Nova Scotia Unlimited Liability Companies

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1 The Alberta Unlimited Liability Corporation by Jack Bernstein and Sky Jondahl Jack Bernstein and Sky Jondahl are with Aird & Berlis LLP in Toronto. Nova Scotia Unlimited Liability Companies (NSULCs) have become popular entities for U.S. investors operating in Canada because of the ability to characterize them for U.S. tax purposes as either an ignored entity or as a partnership. To date, Nova Scotia is the only province with corporate law that allows for the incorporation of unlimited liability companies (ULCs). However, on April 11, 2005, Bill 16, Business Corporations Amendment Act, 2005, received a second reading in Alberta s legislature, and the bill is expected to pass a third reading and receive royal assent. Bill 16, which contains various amendments to Alberta s Business Corporations Act, R.S.A. 2000, c. B-9 (the Alberta Act), adds the concept of ULCs into Alberta corporate law (AULCs). (For prior coverage, see Tax Notes Int l, Apr. 11, 2005, p. 141.) The main advantage of using an NSULC or an AULC is that different tax treatment is afforded to ULCs in the United States and Canada. In Canada, NSULCs and AULCs are treated as corporations for tax purposes because they are incorporated under Nova Scotia or Alberta legislation. As a result, they do not have the character of a flow-through entity and are subject to Canadian federal and provincial corporate income tax. NSULCs or AULCs are not treated differently from limited companies incorporated in Canada under federal or provincial law. However, in the United States, NSULCs or AULCs may elect to be treated as flow-through entities. On January 1, 1997, the U.S. Treasury introduced the check-the-box regulations under sections to of the Treasury regulations. The regulations provide for two types of entities, per se corporations and eligible entities. Per se corporations are treated as corporations for U.S. tax purposes, while eligible entities can elect their classification. All corporations under Canadian federal and provincial law except NSULCs and AULCs are per se corporations. NSULCs and AULCs are excluded from the list of per se corporations as they are corporations formed under a Canadian federal or provincial law in which the liability of the members is unlimited. As a result, NSULCs and AULCs may be classified as branches for U.S. tax purposes (if there is only one shareholder) or as partnerships (if there is more than one shareholder), both of which are flow-through entities. This article provides background on the tax treatment of ULCs, compares Nova Scotia and Alberta corporate law, and suggests planning opportunities. Background on Nova Scotia ULCs As a result of inheriting old English companies law, Nova Scotia s Companies Act, R.S.N.S. 1989, c.81 (the Nova Scotia Act), is until Bill 16 passes the only corporate legislation in Canada that provides for the incorporation of ULCs. While other provinces adopted broad-based reforms to their corporate statutes, Nova Scotia kept the English companies law model, which permits three forms of companies: companies with liability limited by shares, companies with liability limited by guarantee, and companies with unlimited liability. NSULCs are formed under section 9 of the Nova Scotia Act, which permits a company to be incorporated with or without liability and not having any limit on the liability of its members. The members of NSULCs differ from the shareholders of limited companies as their liability is not limited: though the members are not directly liable to creditors, their liability is crystallized if the creditors petition the court for a winding-up order, or if the NSULC becomes bankrupt, and the creditors liabilities have not been satisfied by the company itself. Alberta s Response As outlined above, NSULCs are attractive corporate vehicles, and U.S. investors routinely incorporate NSULCs. The result is that other Canadian provinces have been losing revenue directly and indirectly by not having ULCs in their jurisdictions. Nova Scotia s provincial treasury has directly benefited from the incorporation and registration fees of NSULCs. In Canada, companies pay provincial tax if they carry on business in a province through a permanent establishment. Most NSULCs do not pay provincial tax as all business is carried on in other provinces. Thus, it is not surprising that the Alberta government has introduced Bill 16 and is amending its corporate legislation to allow for AULCs. In Tax Notes International August 8,

2 contrast to the Nova Scotia Act, however, the Alberta legislation is based on the modern Business Corporations Act model. Comparison of NSULCs and AULCs Formation and Fees An NSULC is formed in a similar manner to a Nova Scotia limited company, the primary difference being that the memorandum of association for an NSULC does not contain a statement that the liability of the members is limited. Generally, an NSULC is incorporated by filing a signed memorandum of association and articles of association, a solicitor s declaration concerning the propriety of the incorporation, and a list of officers and directors with the Nova Scotia Registrar of Joint Stock Companies. NSULCs may be created with or without share capital, though standard practice is for NSULCs to have share capital either with or without par value. When the company has share capital, section 12 of the Alberta Act provides that each subscriber to the incorporating document must take at least one share. NSULCs are incorporated by members, and members do not necessarily have to be shareholders. The incorporation fee for an NSULC is C $4,000, and there is an annual registration tax of C $2,000. Thus, when an NSULC is incorporated, a total of C $6,000 is charged by the government of Nova Scotia. It will be interesting to see if the Nova Scotia government continues to charge monopolist fees once Bill 16 is passed. It is not surprising that the Alberta government has amended its