Introduction – Unlimited Liability Company
To many people, an unlimited liability company (ULC) may sound like a contradiction in terms. After all, one of the chief purposes of incorporation is to shield the owner from the debt and other financial liabilities of the corporation. Nevertheless, ULCs are recognized in Nova Scotia, Alberta, and British Columbia. One of the main reasons for the existence and statutory recognition of ULCs is that a Canadian ULC can offer advantageous tax treatments for an American entity, often an individual corporation or a US partnership, to carry on business in Canada.
Difference Between Taxation of Limited and Unlimited Liability Corporations
Although a ULC can expose its shareholders to its debts and other financial liability, it is not treated differently compared to an ordinary limited liability corporation for Canadian tax purposes. For Canadian income tax purposes, ULCs are still treated as ordinary corporations. Interest, dividends, royalties, and other payments from a Canadian ULC to a foreign shareholder are still potentially subject to Part XIII withholding taxes, prescribed by the Income Tax Act at a rate of 25 percent. However, under Article X of the Canada – United States Tax Treaty, payments by a Canadian ULC will be reduced to a 5 percent withholding tax instead of the 25 percent under the Income Tax Act.
The advantageous tax treatment of a US-owned Canadian ULC lies in the treatment of ULCs under US tax law. Under US tax law, the ULC is disregarded as a separate legal entity from its owner(s) for tax purposes. This means that the US parent corporation or partnership will add any income, which may include interest, dividend, and royalties, from its Canadian ULC to its revenue when calculating its US tax liabilities. This triggers the operation of the Foreign Tax Credit. Unlike the case of a US-owned Canadian limited liability corporation (LLC), section 126 of the Income Tax Act applies to refund the withholding tax, since US tax law treats the earning of the Canadian ULC as part of the earning of its US shareholder.
Canada-United States Tax Treaty: Article IV(7)(b) Anti-Avoidance Rule
In 2010, Article IV(7)(b) was added to the treaty as an anti-avoidance rule, which makes the tax treatment of US-owned Canadian ULCs significantly more complicated. To understand the purpose and operation of Article IV(7)(b), we need first to understand what the terms "hybrid entity" and "fiscally transparent entity" mean.
Hybrid Entity and Fiscally Transparency
A hybrid entity is one that is subject to different tax treatment in each country. A fiscally transparent entity (FTE) means that the entity is disregarded for income tax purposes under the laws of a jurisdiction, and the owner of the entity incurs tax obligations on its gains and losses. As discussed earlier, a US-owned ULC is fiscally transparent for US tax law purposes. Furthermore, an LLC is a US-specific form of business entity that is also fiscally transparent under US tax law.
Purpose of Article IV(7)(b) - The Double Dip Structure
The purpose of Article IV(7)(b) is to prevent the "double-dip" structure by utilizing the US tax law treatment of ULCs and LLCs to claim an interest deduction in two jurisdictions and repatriate the interest income received on a tax-efficient basis. For example, two Canadian corporations can form a US limited partnership (LP) that borrows money from a third-party lender to purchase shares in a Canadian ULC. The Canadian ULC would then use that fund to invest in a US LLC, which will then loan money to an active US business or businesses. But-for the operation of Article IV(7)(b), the interest income from the active US business would receive the following tax treatments.
- For US tax purposes, interest paid by a US borrower to the US LP flows through the US LLC and Canadian ULC. However, this interest is exempt from US withholding taxes, because, from a US perspective, both the Canadian ULC and the US LLC are disregarded, and payment is considered a direct payment from the US borrower to the US LP.
- For US tax purposes, the interest paid by the US borrower is included in the US LP's income but will be offset by the interest paid by the US LP on the third-party loan
- For Canadian tax purposes, the interest paid by the US borrower to the US LLC is considered to be active business income and is included in the exempt surplus of the US LLC.
- For Canadian tax purposes, dividends from exempt surplus paid by the US LLC to the Canadian ULC are not subject to Canadian taxation, since the ULC is not regarded as fiscally transparent under Canadian tax law.
