.
Lastly, a ULC’s retained earnings can be repatriated to the U.S. parent with only a 5% withholding tax. However, the repatriation requires a unique two-step distribution process.
Generally, dividends paid by a Canadian corporation to a non-resident are subject to a 25% withholding tax under Part XIII of the Act. However, the rate of withholding tax may be reduced under Canada’s bilateral tax treaties. The rate is reduced to 5% under the Canada-U.S. Tax Convention if not for an anti-avoidance rule contained in Articles IV(7)(b) of that treaty. Article IV(7)(b) is an anti-avoidance rule that applies to entities know as hybrids – such as a ULC.
The different treatment of hybrids in different countries can be used to reduce tax in in a way that may be viewed as abusive depending on the circumstances. As a result, Article IV(7)(b) was added to the fifth protocol to the Canada-U.S. Tax Treaty.
Dividends paid by a ULC to its U.S. parent falls within the Article IV(7)(b) anti-avoidance rule, thereby preventing a reduction of the 25% Part XIII withholding tax. The reason being that:
- Canada views the U.S. parent as receiving the dividend from a corporation resident in Canada;
- the ULC is treated as fiscally transparent in the U.S.; and
- since the ULC is treated as fiscally transparent, the dividend is disregarded for U.S. tax purposes whereas it would not be disregarded if the ULC were not treated as fiscally transparent.
The distribution of retained earnings by a ULC to its U.S. parent is understood to be a transaction that is not abusive but caught under Article IV(7)(b). The CRA agrees with this view and issued a positive ruling with respect to a method to allow retained earnings of a ULC to be repatriated with a 5% withholding rate under what is now known as a two-step distribution.
The first step requires the ULC to increase the paid-up-capital (“PUC”) on a class of its shares by capitalizing retained earnings. The increase in PUC on a class of shares by capitalizing retained earnings triggers a “deemed dividend” on those shares for purposes of Canadian taxation. The amount of the dividend equals the increase in PUC. The amount of the deemed dividend is subject to withholding tax at a reduced rate of 5% under Part XIII of the Act.
The deemed dividend is disregarded for U.S. tax purposes regardless of whether the ULC is fiscally transparent or not. As a result, the third requirement of Article IV(7)(b) is not met and therefore not applicable.
The second step requires the ULC to reduce its newly created capital and distribute that amount to its U.S. parent. A reduction of PUC does not give rise to Canadian taxation provided the reduction does not exceed the amount of PUC on that class of shares. As a result, the ULC will be able to return capital to its U.S. parent without triggering further tax in Canada or the U.S.