corporate legislation to allow for AULCs. A corporation may be incorporated under the Alberta Act by delivering to an authorized agent of the registrar signed articles of incorporation, documents relating to the corporate name, a notice of directors, and a notice of the registered office and records office within Alberta. Bill 16 will add section 15.3 to the Alberta Act, which will state that, in addition to meeting the current incorporation requirements, the articles of incorporation, amalgamation, amendment, continuance, or conversion of an AULC shall contain an express statement that the liability of each of the shareholders for any liability, act, or default of the AULC is unlimited in extent and joint and several in nature. Unlike in Nova Scotia, all shares of an Alberta corporation must be without nominal or par value shares. The fee charged by the government of Alberta for incorporation is C $100, and there are no annual government fees. However, as incorporation services have been privatized in Alberta that is, private-sector firms have been authorized by the government to offer most corporate registry services agent fees also apply. In Alberta, certificates of incorporation are issued by Alberta Registry Agents, as agents for the government. The service fees are not capped, and a typical agent fee for incorporation is between C $120 and C $200. Continuance A company formed under the laws of a jurisdiction other than Nova Scotia cannot directly continue as an NSULC because under section 133(4)(b) of the Nova Scotia Act, shareholder liability continues to be limited after a continuance. Thus, a corporation formed outside Nova Scotia may become an NSULC by first continuing in Nova Scotia and then amalgamating with a shell company. As is discussed below, this method requires the consent of the Nova Scotia Supreme Court. Continuance as an ULC will be much easier in Alberta. Under section 188 of the Alberta Act, an extraprovincial corporation may be continued as an Alberta corporation if so authorized by the laws of the jurisdiction in which it is incorporated, and the corporation applies to the registrar for a certificate of continuance. Bill 16 will add section 15.5(1) to the Alberta Act, which will clarify that section 188 applies to extraprovincial corporations that continue as AULCs. Section 15.5(1) will also provide that the property of such an extraprovincial corporation will continue to be the property of the AULC. As well, if the extraprovincial corporation was an ULC, the shareholders continue to be liable for any liability, act, or default of the extraprovincial corporation; if the extraprovincial corporation was incorporated as a limited corporation, the shareholders of the AULC become liable for any liability, act, or default of the extraprovincial corporation that existed before the continuance. Amalgamation Section 134 of the Nova Scotia Act provides authority for the amalgamation of two or more companies; however, only companies that are formed under or continued under that act may amalgamate. Under section 134(4) of the Nova Scotia Act, the amalgamation of companies must be approved by three-quarters of the shareholders of each company; also, under section 134(8) the amalgamation must be approved by the Supreme Court of Nova Scotia. Under section 26(9), where the power to amalgamate is not contained in the NSULC s memorandums of association, a court order is also required to pass a special resolution approving the amalgamation. All amalgamations must be long-form amalgamations. While the Nova Scotia Act does not impose 528 August 8, 2005 Tax Notes International

3 solvency tests, the court may require that notice is given to the creditors of the amalgamating companies. The Alberta Act allows for both short-form and long-form amalgamations. Parent corporations and their subsidiaries, as well as two or more subsidiaries, may use the short-form procedure, which only requires approval by the boards of directors of each amalgamating corporation. Long-form amalgamations must be approved by the requisite number of shareholders under section 183 of the Alberta Act, but unlike Nova Scotia, court approval is not required. Under section 187, Alberta corporations may be amalgamated with extraprovincial corporations where one of the corporations is a wholly owned subsidiary of the other, and if the extraprovincial corporation is so authorized by the laws of the jurisdiction in which the extraprovincial corporation is incorporated. Such amalgamations require the approval of the boards of directors of the corporations. Note, however, there is some confusion as to whether the registrar of the other jurisdiction would accept the extraprovincial amalgamation where that jurisdiction s corporate legislation does not contain a similar provision. Section 15.6(2) provides that the shareholders of the amalgamated AULC are liable for an existing claim or liability as it existed before amalgamation. The Canadian and the U.S. income tax consequences of an amalgamation should be considered before a transaction is undertaken. Amalgamations, if properly structured, may be undertaken on a tax-deferred basis under section 87 of the Income Tax Act (Canada) (the Tax Act). However, as a result of an amalgamation, each predecessor is deemed to have a year-end immediately before the amalgamation; the amalgamated corporation is treated as a new corporation; and the tax status of the predecessor corporations does not necessarily flow through to the new corporation. Liability of Shareholders As noted above, the shareholders of an NSULC are not directly liable to creditors; however, their liability is crystallized upon the winding-up or bankruptcy of the company. Liquidators of an NSULC may require current members of the NSULC to contribute to payments for the company s debts and the costs of winding up; also, under section 135 of the Nova Scotia Act, past members are required to contribute unless they ceased to be a member at least one year before the commencement of the