- For Canadian tax purposes, dividends received by the US LP from the Canadian ULC that are allocated to the Canadian corporate partners are not subject to Canadian taxation, since the ULC is not regarded as fiscally transparent under Canadian tax law.
- For Canadian tax purposes, the Canadian corporate partners of the US LP are entitled to an interest deduction in Canada on interest paid or payable by the US LP on the third-party loan
- For Canadian tax purposes, similar to (2), the interest paid by the Canadian-owned US partnership can be deducted by the two Canadian corporations when reporting their incomes to the CRA.
- For US and Canadian tax purposes, interest paid by US LP on the third-party loan is not subject to Canadian or US withholding taxes.
Through this complex arrangement, the interest paid to the third-party lender is deducted in both jurisdictions, while any income received from lending out money to the US borrower carrying on active business is not subject to any withholding tax in either jurisdiction and receives favorable tax treatment under the Income Tax Act.
Operation of Article IV(7)(b)
The Canadian government considered such an arrangement abusive and amended the treaty with the government of United States to include Article IV(7)(b) in order to prevent such a double-dip structure. Article IV(7)(b) applies to an FTE that is not located in the state in which the taxpayer resides: treaty benefits are denied, if the entity's fiscally transparent status in the state in which the income's recipient is located results in a different tax treatment of that income from what it would have been if the entity were not fiscally transparent. Article IV(7)(b) applies to an entity that is an FTE under the law only of the country in which the taxpayer resides and not the other country.
The CRA considers an amount of Canadian-source income, profits or gains to receive the same US tax treatment if the timing of the recognition/inclusion of the amount, the character of the amount, and the quantum of the amount are the same under the scenarios required to be compared with each other. The geographic source of an amount is relevant only if it affects the treatment of the amount, as an item of income, under the taxation laws of the US.
Article IV(7)(b) also denies treaty benefits to a US corporation that receives income from a Canadian ULC. Dividends and royalties paid by a ULC directly to a US corporation are denied treaty benefits, if the ULC is an FTE: the income's US tax treatment differs from what would have been its tax treatment, if the ULC had not been an FTE.
Tax Tip - Getting around Article IV(7)(b) - Distribution through Interest to US Partnership.
However, Article IV(7)(b) was drafted in extremely broad language and captured non-double dip structures as well. The CRA has confirmed in its ruling publications that it is possible for a Canadian ULC to distribute to its US owner without the distribution being captured by Article IV(7)(b).
One possible way is through an interest payment to a US limited partnership. If a Canadian ULC is held by a US partnership, and the ULC pays an interest payment to its parent partnership instead of dividends, the interest payment receives the same treatment under US law and Canadian law.
Consider the following example: a US corporation (Aco) forms a limited partnership (USLP) under US state law with one of its wholly-owned US subsidiaries (Bco), with Aco as the general partner and Bco as the limited partner. Aco makes a capital contribution to the USLP, which means that the interest income generated by the USLP will be mostly attributed to Aco as a general partner and Bco as a limited partner. Now, consider if Aco also forms a Canadian ULC that carries on an active business in Canada using a loan from USLP. As a result, the Canadian ULC can make interest payments back to Aco without being captured by Article IV(7)(b) for the following reasons.
- For US tax purposes, the partner and the partnership are not disregarded and are generally recognized as separate entities. The interest was considered to have been paid on a debt owed by the ULC branch of a partner to a partnership
- For Canadian tax purposes, the ULC is not disregarded from its owner. However, entitlement to treaty benefits for payments made to a partnership is determined and claimed by a partner for its share of the payment
Therefore, the interest paid by the ULC that will ultimately be received by Aco receives the same treatment for the purpose of Article IV(7)(b). The CRA has ruled that Article IV(7)(b) does not apply in this case. Additionally, the CRA has ruled that GAAR does not apply to the insertion of US LP to avoid Article IV(7)(b).
Before taking advantage of the tax treatment of a US-owned Canadian ULC, it is prudent to consult an experienced Canadian tax lawyer to ensure that your arrangement is not captured by Article IV(7)(b). Our expert Canadian tax lawyers will help you navigate through the complexities and uncertainties of international tax treaties.
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.