The unlimited liability company is an archaic form of
corporation tracing its origins back to the United Kingdom's
Companies Act of 1862. In these early years of the
Corporation, limited liability required more than mere
incorporation. It required a Royal Charter. And so, corporations
without limited liability (ULCs) were commonplace and have endured
in the U.K. to this day.
In Canada, however, the ULC was lost to history and forgotten
over the intervening one and a half centuries. Then, in the
mid-1990s, a U.S. tax practitioner discovered a surviving ULC in
the Canadian province of Nova Scotia. Having all the criteria of a
corporation except one—limited liability, this last of
the Canadian ULCs had important and hitherto unforeseen uses for
U.S. tax practitioners.
Since 1997, U.S. taxpayers can choose not to recognize a Nova
Scotia ULC as a corporation for U.S. tax purposes. A ULC can be
ignored or, in tax parlance, treated as a 'disregarded'
entity. Thus, while a ULC is a corporation like any other for
Canadian tax purposes, U.S. shareholders can deduct a ULC's
losses against their own income, just as they would the losses of a
partnership or sole proprietorship. Additional uses include the
step-up in the cost base of capital assets when the ULC is used as
an acquisition vehicle, an increase of foreign tax credits and more
besides than can be usefully described here. So popular did Nova
Scotia's ULC become, and so lucrative for that province's
government, that the provinces of Alberta and British Columbia
amended their corporate statutes to reintroduce the ULC in their
jurisdictions as well.
Then, after just ten years, the situation changed. In 2007, the
Fifth Protocol amended the Canada-U.S. Tax Convention
(1980) to deny treaty benefits to U.S. recipients of income,
profits or gains distributed by ULCs. What this means is that
payments of dividends, rents, royalties, interest and similar
passive forms of income remain subject to the full 25% tax rate
under Canada's Income Tax Act, without the usual
treaty reductions and exemptions. Effective as of January 1, 2010,
this change sounded the death knell of the ULC. But, is the ULC
And the Resurrection
The Canada Revenue Agency has endorsed a seemingly superficial
solution to the Fifth Protocol. According to its plain wording, the
treaty amendment applies only to amounts that would be treated
differently for U.S. and Canadian tax purposes by reason of the ULC
being 'fiscally transparent' (a disregarded entity) under
U.S. law. Consequently, this limitation can be avoided, first, by
increasing stated capital by the amount that would otherwise be
distributed as a dividend and then distributing the amount of this
increase as a non-taxable return of capital.
The addition to stated capital results in a taxable dividend for
Canadian tax purposes. Since this is a non-taxable event in the
U.S. regardless of whether the ULC is fiscally transparent, it
cannot be said that the treatment differs in the U.S. by reason of
the ULC being a disregarded entity. The treaty therefore continues
to apply, reducing the applicable rate from 25% to either 5% or
15%, according to whether the dividend recipient owns more or less
than 10% of the ULC's voting shares. Next, the subsequent
distribution of stated capital is a non-taxable event in both
jurisdictions, regardless of the disregarded nature of the ULC.
Treaty protection at this stage is therefore both available and
One may rightly wonder why this particular treaty amendment was
made at all.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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