winding-up. The liability of shareholders of AULCs is broader than that of members of NSULCs. An AULC will be defined in section 1 of the Alberta Act as a corporation whose shareholders have unlimited liability for any liability, act or default of the corporation, as set out in section Section 15.2 of the Alberta Act provides that the liability of each of the shareholders of a corporation incorporated under this Act as an unlimited liability corporation for any liability, act or default of the unlimited liability corporation is unlimited in extent and joint and several in nature. Thus, it appears the unlimited liability begins from incorporation. Residence of Directors The Nova Scotia Act does not have any Canadian residency requirements for directors of NSULCs. The Alberta Act will provide that at least onequarter of the directors of an AULC must be resident in Canada. Currently, section 105(3) of the Alberta Act provides that one-half of the directors of an Alberta corporation must be resident in Canada. The Canadian director must be a person, and cannot be a holding corporation. Powers and Duties of Directors The Nova Scotia Act does not detail the responsibilities of the directors, and the liability of directors under that act is less onerous than under other Canadian corporate statutes. Under the Nova Scotia Act, the power to manage the company is given to the members, who may delegate this authority. The incorporating documents of a company formed under the Nova Scotia Act form a contract among the members of the company and their successors. The directors powers arise from the incorporating documents, while their duties generally arise from their fiduciary duty at common law. This is unlike the Business Corporations Act model, which mandates management by the directors of a corporation. The Alberta Act allows for both short-form and long-form amalgamations. The Alberta Act gives directors the duty to manage, or supervise the management of, the business and affairs of the corporation. Section 101(1) provides that, subject to any unanimous shareholder agreement, the directors shall manage the business and affairs of the corporation. Director liability is codified in section 118 of the statute and includes liability for the improper issuance of shares, the improper acquisition of shares, improper payments of dividends, and improper payments to shareholders. Returns of Capital The Nova Scotia Act does not contain the stated capital concept. However, NSULCs can have par value and no par value shares, and par value shares may be used to regulate the paid-up capital of shares for corporate and tax purposes. In Nova Scotia, both Tax Notes International August 8,

4 shareholder and court approval is required for an NSULC to reduce its share capital. Under the Alberta Act, corporations may reduce their stated capital if they have the requisite level of shareholder approval and meet a solvency test. Section 38 of the Alberta Act pertains to reductions of stated capital and provides that a corporation may, by special resolution, reduce its stated capital. A special resolution requires the approval of twothirds of the shareholders. No par value shares can be issued in Alberta. Tax Planning Using AULCs Use of an AULC vs. a Canadian Branch AULCs avoid a number of potentially negative U.S. tax consequences associated with ownership of a foreign corporation by a U.S. person. As they are not regarded as corporations, the U.S. subpart F rules, passive foreign investment company regime, and personal holding company regime do not apply. For U.S. entities whose U.S. tax status depends on the underlying activities of the entity, a direct investment in a Canadian corporation may not be a qualifying investment. AULCs avoid this as the underlying activities of an AULC will be considered to be carried on directly by the U.S. entity. The effect of the Canadian short-term preferred shares and term-preferred share rules should be considered in structuring the transactions. An important advantage to a U.S. corporation using an AULC is that any Canadian-source losses can be flowed through to the U.S. corporate shareholder. An AULC would be a branch operation for U.S. tax purposes with the result that losses may be applied against U.S. profits of the U.S. shareholders without being subject to branch tax in Canada. The U.S. dual consolidated loss rules should not apply because, for Canadian purposes, the losses will be available only to the AULC. The use of an AULC, as opposed to a branch of a U.S. corporation, would obviate the need for a U.S. corporate shareholder to file a Canadian tax return for all of its operations. For Canadian purposes, the AULC would be regarded as a Canadian corporation, and it would file a Canadian tax return for its operations. Although treated as a branch for U.S. purposes, no Canadian branch tax arises. The AULC, if controlled by nonresidents of Canada, will not be entitled to the small-business deduction or to refundable dividend tax on hand. As a result, the corporation will be taxable at the top corporate rate of approximately 34 percent unless it is a manufacturer. Although formed in Alberta, the AULC will be subject to provincial tax only in the provinces in which it maintains a permanent establishment or has employees. Canadian corporate taxes will be available to U.S. shareholders as a foreign tax credit, within prescribed limits, against U.S. taxes. Dividends paid to a U.S. resident will be subject to Canadian withholding tax at the rate of 15 percent unless the U.S. shareholder is a corporation (other than an LLC, which is subject to 25 percent withholding) that owns more than 10 percent of the shares, in which case the rate of withholding tax is 5 percent. An unrelated pension fund would not be subject to Canadian withholding tax on dividends. Interest payments to a U.S. shareholder (other than an unrelated pension) would be subject to Canadian withholding tax at the rate of 10 percent. Interest on arm s-length nonparticipating loans from a nonresident having a term of at least five years are exempt from Canadian withholding tax provided certain conditions are met. The subsequent sale of the AULC by a U.S. shareholder (other than an LLC) would be exempt from Canadian tax under Article XIII of the Canada- U.S. tax treaty, on the assumption that the assets of the AULC are not primarily real estate. Purchase of Canadian Business Many acquisitions of Canadian private and public companies have been frustrated by the desires of Canadian shareholders to sell shares and of the American purchaser to acquire assets. For a Canadian shareholder of a Canadian private company, the ability to access the C $500,000 capital gains exemption available on the sale of shares of a qualified small-business corporation is important. One way to resolve that stalemate is to use an AULC. An AULC will also enable a U.S. corporate purchaser to treat the transaction as the acquisition of assets for U.S. tax purposes, with the result that the purchaser may deduct goodwill over 15 years and offset losses from Canadian operations against U.S. profits (subject to the U.S. dual consolidated loss rules). Taxes paid by the AULC in Canada would be available as a foreign tax credit in the United States. It is possible to continue an Ontario company that is to be sold (the target company) into an AULC and to obtain the optimum tax result for the U.S. purchaser. 1. This may be done by incorporating an AULC (Purchaserco). Shares of the corporation would be owned by the U.S. purchaser or, possibly, by a new U.S. subsidiary of the U.S. purchaser. The use of a Purchaserco will enable the U.S. purchaser to capitalize the company in the optimum manner. For 530 August 8, 2005 Tax Notes International

5 example, a U.S. purchaser may benefit from a return of capital (a reduction of paid-up capital of shares or repayment of a loan) without triggering Canadian withholding tax on a dividend. That favorable result is not available when a U.S. purchaser directly acquires the shares of a Canadian corporation from an existing shareholder. In that case, the purchased shares will have a high basis but a low paid-up capital. Purchaserco would be the purchaser of the shares of the target company once the target has been converted to an AULC. It should be understood that a shareholder of a ULC is liable for the obligations of the corporation. Accordingly, to isolate the liability, the U.S. purchaser may wish to incorporate a new company under the laws of one of the U.S. states (U.S. Holdco) to own all the shares of Purchaserco. An S corporation, a C corporation, or a U.S. limited partnership may be used. A U.S. LLC should not be used to hold the shares of Purchaserco because it would not benefit from the Canada-U.S. tax treaty. 2. Purchaserco will be financed to enable it to complete the acquisition, with the financing being structured so that 33-1/3 percent of the total financing is equity and 66-2/3 percent is interest-bearing debt of Purchaserco. That will enable the Canadian company to deduct the interest expense. Canadian thin capitalization rules permit a debt-to-equity ratio of 2 to 1 from specified nonresident shareholders. The principal of the loan and the paid-up capital of the shares may be repaid to the U.S. shareholder free of Canadian withholding tax. A director s resolution will be required to reduce the paid-up capital of the shares. That will avoid Canadian withholding tax on the return of capital. Interest paid to a U.S. resident would be subject to Canadian withholding tax at the rate of 10 percent, and dividends paid to a U.S. corporate parent (other than an LLC) would be subject to Canadian withholding tax at the rate of 5 percent. As Purchaserco is disregarded and treated as a branch of its shareholder, the interest income should not be taxable in the United States if paid to the shareholder of Purchaserco. It may be possible in the United States to amortize the goodwill of the business over 15 years. The interest deduction in Canada should compensate in part for the lack of a step-up in the cost of the assets for Canadian tax purposes. The interest rate applicable to the debt should be reasonable, taking all the circumstances into account (for example, the creditworthiness of the debt and the terms of, and security for, the loan). Debt financing could be provided by the U.S. purchaser of U.S. Holdco or any of their affiliates. 3. Purchaserco will acquire all of the outstanding shares of the target company once it has been converted to an AULC. It may be continued as an AULC immediately after the purchase (in which case a section 338 election may be filed in the United States). The target and Purchaserco would be amalgamated immediately after the sale. Because the target company will be a flow-through tax entity for U.S. purposes, the purchaser will get a stepped-up basis for the assets for U.S. tax purposes. An increase in basis will arise either as a result of the section 338 election or if the amalgamation precedes the purchase. 4. Following completion of the purchase of shares of the target company by Purchaserco, the target company and Purchaserco will amalgamate, thereby enabling interest on the debt contemplated above to be deducted from the income of the target company business in determining the taxable income of the amalgamated corporation for Canadian income tax purposes. If the target company owned nondepreciable Canadian capital property, it may be wound up or amalgamated. The drawback to using an AULC as the direct owner of a property is the exposure to both provincial capital tax and Canadian large corporation tax. The cost base of the nondepreciable capital property (land or shares) may be increased to the fair market value for Canadian tax purposes. Paragraph 88(1)(d) of the Tax Act permits a limited bump in the cost base of nondepreciable capital property (such as shares or land) of a wholly owned Canadian subsidiary on a wind-up. The bump is limited to the difference between the adjusted cost base (tax cost) of the shares of the subsidiary and the tax cost of its assets, up to the fair market value of the particular assets. This may facilitate the transfer of a U.S. subsidiary of the target Canadian company to the U.S. purchaser. The bump in the cost for Canadian tax purposes, plus the ability to return capital free of Canadian tax, may enable the U.S. subsidiary to be transferred, after the purchase, to the U.S. purchaser with a minimum of Canadian tax. The word limited cannot be used in the name of the amalgamated corporation. The new name will end with either Unlimited Liability Corporation, or the abbreviation ULC. For Canadian income tax purposes, the amalgamation will trigger a year-end of the predecessor companies. That may result in an acceleration of reporting of income for Canadian tax purposes. If a shareholder of the Ontario corporation is a U.S. resident at the time of the corporate continuance to Alberta, the transaction would be treated as Tax Notes International August 8,

6 a liquidation for U.S. tax purposes. The resulting U.S. tax may make that alternative impractical for a preexisting U.S. shareholder of an Ontario company. That has proven to be a problem when parent companies resident in Canada who have previously done an estate freeze of their Canadian companies in favor of their subsidiaries in the United States want to convert the Canadian companies to AULCs to avoid passive foreign investment company problems for the U.S. subsidiaries. It may be appropriate, however, to convert the company to an AULC if a parent company plans to issue shares of a Canadian company earning passive income to a subsidiary that is or will be a U.S. resident. Exchangeable Shares Over the past several years, it has become common for U.S. public, and some private, companies to acquire Canadian public or private companies in exchange for shares of the U.S. company. The problem for Canadian tax purposes, when the sharefor-share exchange is not to a Canadian company, is that the share exchange is taxable. The October 2000 minibudget announced that a tax-deferred cross-border share-for-share exchange provision will be considered. Draft legislation is expected this year. However, until the proposals are enacted, exchangeable shares continue to be used. That problem has been resolved by having the U.S. company form a subsidiary in Canada (perhaps an AULC) that will acquire the shares of the target company in exchange for shares. The target company may, if advantageous, be converted to an AULC, thus permitting the U.S. purchaser to get a stepped-up basis for the target company s assets for U.S. tax purposes. The share capital of the target company may be reorganized to enable the existing common shares to be converted by the Canadian shareholders into nonvoting redeemable exchangeable shares. The exchangeable shares will mirror or track the U.S. shares. There is a U.S. tax issue about whether the exchangeable share may be viewed as a U.S. share for U.S. tax purposes. The Canadian vendors will benefit from a rollover under subsection 85(1) or section 86 of the Tax Act, and the transaction may be structured to enable the Canadian vendors to claim their Canadian capital gains exemptions, if available, and to defer Canadian tax until the preferred shares are disposed of. New common shares of the target company would be issued to the AULC holding company. The AULC holding company may ultimately purchase the exchangeable shares in exchange for shares of the U.S. company. The transaction would be structured to increase the paid-up capital of the AULC holding company to reflect the purchase price, thus facilitating the future repatriation of the purchase price free of Canadian withholding tax. The preference shares would be exchangeable at the option of the Canadian shareholder for a predetermined number of shares of the U.S. company. The Canadian shareholder would typically trigger the exchange by choosing to dispose of the shares of the U.S. company. Although the transaction will be taxable in Canada, there is a matching of the Canadian gain with sale proceeds. The foreign investment entity rules require a mark-to-market method of reporting the exchangeable shares. That would be problematic if the U.S. company has more than 50 percent of the carrying value of the company in investment assets, because it would undermine the tax deferral. Except in the case of a U.S. real estate company, the gain on the sale of shares of the U.S. company by a Canadian shareholder may be protected from U.S. tax by virtue of Article XIII of the Canada-U.S. tax treaty. It has become common for a U.S. company to provide a support agreement guaranteeing the redemption or exchange of the shares and pro rata dividends on the Canadian shares (to match dividends paid in the United States) and to have the U.S. company issue voting nonparticipating shares to a U.S. trust to enable the Canadian shareholders to exercise pro rata votes in the United States. The effect of the Canadian short-term preferred shares and term-preferred share rules should be considered in structuring the transactions. A refundable tax of 66-2/3 percent or 40 percent to the Canadian company may be triggered on the payment of dividends or the redemption (rather than the sale) of the Canadian preference shares. Alternative We have been involved in several takeovers of Canadian public companies by U.S. public companies. U.S. advisers have structured several of the transactions as amalgamations to trigger a disposition for U.S. tax purposes and have made a protective election under IRC section 338. The transactions were treated as a purchase of assets for U.S. purposes, without using an NSULC. By using exchangeable shares, which are deemed for U.S. purposes as the shares into which they can be exchanged, a pooling of interests was achieved and foreign tax credits were maximized. Acquiring Canadian Real Estate While the optimum structure for the acquisition of Canadian real estate by a U.S. resident is dependent on several factors and cannot be dealt with in detail here, an AULC may be a useful vehicle. A Canadian corporation owned by a U.S. resident would not be Canadian-controlled and would pay tax 532 August 8, 2005 Tax Notes International

7 at the top corporate rate on net rental income, recaptured depreciation, taxable capital gains, and inventory gains. Dividend distributions would be subject to Canadian withholding tax at 5 percent if paid to a corporate shareholder (other than an LLC) owning at least 10 percent of the shares, and 15 percent otherwise. There would be no Canadian withholding tax on dividends paid to an unrelated U.S. pension. In many cases, taxable income is not expected for several years as a result of other expenses, including interest. By using an AULC, the U.S. shareholder may be regarded as the direct owner for U.S. tax purposes. The U.S. controlled foreign corporation and personal holding company regimes will not apply. Foreign tax credits will be available in the United States. If the property is to be financed by a U.S. financial institution, the U.S. lender may make a five-year loan to the AULC, free of Canadian withholding tax. The drawback to using an AULC as the direct owner of the property is the exposure to both provincial capital tax and Canadian large corporation tax. The interposition of a Canadian trust to take title to the property would preclude the large corporation tax but not provincial capital tax, if there is a corporate beneficial owner. Several scenarios are possible. The AULC owned by a U.S. shareholder may be a beneficiary of a Canadian trust that would take title. The AULC may be owned by a corporation owned by a U.S. shareholder (an S or C corporation). The U.S. shareholder may lend funds at interest to the Canadian trust that would currently not be subject to the thin capitalization restrictions imposed on a corporate borrower. Ideally, on the sale of the property, a purchaser would invest funds in the AULC and finance a purchase for cancellation of the shares of the U.S. shareholder, subject to Canadian withholding tax at the rate of 5 percent (assuming a significant U.S. corporate shareholder). The purchaser would discount the price accordingly. A purchase for cancellation triggers a deemed dividend for Canadian tax purposes equal to the difference between the redemption price and the paid-up capital of the shares. The shares are then deemed to be disposed of for proceeds net of the deemed dividend. A clearance certificate under section 116 is also required. Existing Canadian Investments of U.S. Shareholders As indicated above, the continuance of a Canadian company owned by a U.S. shareholder into an Alberta company would be a liquidation for U.S. tax purposes and may, therefore, not be feasible. Active Business Investments If a U.S. shareholder owned 50 percent or less of the shares of a Canadian holding company (the balance being held by a Canadian resident) that owned shares of another Canadian company carrying on an active business, the U.S. shareholder may be in a worse position if both companies are converted to AULCs. Under the current structure, the company carrying on an active business benefits from the small-business deduction (in Ontario, effectively a 19 percent combined federal and provincial tax on the first C $250,000 per annum of active business income). Also, it may pay tax-free intercorporate dividends to the holding company, which may either reinvest the dividends in active businesses or distribute the dividends at a 5 percent rate of Canadian withholding tax to a U.S. corporate shareholder. The use of an AULC may be an attractive vehicle for U.S. investors to avoid timing differences. If both the Canadian holding company and the operating company were instead AULCs, the U.S. shareholder would report the active business income in the United States on a current basis, with a foreign tax credit for the Canadian corporate tax paid. No foreign tax credit would be available in Canada. Holding Passive Canadian Investments The use of an AULC may be an attractive vehicle for U.S. investors to avoid timing differences, as well as the personal holding company and passive foreign investment company characterizations. If a Canadian resident individual is moving to the United States, consideration should be given to converting any passive Canadian holding company into an AULC before departure to step up the tax cost of the assets for U.S. tax purposes to fair market value and to benefit from the ability to claim a foreign tax credit in the United States. The investment income earned by the AULC would be taxable in the United States to the U.S. shareholder on an undistributed basis, with a foreign tax credit available for the Canadian corporate tax. As the Canadian corporate tax would be roughly 34 percent, it would exceed the U.S. tax. By interposing a U.S. corporation (for example, an S corporation) to own the AULC, the shares of the AULC would not be subject to Canadian capital gains tax on the death of the U.S. individual who owns the shares, dividends would be eligible for the 5 percent Canadian withholding tax rate, and limited liability will be achieved for the shareholders. Tax Notes International August 8,

8 If the AULC borrows funds from a Canadian lender, there is exposure for U.S. withholding tax on the interest. Because the AULC is regarded as a branch of the U.S. business for U.S. tax purposes, the interest is treated as being paid by a U.S. resident to a Canadian lender. Article XI of the Canada-U.S. treaty refers to interest arising where the payer is resident. Under U.S. Internal Revenue Code section 901(b)(3), an alien resident of the United States is allowed a credit against U.S. tax in the amount of any taxes paid or accrued during the tax year to a foreign country. When such an alien resident is a member of a partnership, he or she is entitled to his or her proportionate share of the foreign taxes paid by the partnership. For purposes of the foregoing, an AULC having more than one owner should be treated as a foreign partnership for purposes of U.S. taxation. A U.S. resident may interpose an AULC to take advantage of Canada s treaty network. Section 904 imposes a limitation on the amount of foreign tax credits that may be claimed by a taxpayer. The amount may not exceed the proportion of the tax against which the credit is taken that the taxpayer s taxable income from sources outside the United States bears to its entire taxable income for the same tax year. Whereas Canadian taxes paid by the AULC on Canadian-source interest and dividends should be treated as sourced outside of the United States, and therefore be includable in computing the numerator of the foreign tax credit limitation, subject to any treaty provisions to the contrary, the opposite would apply to gains realized on the disposition of securities (see section 865(a)). Under Article XXIV of the income tax treaty between the United States and Canada, the United States is required to allow a U.S. resident a foreign tax credit for income taxes paid to or accrued to Canada, computed in accordance with the provisions and subject to the limitations of U.S. law. In calculating the limitation, an item of income of a U.S. resident that may be taxed by Canada under the treaty is considered to arise in Canada for purposes of the foreign tax credit limitations (Article XXIV (3)). Under Article XXIX of the treaty, subject to the obligations imposed on a treaty country regarding the provision of foreign tax credits, either party to the treaty may tax its residents as if there were no income tax treaty in force between the United States and Canada. For purposes of the foregoing, the term resident of Canada means any person that, under the laws of Canada, is subject to tax by reason of the person s place of management, place of incorporation, or other criterion of similar nature. Accordingly, Canada is entitled to tax an AULC on all of its income, regardless of the source, notwithstanding that the United States may treat the AULC as a transparency or a partnership. Given that Canada is permitted, under the treaty, to tax the AULC on all of its income realized, regardless of source, as a technical matter, all of the AULC s income should be treated under Article XXIV(3) as sourced in Canada for purposes of calculating the foreign tax credit limitation on income realized by the U.S. shareholder through the AULC. See also section 865(h), under which gain realized on the disposition of stock of a foreign corporation that would otherwise be sourced in the United States will be treated as from foreign sources when, under a treaty obligation of the United States, the gain would be sourced outside of the United States. Notwithstanding the foregoing, concern has been expressed by U.S. practitioners regarding the creditability of taxes paid by an AULC regarding capital gains that it might realize on the sale or other disposition of shares of stock and debt obligation items that, if realized by a U.S. shareholder directly, would be sourced in the United States. One argument against the provision of a credit for Canadian taxes paid on those items relates to the construction accorded to Articles XXIV(3) and XXIX. The U.S. Internal Revenue Service may contend that Canada s right to tax the AULC on the gains and other income items derives not from the treaty which is intended to prevent double taxation by restricting those items of income that, when realized by a resident of one signatory to the treaty, may be taxed by the other signatory to the treaty but rather, from Canada s internal laws of taxation. It would then follow that the provisions of Article XXIV(3) treating items of income that may be taxed by Canada under the treaty have no relevance and, therefore, do not apply to resource gains realized by the Canadian company from the United States to Canada. In light of the exposure to double taxation on items that do not have a foreign source under U.S. domestic tax law, consideration should be given to restricting the AULC s investments to those items that would clearly give rise to foreign source if realized directly by the U.S. shareholder. Thus, the AULC should restrict its portfolio to debt instruments issued by entities other than the U.S. government and other U.S. issuers and hold those obligations to maturity, lest any premature sale may give rise to income other than interest sourced outside of the United States. 534 August 8, 2005 Tax Notes International

9 International Conduit A U.S. resident may interpose an AULC to take advantage of Canada s treaty network. The AULC may own shares of a company carrying on an active business in a treaty jurisdiction. Canada will not tax dividends received by the AULC out of exempt surplus of a foreign affiliate. Dividends paid to the U.S. corporate shareholder of the AULC would be subject to Canadian withholding tax at 5 percent. That may be advantageous if Canada has a more preferential treaty rate than the United States on dividends received from a third country. It should be noted that Canada s treaties generally do not have a limitation on benefits provision. Similarly, the AULC may be used for a back-to-back royalty with a third country (such as U.S.-Canada-third country), subject to transfer pricing issues. Assume that a U.S. corporation imports goods from Asia for sale to Canadian customers in Canada. The Canadian import duties are based on the sale prices to the Canadian customers. The high duties make it difficult to compete with Canadian importers. Further assume that the U.S. shareholder of the S corporation has subsidiaries in Canada. The S corporation owns 49 percent of the voting shares and, say, 90 percent of the equity shares of an AULC. The Canadian resident subsidiaries may own 51 percent of the voting shares and 10 percent of the equity shares of an AULC. The AULC would be the importer of record and would resell to the Canadian customers. The S corporation would do most of the work (order the product, provide letters of credit, arrange for shipments to Canada, and negotiate all sales on behalf of the AULC). The AULC would pay duties based on its cost of goods, rather than on the resale price. The AULC may benefit from the small-business deduction on C $250,000 of annual income, subject to Canada arguing de facto control by the U.S. parent. The bulk of the profits of the AULC would be paid as a reasonable management fee (not subject to Canadian withholding tax) to the S corporation. The S corporation may also finance the AULC with C $2 of interest-bearing debt for every C $1 of equity. Interest paid to the S corporation would be deductible in Canada and would be subject to 10 percent Canadian withholding tax. It would not be taxable to the S corporation. U.S. Beneficiaries of Canadian Trusts Assume that a U.S. resident is a beneficiary of a Canadian trust that is to be subject to the 21-year deemed realization for Canadian tax purposes. The trust is deemed to sell and reacquire its assets, other than Canadian real property, at fair market value. The tax is often avoided by rolling over the trust property to the beneficiaries before the 21st anniversary. However, subsection 107(5) of the Income Tax Act generally precludes the rollover of assets to a nonresident beneficiary of a Canadian trust. An alternative may be to have the U.S. beneficiary roll over the trust interest to an AULC in exchange for shares before the 21st anniversary of the trust. An election would be made under section 85 of the Income Tax Act and no tax would arise in the United States, as the AULC would be ignored for U.S. tax purposes. The trust may then make a tax-free capital distribution of trust property to the AULC. As the AULC will be resident in Canada, the rollover in subsection 107(2) would apply. The deemed realization would be avoided and Canadian tax would be deferred. Financing Alternative 1 A U.S. corporation may enter into a double dip financing arrangement for a Canadian operating company. The U.S. parent of the Canadian company may form two AULCs, which would enter into a partnership. The partnership would elect for U.S. tax purposes to be a foreign corporation. In this way, a U.S. parent corporation can use an AULC to finance its Canadian operating subsidiary. A U.S. parent corporation can use an AULC to finance its Canadian operating subsidiary. The AULC would borrow funds from a U.S. thirdparty lender and make a loan to the Canadian corporation. The loan from the U.S. lender may be structured to qualify for the exemption from Canadian withholding tax under paragraph 212(1)(b)(vii). To satisfy the Canadian withholding tax exemption, the loan must extend for a minimum of five years, with the borrower not required to repay more than 25 percent of the principal during the initial five years, except in case of default. The interest rate must not be participating. The AULCs would invest the funds in the partnership, which would make a loan at interest to the Canadian operating company. The loan would respect the Canadian thin capitalization rules and would be at a reasonable rate. The Canadian company would deduct the interest. The U.S. parent would not be taxable on the interest earned by the partnerships by virtue of the same country relatedperson exemption. The AULCs may receive additional funds from the U.S. parent that would enable the AULCs to pay interest to the U.S. bank free of withholding tax. The U.S. parent would deduct the interest paid by the AULCs to the U.S. bank. Financing Alternative 2 An AULC can be used by a U.S. parent corporation to finance its Canadian operating subsidiary. Tax Notes International August 8,

10 The AULC would borrow funds from a U.S. thirdparty lender and make a loan to the Canadian corporation. The loan from the U.S. lender may be structured to qualify for the exemption from withholding tax under paragraph 212(1)(b)(vii). For the interest to be deductible, the loan must extend for a minimum of five years, with the borrower not required to repay more than 25 percent of the principal during the initial five years, except in case of default. The interest rate must not be participating. The AULC would lend the funds to the operating company. The interest payable by the operating company to the AULC would be satisfied by the issuance of shares having a value equal to the interest. The U.S. parent corporation would contribute additional capital to the AULC to discharge the interest payable to the third-party lender. The loan between the AULC and the operating company must be characterized as common equity for U.S. tax purposes. It is important that section 305 of the U.S. Internal Revenue Code not apply to deem the shares to be preferred shares. That is challenging, given that Canada holds that participating interest in excess of a reasonable interest rate must not be treated as interest to the payer. (See Sherway Centre Ltd. v. R. 98 DTC 6121 (F.C.A.) case.) The objective would be to have the Canadian operating company deduct the related interest expense. The AULC would receive interest income, but have a matching interest expense. For U.S. tax purposes, the U.S. parent would not be taxable on the distribution to the AULC as the funds are reinvested in the Canadian operating subsidiary. Conclusion Americans are increasingly using NSULCs to invest in Canada. While NSULCs are tax neutral from a Canadian standpoint, they provide benefits under U.S. tax law. However, while the use of an NSULC can be advantageous from a tax perspective, NSULCs can be somewhat cumbersome from a corporate perspective as the Nova Scotia Act is based on antiquated companies law. Thus, the introduction of Bill 16 in Alberta should cause many U.S. investors to consider incorporating an AULC in Alberta, rather than incorporating an NSULC in Nova Scotia. The modern statute in Alberta, as well as the lower tax rates in the province generally and the lower incorporation fees, may mean that AULCs will be the favored entity on a going-forward basis. 536 August 8, 2005 Tax Notes International